**UNITED STATES**

**SECURITIES ANDEXCHANGE COMMISSION**

**Washington, DC 20549**

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**FORM 10-Q**

 

**(MARKONE)**

 

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

 

**For the quarterly period ended June 30, 2007**

 

**o**                                 TRANSITIONREPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

 

**For the transition period from    to**

 

**Commission File Number 0-28308**

 

**CollaGenexPharmaceuticals, Inc.**

(Exact Name of Registrant as Specified in Its Charter)

| **Delaware**                                                      |   | **52-1758016**                         |
|-------------------------------------------------------------------|--------|----------------------------------------|
| (State  or Other Jurisdiction of   Incorporation or Organization) |   | (I.R.S.  Employer  Identification No.) |
|                                                              |   |                                   |
| **41 University Drive, Newtown, PA**                              |   | **18940**                              |
| (Address  of Principal Executive Offices)                         |   | (Zip  Code)                            |

 

**(215) 579-7388**

(Registrant’s TelephoneNumber, Including Area Code)

 

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

| Yes:  x |   | No:  o |
|-------------------|--------|------------------|

 

Indicate by check markwhether the registrant is a large accelerated filer, an accelerated filer or anon-accelerated filer. See definition of “accelerated filer and largeaccelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):

| Large accelerated filer  o |   | Accelerated  filer  x |   | Non-accelerated  filer  o |
|--------------------------------------|--------|---------------------------------|--------|-------------------------------------|

 

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

| Yes:  o |   | No:  x |
|-------------------|--------|------------------|

 

Indicate the number ofshares outstanding of each of the issuer’s classes of common stock as of August1, 2007:

| Class                        | ** ** | **Number of Shares** |
|------------------------------|------------|----------------------|
| Common  Stock $.01 par value |       | 21,437,631           |

 

 

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**COLLAGENEX PHARMACEUTICALS, INC.**

**TABLEOF CONTENTS**
|                                             | ** ** | ** **                                                                                                       | ** ** | ** ** | ** ** |
|---------------------------------------------|------------|------------------------------------------------------------------------------------------------------------------|------------|------------|------------|
| PART I.    FINANCIAL  INFORMATION |       |                                                                                                             |       |
| Item 1.                                     |       | Financial Statements (unaudited)                                                                                 |       |       |       |
|                                        |       | Condensed Consolidated Balance Sheets as of June 30,  2007 and   December 31, 2006 (unaudited)                   |       |       |       |
|                                        |       | Condensed Consolidated Statements of Operations for the  Three Months Ended   June 30, 2007 and 2006 (unaudited) |       |       |       |
|                                        |       | Condensed Consolidated Statements of Operations for  the Six Months Ended   June 30, 2007 and 2006 (unaudited)   |       |       |       |
|                                        |       | Condensed Consolidated Statements of Cash Flows for  the Six Months Ended   June 30, 2007 and 2006 (unaudited)   |       |       |       |
|                                        |       | Notes to Condensed Consolidated Financial Statements  (unaudited)                                                |       |       |       |
| Item 2.                                     |       | Management’s  Discussion and Analysis of Financial Condition and Results of Operations                      |       |       |       |
|                                        |       | Results of Operations                                                                                            |       |       |       |
|                                        |       | Liquidity and Capital Resources                                                                                  |       |       |       |
| Item 3.                                     |       | Quantitative  and Qualitative Disclosures About Market Risk                                                      |       |       |       |
| Item 4.                                     |       | Controls and  Procedures                                                                                         |       |       |       |
| PART  II. OTHER INFORMATION                 |       |                                                                                                             |       |
| Item  1A.                                   |       | Risk  Factors                                                                                                    |       |       |       |
| Item 4.                                     |       | Submission of  Matters to a Vote of Security Holders                                                             |       |       |       |
| Item  6.                                    |       | Exhibits                                                                                                         |       |       |       |
| SIGNATURES                                  |       |                                                                                                             |       |       |       |

 

**CollaGenex Pharmaceuticals, Inc.  trademarks:**

Oracea®, Periostat®, Metastat®, Dermostat®,Nephrostat®, Osteostat®, Arthrostat®, Rheumastat®, Corneostat®, Gingistat®,IMPACSTM, PS20®, The Whole Mouth Treatment®, Restoraderm®, Dentaplex®, Lytra®,Periostat-MRTM, SansRosa®, UnorthodoxyTM, UnorthodoxycyclineTM, Aprecin®, ZedaraTM,Optistat®, Xerostat®, Periocycline®, Periostatus®, CollaGenex®, Dermastat®,Periostan®, Periostat-SR®, “C” Logo® and “The Whole Mouth Treatment” Logo®,EsteemaxTM, RubazilTM, LytrazineTM, PalytraTM, LytrazacTM, PrestemeTM, ErubatinTM,RosoralTM, ReveerilTM, CycavinTM, ZyclinilTM, and ImpakenTM.

Marks listed asregistered herein may be registered in the United States or in otherjurisdictions.  All other trade names,trademarks or service marks appearing in this Quarterly Report on Form 10-Q arethe property of their respective owners and are not property of CollaGenexPharmaceuticals, Inc. or any of our subsidiaries.

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**COLLAGENEXPHARMACEUTICALS, INC.AND SUBSIDIARIES**Condensed Consolidated Balance SheetsJune 30, 2007 and December 31, 2006(amounts in thousands, except share data)(unaudited)
| ** **                                                                                                                                                                                                             | ** ** | **June 30,** | ** ** | **December 31,** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------|------------|-----------------------|------------|
| ** **                                                                                                                                                                                                             | ** ** | **2007**          | ** ** | **2006**              | ** ** |
| **Assets**                                                                                                                                                                                                             |       |              |       |                  |       |
| Current assets:                                                                                                                                                                                                        |       |              |       |                  |       |
| Cash and cash  equivalents                                                                                                                                                                                             |       | $                 | 21,361     |                  | $          | 46,493 |   |
| Short-term  investments                                                                                                                                                                                                |       | 36,657            |       | 19,337                |       |
| Accounts  receivable, net of allowances of $290 and $187 at June 30, 2007 and  December 31, 2006, respectively                                                                                                    |       | 10,437            |       | 6,071                 |       |
| Inventories                                                                                                                                                                                                            |       | 2,183             |       | 1,959                 |       |
| Prepaid expenses  and other current assets                                                                                                                                                                             |       | 3,321             |       | 2,416                 |       |
| Total current  assets                                                                                                                                                                                                  |       | 73,959            |       | 76,276                |       |
| Equipment and leasehold  improvements, net                                                                                                                                                                             |       | 1,401             |       | 1,008                 |       |
| Intangible assets, net                                                                                                                                                                                                 |       | 1,687             |       | 1,882                 |       |
| Other assets                                                                                                                                                                                                           |       | 41                |       | 41                    |       |
| Total assets                                                                                                                                                                                                           |       | $                 | 77,088     |                  | $          | 79,207 |   |
| **Liabilities  and Stockholders’ Equity**                                                                                                                                                                         | ** ** | ** **        | ** ** | ** **            | ** ** |
| Current liabilities:                                                                                                                                                                                                   |       |              |       |                  |       |
| Accounts payable                                                                                                                                                                                                       |       | $                 | 6,656      |                  | $          | 9,066 |   |
| Accrued expenses                                                                                                                                                                                                       |       | 8,168             |       | 7,574                 |       |
| Total current  liabilities                                                                                                                                                                                             |       | 14,824            |       | 16,640                |       |
| Deferred  licensing revenue                                                                                                                                                                                            |       | 5,300             |       | —                |       |
| Other  non-current liabilities                                                                                                                                                                                         |       | 187               |       | 265                   |       |
| Total  liabilities                                                                                                                                                                                                     |       | 20,311            |       | 16,905                |       |
| Commitments and  contingencies (Notes 6 and 9)                                                                                                                                                                         |       |              |       |                  |       |
| Stockholders’ equity  (deficit):                                                                                                                                                                                  |       |              |       |                  |       |
| Preferred stock,  $0.01 par value, 5,000,000 shares authorized,                                                                                                                                                        |       |              |       |                  |       |
| 200,000 shares  of Series D-1 Cumulative Convertible Preferred Stock issued and outstanding  at June 30, 2007 and December 31, 2006 (liquidation value of $21,028 at June  30, 2007 and $21,000 at December 31, 2006); |       | 2                 |       | 2                     |       |
| 150,000 shares  of Series A Participating Preferred Stock, designated and no shares issued and  outstanding at June 30, 2007 and December 31, 2006                                                                     |       | —            |       | —                |       |
| Common stock,  $0.01 par value; 75,000,000 shares authorized and 21,407,631and 21,191,724  shares issued and outstanding at June 30, 2007 and December 31, 2006,  respectively                                         |       | 214               |       | 212                   |       |
| Additional  paid-in capital                                                                                                                                                                                            |       | 188,848           |       | 185,581               |       |
| Accumulated  other comprehensive (loss) income                                                                                                                                                                         |       | (3                | )          | 7                     |       |
| Accumulated  deficit                                                                                                                                                                                                   |       | (132,284          | )          | (123,500              | )          |
| Total  stockholders’ equity                                                                                                                                                                                       |       | 56,777            |       | 62,302                |       |
| Total liabilities and  stockholders’ equity                                                                                                                                                                       |       | $                 | 77,088     |                  | $          | 79,207 |   |

 

See accompanying notes to unaudited condensedconsolidated financial statements.

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**COLLAGENEXPHARMACEUTICALS, INC.AND SUBSIDIARIES**Condensed Consolidated Statements of OperationsFor the Three Months Ended June 30, 2007 and 2006(amounts in thousands, except share and per share data)(unaudited)
| ** **                                                                                                       | ** ** | **Three Months Ended June 30,** | ** ** |
|------------------------------------------------------------------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                                                                                       | ** ** | **2007**                                            | ** ** | **2006** | ** ** |
| Revenues:                                                                                                        |       |                                                |       |   |   |
| Net product  sales                                                                                               |       | $                                                   | 16,021     |   | $ | 3,352 |   |
| Contract  revenues                                                                                               |       | 256                                                 |       | 369 |   |
| License revenues                                                                                                 |       | 26                                                  |       | 9 |   |
| Grant revenues                                                                                                   |       | 61                                                  |       | 62 |   |
| Total revenues                                                                                                   |       | 16,364                                              |       | 3,792 |   |
| Operating expenses:                                                                                              |       |                                                |       |   |   |
| Cost of product  sales                                                                                           |       | 2,256                                               |       | 1,091 |   |
| Research and  development                                                                                        |       | 6,842                                               |       | 2,882 |   |
| Selling, general  and administrative                                                                             |       | 12,321                                              |       | 10,186 |   |
| Total operating  expenses                                                                                        |       | 21,419                                              |       | 14,159 |   |
| Operating loss                                                                                                   |       | (5,055                                              | )          | (10,367 | ) |
| Other income (expense):                                                                                          |       |                                                |       |   |   |
| Interest income                                                                                                  |       | 778                                                 |       | 490 |   |
| Interest expense                                                                                                 |       | (8                                                  | )          | — |   |
| Net loss                                                                                                         |       | (4,285                                              | )          | (9,877 | ) |
| Preferred stock  dividend                                                                                        |       | 514                                                 |       | 464 |   |
| Net loss allocable to  common stockholders                                                                       |       | $                                              | (4,799     | ) | $  | (10,341 | ) |
| Net loss per basic and  diluted share allocable to common stockholders                                           |       | $                                                   | (0.23      | ) | $ | (0.59 | ) |
| Weighted average shares used in computing net loss per basic and  diluted share allocable to common stockholders |       | 21,327,736                                          |       | 17,490,374 |   |

 

See accompanyingnotes to unaudited condensed consolidated financial statements.

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**COLLAGENEXPHARMACEUTICALS, INC.AND SUBSIDIARIES**CondensedConsolidated Statements of OperationsFor the Six Months Ended June 30, 2007 and 2006(amounts in thousands, except share and per share data)(unaudited)
| ** **                                                                                                       | ** ** | **Six Months Ended June 30,** | ** ** |
|------------------------------------------------------------------------------------------------------------------|------------|---------------------------------------------------|------------|
| ** **                                                                                                       | ** ** | **2007**                                          | ** ** | **2006** | ** ** |
| Revenues:                                                                                                        |       |                                              |       |   |   |
| Net product  sales                                                                                               |       | $                                                 | 29,975     |   | $ | 6,693 |   |
| Contract  revenues                                                                                               |       | 467                                               |       | 621 |   |
| License revenues                                                                                                 |       | 45                                                |       | 32 |   |
| Grant revenues                                                                                                   |       | 151                                               |       | 167 |   |
| Total revenues                                                                                                   |       | 30,638                                            |       | 7,513 |   |
| Operating expenses:                                                                                              |       |                                              |       |   |   |
| Cost of product  sales                                                                                           |       | 4,492                                             |       | 1,986 |   |
| Research and  development                                                                                        |       | 11,689                                            |       | 6,595 |   |
| Selling, general  and administrative                                                                             |       | 24,790                                            |       | 18,697 |   |
| Total operating  expenses                                                                                        |       | 40,971                                            |       | 27,278 |   |
| Operating loss                                                                                                   |       | (10,333                                           | )          | (19,765 | ) |
| Other income (expense):                                                                                          |       |                                              |       |   |   |
| Interest income                                                                                                  |       | 1,621                                             |       | 1,036 |   |
| Interest expense                                                                                                 |       | (16                                               | )          | — |   |
| Net loss                                                                                                         |       | (8,728                                            | )          | (18,729 | ) |
| Preferred stock  dividend                                                                                        |       | 1,028                                             |       | 928 |   |
| Net loss allocable to  common stockholders                                                                       |       | $                                                 | (9,756     | ) | $ | (19,657 | ) |
| Net loss per basic and  diluted share allocable to common stockholders                                           |       | $                                                 | (0.46      | ) | $ | (1.13 | ) |
| Weighted average shares used in computing net loss per basic and  diluted share allocable to common stockholders |       | 21,287,518                                        |       | 17,417,524 |   |

 

See accompanyingnotes to unaudited condensed consolidated financial statements.

 

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**COLLAGENEXPHARMACEUTICALS, INC.****AND SUBSIDIARIES**Condensed Consolidated Statements of Cash FlowsFor the Six Months Ended June 30, 2007 and 2006(dollars in thousands)(unaudited)
| ** **                                                                   | ** ** | **Six Months Ended June 30,** | ** ** |
|------------------------------------------------------------------------------|------------|---------------------------------------------------|------------|
| ** **                                                                   | ** ** | **2007**                                          | ** ** | **2006** | ** ** |
| Cash flows from  operating activities:                                       |       |                                              |       |   |   |
| Net loss                                                                     |       | $                                                 | (8,728     | ) | $ | (18,729 | ) |
| Adjustments to  reconcile net loss to net cash used in operating activities: |       |                                              |       |   |   |
| Stock-based  compensation                                                    |       | 1,322                                             |       | 1,668 |   |
| Write-down of  inventory                                                     |       | —                                            |       | 90 |   |
| Depreciation and  amortization expense                                       |       | 488                                               |       | 255 |   |
| Accounts  receivable provisions                                              |       | 103                                               |       | 7 |   |
| Charge for  in-process research and development                              |       | 2,182                                             |       | 200 |   |
| Changes in  operating assets and liabilities:                                |       |                                              |       |   |   |
| Accounts  receivable                                                         |       | (4,469                                            | )          | (635 | ) |
| Inventories                                                                  |       | (224                                              | )          | (451 | ) |
| Prepaid expenses  and other current assets                                   |       | (905                                              | )          | (124 | ) |
| Accounts payable                                                             |       | (2,410                                            | )          | (881 | ) |
| Accrued expenses                                                             |       | 1,539                                             |       | 284 |   |
| Other  non-current liabilities                                               |       | (35                                               | )          | (64 | ) |
| Deferred  licensing revenue                                                  |       | 5,300                                             |       | — |   |
| Net cash used in  operating activities                                       |       | (5,837                                            | )          | (18,380 | ) |
| Cash flows from  investing activities:                                       |       |                                              |       |   |   |
| Capital  expenditures                                                        |       | (686                                              | )          | (180 | ) |
| Purchase of  in-process research and development                             |       | (2,182                                            | )          | (200 | ) |
| Purchase of  short-term investments                                          |       | (38,450                                           | )          | (21,380 | ) |
| Sale or maturity  of short-term investments                                  |       | 21,120                                            |       | 18,184 |   |
| Net cash used in  investing activities                                       |       | (20,198                                           | )          | (3,576 | ) |
| Cash flows from  financing activities:                                       |       |                                              |       |   |   |
| Net proceeds  from issuance of common stock                                  |       | —                                            |       | 11,594 |   |
| Net proceeds  from the exercise of stock options                             |       | 1,570                                             |       | 972 |   |
| Net proceeds  from the exercise of common stock warrants                     |       | 376                                               |       | — |   |
| Payment of  preferred dividends                                              |       | (1,000                                            | )          | (900 | ) |
| Principal  payments on capital leases                                        |       | (43                                               | )          | — |   |
| Net cash  provided by financing activities                                   |       | 903                                               |       | 11,666 |   |
| Net decrease in  cash and cash equivalents                                   |       | (25,132                                           | )          | (10,290 | ) |
| Cash and cash  equivalents at beginning of period                            |       | 46,493                                            |       | 26,219 |   |
| Cash and cash  equivalents at end of period                                  |       | $                                                 | 21,361     |   | $ | 15,929 |   |
| Supplemental disclosure  of cash flow information:                           |       |                                              |       |   |   |
| Cash paid for  interest                                                      |       | $                                                 | 16         |   | $ | — |   |
| Reversal of  liability for UK income tax payable (see Notes 1 and 10)        |       | $                                                 | 945        |   | $ | — |   |
| Accrued liability for  capitalized product development milestone fees        |       | $                                                 | —     |   | $ | 1,000 |   |

 

See accompanying notes to unaudited condensedconsolidated financial statements.

 

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**COLLAGENEX PHARMACEUTICALS, INC.AND SUBSIDIARIES**

**NOTES TO CONDENSED CONSOLIDATEDFINANCIAL STATEMENTSJune 30, 2007 and 2006(dollars in thousands, except per share data)(unaudited)**

**Note 1 — Basis ofPresentation**

The unaudited condensed consolidated financialstatements included herein have been prepared by CollaGenex Pharmaceuticals,Inc. and subsidiaries, or the Company, pursuant to the rules and regulations ofthe Securities and Exchange Commission and in accordance with accountingprinciples generally accepted in the United States of America, or U.S. GAAP.Certain information and footnote disclosures normally included in the annualconsolidated financial statements prepared in accordance with U.S. GAAP, havebeen condensed or omitted pursuant to such rules and the regulations of theSecurities and Exchange Commission. These unaudited condensed consolidatedfinancial statements should be read in conjunction with the Company’s 2006audited consolidated financial statements and footnotes included in its AnnualReport on Form 10-K for the year ended December 31, 2006.

The accompanying unaudited condensed consolidatedfinancial statements include the results of operations of the Company and itsmajority-owned subsidiaries. All intercompany accounts and transactions havebeen eliminated in consolidation.

In the opinion of the Company’s management, theaccompanying unaudited condensed consolidated financial statements have beenprepared on a basis substantially consistent with the audited consolidatedfinancial statements for the year ended December 31, 2006 and containadjustments, all of which are of a normal, recurring nature necessary topresent fairly the Company’s consolidated financial position at June 30, 2007,the results of operations for the three and six months ended June 30, 2007 and2006, and the cash flows for the six months ended June 30, 2007 and 2006.  Interim results are not necessarilyindicative of results anticipated for the full fiscal year.

The preparation of consolidated financial statementsin conformity with U.S. GAAP requires management to make estimates andassumptions that affect the amounts reported in the consolidated financialstatements and accompanying notes. Actual results could differ from those estimates.

***Net Product Sales***

The Company generally recognizes revenues for productsales upon shipment to wholesale customers, net of estimated returns andestimates for chargebacks, applicable wholesale distribution fees and rebatesprovided that collection is probable and no significant obligations remained.However, following the launch of a third party generic competitor to Periostat® in May 2005 and commencing with the secondquarter of 2005, the Company began recognizing Periostat sales revenue based onproduct sales to end-users, which are estimated using prescription dispensingdata generated by an independent prescription tracking service, as well ason-hand inventory estimates in the distribution channel. The Company does notindependently verify the prescription dispensing data; however, it does analyzeshipments to end-users and estimates of channel inventory to determine if theprescription dispensing data is consistent with the Company’s records. For allother products sold, the Company records sales discounts, allowances, rebatesand returns upon the recognition of product sales.  The Company only accepts returns of damagedor expired products. The return allowance, when estimatable, is based on ananalysis of the historical returns of the product and the Company considers currentend user demand and wholesale and retail inventory levels. If product returnsare not estimatable, the Company defers revenue recognition for all outstandingproducts in the wholesale and retail channel that are subject to return.Chargebacks, wholesale distribution fees and rebates are based on an analysisof the applicable agreements and historical experience. In addition, theCompany also considers the volume and price of the product in the channel,trends in wholesaler and retailer inventory levels, conditions that mightaffect end-user demand (such as generic competition) and other relevantfactors.

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 The Companycurrently utilizes a patient rebate program for Oracea®  prescriptions. The Company accounts for thesepatient rebates as a reduction of net product sales.

***Contractand License Revenues***

Non-refundable up-front contract and license fees aredeferred and amortized to revenue over the related performance period. TheCompany estimates the performance period based on the specific terms of each ofthe license or contract agreements. The Company recognizes periodic paymentsover the period that the Company performs the related activities under theterms of the agreements. Revenue resulting from the achievement of milestoneevents stipulated in the agreements is recognized when the milestone isachieved if reliable, verifiable and objectively determinable evidence of fairvalue is established. If such evidence of fair value cannot be established, thetotal revenue resulting from any such agreement will be recognized over thetotal performance period of such agreement.

Pursuant to the Company’s Promotion and CooperationAgreement, or the Promotion Agreement, with Primus Pharmaceuticals, Inc., orPrimus, contract revenues for AlcortinTM, a prescription topical antifungalsteroid combination and NovacortTM,a prescription topical steroid and anesthetic, are fee-based arrangements wherecontract revenue is earned as prescriptions are filled and recognized as apercentage of the gross profit earned by Primus. The Company does not taketitle to the inventory sold by Primus under the Promotion Agreement.

***GrantRevenues***

During 2005, the Company received a grant from theNational Institutes of Health, or NIH, to fund additional research by theCompany and its collaborators on the potent anti-inflammatory effects ofincyclinide.  The Company expenses suchresearch expenditures as they are incurred and recognizes grant revenue whenearned for the portion of the expenditures that are reimbursable by the NIH.The Company recognized $61 and $151 in grant revenues for the three and sixmonths ended June 30, 2007 and $62 and $167 in grant revenues for the three andsix months ended June 30, 2006.

***Researchand Development***

Research and productdevelopment costs are expensed as incurred. Research and development expenses consist primarily of personnel costsand funds paid to third parties for the provision of services and materials fordrug development, manufacturing and formulation enhancements, clinical trials(including post FDA-approval, clinical trials), statistical analysis and reportwriting and regulatory compliance costs, including governmental filing fees.

As described above, some of the Company’s research anddevelopment is conducted by third parties, including contract research anddevelopment service providers. At the end of each quarter, the Company comparesthe payments made to each service provider to the estimated progress towardcompletion of the research or development objectives. Such estimates aresubject to change as additional information becomes available. Depending on thetiming of payments to the service providers and the progress that the Companyestimates has been made as a result of the service provided, the Company mayrecord net prepaid or accrued expense relating to these costs.

Costs to acquire in-process research and developmentprojects and technologies which have not achieved technical feasibility at thedate of acquisition are expensed as research and development expense asincurred.  The Company expensed $1,932and $2,182 of in-process research and development for the three and six monthsended June 30, 2007 and $200 for the three and six months ended June 30, 2006.

***Inventories***

Inventories are stated at the lower of cost ormarket.  Cost is determined using thefirst-in, first-out method.  Criticalaccounting estimates and assumptions related to inventory carrying values areevaluated periodically and consider the saleable quantities of inventory versusquantities of inventory on-hand.

The Company classifies costs relating to themanufacture of product inventory and samples in advance of a new product launchas research and development expense until the product is approved by the Foodand Drug Administration, or 

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FDA. Following FDAapproval, the Company’s policy is to capitalize any inventory costs that werenot previously recognized as a research and development expense.

***Stock-BasedCompensation***

The Company recognizes the fair value of stock-basedcompensation awards in the Company’s consolidated financial statements usingthe modified prospective method. The Company applies the Black-Scholes optionpricing model to determine the fair value of stock options on the date of grantand estimates key assumptions that are important elements in the model, such asthe expected stock-price volatility and expected stock option life. The Company’sestimates of these key assumptions and expected forfeiture rates are based onhistorical data and judgment regarding market trends and factors.  These estimates are not intended to predictactual future events or the value ultimately realized by individuals whoreceive equity awards.

***Cash,Cash Equivalents and Short-Term Investments***

The Company considers all highly liquid investmentswith an original maturity of three months or less at the date of acquisition tobe cash equivalents. Cash equivalent investments are held at amortized cost,which approximates fair value.  Allshort-term investments have original maturity dates of between three months andone year. The Company’s short-term investments are primarily composed ofcommercial paper and government notes. At June 30, 2007, all of the Company’sshort-term investments, carried at fair value, were classified asavailable-for-sale with unrealized gains and losses included as a separatecomponent of stockholders’ equity. The accumulated net unrealized loss onshort-term investments at June 30, 2007 was $3. The accumulated net unrealizedgain on short-term investments was $7 at December 31, 2006.

***AccountingChange***

In July 2006, the Financial Accounting StandardsBoard, or FASB, issued FASB Interpretation No. 48, *Accountingfor Uncertainty in Income Taxes,* or FIN 48, which is applicable forfiscal years beginning after December 15, 2006. FIN 48 clarifies the accountingfor uncertainty in income taxes recognized in an enterprise’s financialstatements in accordance with SFAS No. 109, *Accounting for IncomeTaxes*. FIN 48 prescribes a recognition threshold and measurement forfinancial statement recognition and measurement of a tax position reported orexpected to be reported on a tax return. FIN 48 also provides guidance onderecognition, classification, interest and penalties, accounting in interimperiods, disclosure, and transition. On January 1, 2007, the Company adoptedFIN 48. Prior to the adoption of FIN 48, the Company’s policy was to recognizetax benefits of uncertain tax positions only if it was “probable” that theposition would be sustained.  FIN 48requires application of a “more likely than not” threshold to the recognitionand derecogntion of tax positions. As a result of the adoption of FIN 48,retained earnings increased in the amount of $945 and accrued expensesdecreased by the same amount as of January 1, 2007 (see Note 10).

The Company and its subsidiaries file income taxreturns in the U.S. federal jurisdiction and in various states.  The Company has tax net operating loss andcredit carryforwards that are subject to examination for a number of yearsbeyond the year in which they are utilized for tax purposes. Since a portion ofthese carryforwards will be utilized in the future, many of these attributecarryforwards may remain subject to examination. The Company’s policy is torecord interest and penalties on uncertain tax positions as income tax expense.  At June 30, 2007, the Company has no amountsrecorded for uncertain tax positions, interest or penalties in the accompanyingconsolidated financial statements.

***RecentlyIssued Accounting Pronouncements***

In September 2006,the FASB issued Statement of Financial Accounting Standards, or SFAS, StatementNo. 157, “*Fair Value Measurements*”,or SFAS 157. SFAS 157 clarifies the definition of fair value, establishes aframework for measuring fair value and expands the disclosures on fair valuemeasurements.  SFAS 157 is effective forthe Company beginning January 1, 2008. The Company is currently evaluating theimpact, if any, of SFAS 157 adoption on its consolidated financial statements.

In February 2007,the FASB issued SFAS No.159, *The Fair Value forFinancials Assets and Financial Liabilities or* SFAS No. 159.  SFAS No. 159 permits entities to choose tomeasure financial assets and liabilities, with certain exceptions, at fairvalue at specified election dates.  Abusiness entity shall report unrealized gains and losses on items for which thefair 

8

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valueoption has been elected in earnings at each subsequent reporting date.  SFAS No. 159 is effective as of the beginningof an entity’s first fiscal year that begins after November 15, 2007.  The Company has not determined the impact, ifany, SFAS No. 159 will have on its consolidated financial statements.

**Note 2 — Concentration ofCredit and Segment Information**

The Companyinvests its excess cash in money market funds with major U.S. financialinstitutions, commercial paper, certificates of deposit and government notes,based on its investment guidelines designed to protect the safety and liquidityof these investments.

The Companycurrently contracts with a single source for the manufacturing of Oraceacapsules and Periostat tablets and has an agreement with a single company tosupply the active ingredient in Oracea and Periostat.  A single company also provides allwarehousing and distribution services to the Company.

As indicated inthe table below, three customers accounted for 91% of net product sales for thethree months ended June 30, 2007 and 88% for the three months ended June 30,2006. The same three customers accounted for 90% and 91% of net product sales duringthe six months ended June 30, 2007 and 2006.

|              | ** ** | **% of Net Product Sales  Three Months Ended** | ** ** |
|-------------------|------------|------------------------------------------------------------------------------|------------|
| **Customer**      | ** ** | **June 30,  2007**                                                      | ** ** | **June 30,  2006** | ** ** |
| Cardinal Health   |       | 44                                                                           | %          | 49 | % |
| McKesson          |       | 33                                                                           | %          | 24 | % |
| AmerisourceBergen |       | 14                                                                           | %          | 15 | % |
| Total             |       | 91                                                                           | %          | 88 | % |

 

|               | ** ** | **% of Net Product Sales  Six Months Ended ** | ** ** |
|--------------------|------------|----------------------------------------------------------------------------------|------------|
| **Customer ** | ** ** | **June 30,  2007 **                                                    | ** ** | **June 30,  2006 ** | ** ** |
| Cardinal Health    |       | 43                                                                               | %          | 52 | % |
| McKesson           |       | 34                                                                               | %          | 25 | % |
| AmerisourceBergen  |       | 13                                                                               | %          | 14 | % |
| Total              |       | 90                                                                               | %          | 91 | % |

 

Asindicated in the table below three customers accounted for 90% of gross tradeaccounts receivable balance at June 30, 2007 and 94% at December 31, 2006.

|                   | ** ** | **% of Gross Trade Accounts  Receivable Balance at** | ** ** |
|-------------------|------------|------------------------------------------------------------------------------------|------------|
| **Customer**      | ** ** | **June 30,  2007**                                                            | ** ** | **December 31,  2006** | ** ** |
| Cardinal Health   |       | 48                                                                                 | %          | 58 | % |
| McKesson          |       | 32                                                                                 | %          | 29 | % |
| AmerisourceBergen |       | 10                                                                                 | %          | 7 | % |
| Total             |       | 90                                                                                 | %          | 94 | % |

 

The Companyoperates as one business that is managed by a single management team reportingto the chief executive officer.  TheCompany does not prepare discrete financial information with respect toseparate product or product candidate areas or by location and does not haveseparately reportable segments. During each of the three and six months endedJune 30, 2007 and June 30, 2006, the Company’s total net revenues werecomprised of the following: 

9

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|                    | ** ** | **Three Months Ended** | ** ** |
|--------------------|------------|----------------------------------|------------|
| ** **         | ** ** | **June 30**                 | ** ** |
| ** **         | ** ** | **2007**                         | ** ** | **2006** | ** ** |
| Oracea             |       | 80                               | %          | N/A |   |
| Other  dermatology |       | 11                               | %          | 45 | % |
| Dental             |       | 9                                | %          | 53 | % |
| Grant revenue      |       | —                           |       | 2 | % |
| Total              |       | 100                              | %          | 100 | % |

 

|                    | ** ** | **Six Months Ended  June 30,** | ** ** |
|--------------------|------------|-----------------------------------------------|------------|
| ** **         | ** ** | **2007**                                      | ** ** | **2006** | ** ** |
| Oracea             |       | 79                                            | %          | N/A |   |
| Other  dermatology |       | 11                                            | %          | 41 | % |
| Dental             |       | 10                                            | %          | 57 | % |
| Grant revenue      |       | —                                        |       | 2 | % |
| Total              |       | 100                                           | %          | 100 | % |

 

**Note 3 — Stock-BasedCompensation**

At June 30, 2007 the Company had one activestock-based employee compensation plan. Stock option awards to employees aregranted with an exercise price equal to the fair market value of the Company’scommon stock on the date of grant. The option awards typically have a term often years and generally vest over a period ranging from two to five years.   Certain options are subject to acceleratedvesting if there is a change in control (as defined in the plan and change ofcontrol agreements, if applicable).

Stock-based compensation for the three and six monthsended June 30, 2007 and 2006 are as follows:

|                                 | ** ** | **Three Months Ended  June 30, ** | ** ** |
|--------------------------------------|------------|-------------------------------------------------------|------------|
| ** **                           | ** ** | **2007**                                              | ** ** | **2006** | ** ** |
| Research and  development            |       | $                                                     | 128        |   | $ | 111 |   |
| Selling, general  and administrative |       | 562                                                   |       | 764 |   |
| Total                                |       | $                                                     | 690        |   | $ | 875 |   |

 

|                                 | ** ** | **Six Months Ended  June 30, ** | ** ** |
|--------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                           | ** ** | **2007**                                            | ** ** | **2006** | ** ** |
| Research and  development            |       | $                                                   | 244        |   | $ | 210 |   |
| Selling, general  and administrative |       | 1,078                                               |       | 1,458 |   |
| Total                                |       | $                                                   | 1,322      |   | $ | 1,668 |   |

 

No amount of stock-based compensation cost has beencapitalized into inventory or other assets during the three and six monthsended June 30, 2007 and 2006.

Certain options granted in 2003 have been amortized atan accelerated rate versus the contractual vesting period of such options asthese options are performance-based and it was anticipated that the performancecriteria would be met prior to straight-line vesting. Such options were fullyamortized at December 31, 2006.

The following table summarizes activity under allstock option plans. 

|                                                                                 | ** ** | **Six Months Ended** | ** ** |
|---------------------------------------------------------------------------------|------------|--------------------------------|------------|
| ** **                                                                      | ** ** | **June 30,**              | ** ** |
| **(dollars in thousands, except per share data)** | ** ** | **2007**                       | ** ** | **2006** | ** ** |
| Weighted-average  fair value of options granted per share                       |       | $                              | 8.59       |   | $ | 7.69 |   |
| Intrinsic value of  options exercised                                           |       | $                              | 890        |   | $ | 446 |   |

 

At June 30, 2007, the value of the unvested portion ofall outstanding stock-related awards was $8,614 which the Company expects toamortize and recognize as compensation expense over the weighted-averageservice period of approximately three years.

The amount of cash received during the six monthsended June 30, 2007 and 2006 from the exercise of options was $1,570 and $972,respectively. No related tax benefit from the exercise of such options wasrealized as a result of the Company’s net operating loss carryforwards and fullvaluation allowance.

The Company received $376 in cash during the sixmonths ended June 30, 2007 as a result of the exercise of 40,000 warrants onJune 28, 2007.  As of June 30, 2007, theCompany has no outstanding warrants.

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The fair values of the options granted during thesix  months ended June 30, 2007 and 2006were determined using the Black-Scholes option pricing model, whichincorporates various assumptions. The risk-free rate of interest for theaverage contractual life of the option is based on U.S. Government SecuritiesTreasury Constant Maturities. Expected volatility is based on the historicaldaily volatility of the Company’s common stock. The expected life is determinedusing the short-cut method permitted under Staff Accounting Bulletin No. 107, *Share-Based Payment*. The expected dividendrate yield is zero because the Company currently does not pay or expect to paydividends to common stockholders.

The following are the weighted average assumptionsused during the respective periods:

|                         | ** ** | **Three Months Ended** | ** ** |
|-------------------------|------------|----------------------------------|------------|
| ** **              | ** ** | **June 30,**                | ** ** |
| ** **              | ** ** | **2007**                         | ** ** | **2006** | ** ** |
| Expected life in years  |       | 6.50                             |       | 6.50 |   |
| Risk-free interest rate |       | 4.80                             | %          | 4.92 | % |
| Volatility              |       | 58.53                            | %          | 66.50 | % |
| Expected dividend yield |       | —                           |       | — |   |

 

|                         | ** ** | **Six Months Ended** | ** ** |
|-------------------------|------------|--------------------------------|------------|
| ** **              | ** ** | **June 30,**              | ** ** |
| ** **              | ** ** | **2007**                       | ** ** | **2006** | ** ** |
| Expected life in years  |       | 6.50                           |       | 6.50 |   |
| Risk-free interest rate |       | 4.66                           | %          | 4.62 | % |
| Volatility              |       | 61.26                          | %          | 69.00 | % |
| Expected dividend yield |       | —                         |       | — |   |

 

Stock option activityduring the six months ended June 30, 2007 was as follows: 
| ** **                        | ** ** | ** **         | ** ** | **Weighted**            | ** ** | **Weighted Average** | ** ** | ** **         | ** ** |
|-----------------------------------|------------|--------------------|------------|-------------------------|------------|---------------------------|------------|--------------------|------------|
| ** **                        | ** ** | ** **         | ** ** | **Average**             | ** ** | **Remaining**             | ** ** | **Aggregate**      | ** ** |
| ** **                        | ** ** | **Number of** | ** ** | **Exercise Price** | ** ** | **Contractual**           | ** ** | **Intrinsic**      | ** ** |
| ** **                        | ** ** | **Shares**         | ** ** | **per Share**      | ** ** | **Term (years)**     | ** ** | **Value **(1) | ** ** |
| Outstanding at December  31, 2006 |       | 3,478,590          |       | $                       | 9.72       |                      |       |               |       |   |
| Options granted                   |       | 489,760            |       | 13.63                   |       |                      |       |               |       |
| Options  exercised                |       | (175,907           | )          | 8.92                    |       |                      |       |               |       |
| Options  forfeited or cancelled   |       | (45,913            | )          | 12.38                   |       |                      |       |               |       |
| Outstanding at June 30,  2007     |       | 3,746,530          |       | $                       | 10.21      |                      | 6.24       |               | $          | 8,205 |   |
| Unvested at June 30,  2007        |       | 1,507,003          |       | $                       | 10.64      |                      | 8.43       |               | $          | 2,652 |   |
| Exercisable at June 30, 2007      |       | 2,239,527          |       | $                       | 9.92       |                      | 4.76       |               | $          | 5,554 |   |

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(1)             Theaggregate intrinsic value was calculated based on the positive differencebetween the closing sales price of the Company’s common stock ($12.40 pershare) on June 29, 2007 and the exercise prices of the underlying options.

**Note 4 —Inventories**

Inventories at June 30,2007 and December 31, 2006 consist of the following:

|                  | ** ** | **June 30** | ** ** | **December 31,** | ** ** |
|------------------|------------|------------------|------------|-----------------------|------------|
| ** **       | ** ** | **2007**         | ** ** | **2006**              | ** ** |
| Raw materials    |       | $                | 838        |                  | $          | 978 |   |
| Work in processs |       | 382              |       | 339                   |       |
| Finished goods   |       | 963              |       | 642                   |       |
| Total            |       | $                | 2,183      |                  | $          | 1,959 |   |

 

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During the six months ended June 30, 2006 the Companyrecorded a charge of $90 to cost of product sales related to excess Periostatinventories. No charges for excess and obsolete or short—dated inventory weretaken during the six months ended June 30, 2007.

**Note5— Intangible Assets, Net**

Intangible assets, net at June 30, 2007 and December31, 2006 consist of the following:

|                                     | ** ** | **June 30,** | ** ** | **December 31,** | ** ** |
|-------------------------------------|------------|-------------------|------------|-----------------------|------------|
| ** **                          | ** ** | **2007**          | ** ** | **2006**              | ** ** |
| Oracea milestone fees               |       | $                 | 1,670      |                  | $          | 1,670 |   |
| Accumulated  amortization           |       | (111              | )          | (56                   | )          |
| Oracea milestone  fees, net         |       | $                 | 1,559      |                  | $          | 1,614 |   |
| Atrix acquired product  rights      |       | $                 | 1,876      |                  | $          | 1,876 |   |
| Accumulated  amortization           |       | (1,748            | )          | (1,608                | )          |
| Atrix acquired  product rights, net |       | $                 | 128        |                  | $          | 268 |   |
| Total intangible  assets, net       |       | $                 | 1,687      |                  | $          | 1,882 |   |

 

In August 2001,the Company signed a license agreement with Atrix Laboratories, Inc. (now knownas Tolmar Inc., a subsidiary of Technofarma, S.A.), for the rights to marketAtridox®,Atrisorb FreeFlow® and Atrisorb-D® inthe United States.  On May 14, 2007, theCompany received written notice of termination effective November 14, 2007 ofthe Company’s License Agreement with Tolmar Inc.  The amortization of acquired product rightshas been adjusted to coincide with the termination date of the contract.

Oracea milestone fees represent the unamortizedcomponent of Oracea formulation milestones paid post-FDA approval of Oracea andare being amortized on a straight-line basis over a fifteen year periodcommencing in July 2006.

Amortization expense, which is included in cost ofproduct sales, was $101 and $195 for the three and six months ended June 30,2007 and $134 and $201 for the three and six months ended June 30, 2006.

**Note6 — Line of Credit**

On October 9, 2006, the Company entered into a SixthLoan Modification Agreement with Silicon Valley Bank. Pursuant to the terms ofthis agreement, the expiration date of the amended credit facility has beenextended to October 9, 2008. Under the amended credit facility, the Company mayborrow up to the lesser of (i) $10,000 or (ii) 80% of eligible receivables pluscertain specified amounts, subject to reduction during the period October 9,2006 through December 31, 2007. The amount available to the Company is reducedby any outstanding letters of credit that may be issued under the amendedcredit facility in amounts totaling up to $2,000. As the Company pays downamounts under any letter of credit, the amount available to it under the creditfacility increases. The Company is not obligated to draw down any amounts underthe amended credit facility and any borrowings shall bear interest, payablemonthly, at Silicon Valley Bank’s prime rate, or 8.25%, at June 30, 2007. Underthe Sixth Loan Modification Agreement, the Company is charged an unused linecredit fee of 0.25% per annum. In addition, under the amended credit facility,the Company is subject to financial covenants that require the Company tomaintain certain minimum liquidity and tangible net worth levels on a quarterlybasis. During the six months ended June 30, 2007 and 2006, the Company’s unusedline of credit fee was $24 and $13, respectively. As of June 30, 2007 theCompany had no borrowings outstanding.

**Note7— Contract and License Revenues**

The Company recorded contract and license revenues of$282 and $512 for the three and six months ended June 30, 2007 and $378 and$653 for the three and six months ended June 30, 2006. In June 2005, theCompany entered into the Promotion Agreement with Primus, under which theCompany promotes Alcortin, a prescription topical antifungal steroid 

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combination, and Novacort, a prescription topicalsteroid and anesthetic. Under the Promotion Agreement, the Company receives apercentage of the gross profit arising from prescriptions written bydermatology professionals (or offices) that result in sales of the products inthe United States. Through June 30, 2006, the majority of marketing expenses,excluding sales force compensation and sample product costs, related to thepromotion of the Primus products were funded by Primus and the majority ofproduct sample costs and all sales force compensation were funded by theCompany. Effective July 1, 2006, the Company and Primus amended the PromotionAgreement. As a result of the amendment, sample expenses and marketing costs,excluding sales force compensation, are funded 60% by the Company and 40% byPrimus.

On December 18, 2006, the Company executed a Licenseand Supply Agreement with MediGene AG, or MediGene, a corporation existingunder the laws of Germany, that became effective on January 1, 2007. Under thisagreement, MediGene has the right to manufacture, register, market and sellOracea in the European Union, certain contiguous countries and Russia. MediGenemay exercise its right to manufacture Oracea at any time during the term of theagreement upon twelve months notice to the Company. During the six months endedJune 30, 2007, the Company classified the up front non-refundable fee of $5,000as non-current deferred licensing revenue. Additionally, the Company may beentitled to an additional $7,500 in milestone payments upon the achievement ofcertain annual sales thresholds achieved by MediGene. In addition, the Companywill receive an agreed upon transfer price and a royalty of 12% of annual netsales up to $10,000 and 15% of annual net sales in excess of $10,000 in thespecified territories.

In October 2002, the Company announced the executionof a license agreement with Medtronic, Inc., or Medtronic, involving the Company’sIMPACSTM compounds, pursuant to which Medtronicobtained an exclusive, worldwide license to use the compounds and certainrelated patent technology to treat aortic aneurysms and other forms of vasculardisease with medical devices. This program is still underway**.** In an amendment to the Medtronic License dated January 27,2007, the Company agreed to narrow the scope of Medtronic’s rights, to providethat the license shall become non-exclusive if certain milestones are nottimely met, and to accelerate the timing of the first milestone payment of $250upon execution of the amendment. During the six months ended June 30, 2007, theCompany received the $250 milestone payment and has classified this innon-current deferred licensing revenue in the accompanying condensedconsolidated balance sheet. Furthermilestone payments of $500 and $2,000 respectively, become due upon first humanuse and first commercial sale, of a product incorporating IMPACS technology.Medtronic must also pay royalties based on a percentage of net sales of such aproduct. Neither the Company nor Medtronic have developed a timetable forclinical development or commercial launch of any product.

**Note8 — Legal Proceedings**

The Company is involved in, or has been involved in,arbitrations or various other legal proceedings that arise from the normalcourse of business. The Company cannot predict the timing or outcome of theseclaims and other proceedings. At June 30, 2007 the Company is not involved inany arbitration and/or other legal proceedings that it expects to have amaterial adverse effect on the business, financial condition, results ofoperations or liquidity of the Company. All legal costs are expensed asincurred.

**Note9 — Legal Expenses to Defend Periostat Patents**

Under the Company’slicense agreement with The State University of New York at Stony Brook, orSUNY, covering Periostat and Oracea, the Company is entitled to deduct costsincurred to defend its patents from current and future royalties due to SUNY onnet sales of Oracea and Periostat. The cumulative legal patent defense,litigation and settlement costs incurred during the litigation period throughJune 30, 2007 currently exceeds the amount of the royalties earned by SUNY, by$3,117. This excess amount, which has been previously expensed, will beavailable to offset future royalties earned by SUNY, if any, on sales ofproducts based on the SUNY technology. The Company recorded $216 and $549 in product royalty expense andcredited legal expense for $216 and $549 related to previously expensed legalfees for the three and six months ended June 30, 2007. Accordingly, $216 and$549 were deducted from royalty payments earned by SUNY during the three andsix months ended June 30, 2007.

**Note 10 —Accrued Expenses**

Accrued expensesat June 30, 2007 and December 31, 2006 consist of the following:

13

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|                                           | ** ** | **June 30,** | ** ** | **December 31,** | ** ** |
|-------------------------------------------|------------|-------------------|------------|-----------------------|------------|
| ** **                                | ** ** | **2007**          | ** ** | **2006**              | ** ** |
| Research and  development costs           |       | $                 | 2,435      |                  | $          | 1,257 |   |
| Payroll and related  costs                |       | 1,615             |       | 3,041                 |       |
| Sales and marketing  costs                |       | 1,570             |       | 786                   |       |
| Product returns                           |       | 1,258             |       | 996                   |       |
| Patient rebates                           |       | 417               |       | 78                    |       |
| Government rebates and  distribution fees |       | 332               |       | 80                    |       |
| Professional and  consulting fees         |       | 210               |       | 132                   |       |
| State and franchise  taxes                |       | 130               |       | 161                   |       |
| Foreign taxes (1)                         |       | —            |       | 945                   |       |
| Other                                     |       | 201               |       | 98                    |       |
| Total                                     |       | $                 | 8,168      |                  | $          | 7,574 |   |

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(1)             InNovember 2004, the Company sold its U.K. and European dental assets to AlliancePharma plc, a U.K specialty pharmaceuticals company. As part of this sale in2004, the Company recorded a liability of $945 within accrued expenses foranticipated U.K. income taxes due on this sale. As described in Note 1, theCompany adopted FIN 48 on January 1, 2007. As a result of the adoption, thisliability was reversed on January 1, 2007, as the threshold for this taxuncertainty was above more-likely-than not. On January 19, 2007, the Companyreceived a notice from the U.K. taxing authorities stating that no amendmentswere needed to the Company’s previously filed tax return. Accordingly, noadditional income taxes were due related to this transaction.

**Note 11 —Common Stock Offering**

In November 2006,the Company raised $42,500 in a public offering, net of placement agency feesand all related offering expenses. In December 2005 and January 2006, theCompany raised $15,500 and $11,600 respectively, in a public offering, net ofplacement agency fees and all related offering expenses.

 

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**Item2.    Management’s Discussion and Analysisof Financial Condition and Results of Operations.**

Our management’s discussion and analysis of ourfinancial condition and results of operations include the identification ofcertain trends and other statements that may predict or anticipate futurebusiness or financial results. There are important factors that could cause ouractual results to differ materially from those indicated. See “Part II, Item1A., Risk Factors.”

**Overview**

CollaGenex Pharmaceuticals, Inc. and subsidiaries is aspecialty pharmaceutical company currently focused on developing and marketinginnovative proprietary medical therapies to the dermatology market. Wecurrently market four prescription pharmaceutical products to the dermatologymarket through our professional dermatology sales force and generate revenuesfrom four other prescription pharmaceutical products that we continue to sellto the dental market. In May 2006, the U.S. Food and Drug Administration, orthe FDA, granted us marketing approval for Oracea® for the treatment of inflammatorylesions (papules and pustules) of rosacea in adult patients. Oracea is thefirst FDA approved, orally-administered, systemically-delivered drug to treatrosacea. In July 2006, we launched Oracea to the U.S. dermatology community.

Our strategy is to become a leading developer andmarketer of innovative prescription pharmaceutical products to the dermatologymarket. We intend to continue to market our current products, including Oracea,and develop and launch new products based on our proprietary platformtechnologies as well as other technologies. Our lead development candidatesare: incyclinide (formerly known as COL-3), which is currently in two separatePhase II dose-finding clinical trials for the treatment of acne and rosacea;COL-118, a topical compound that we are developing for the treatment oferythema (skin redness) associated with dermatological conditions which iscurrently in a Phase II clinical trial; becocalcidiol a recently licensed vitaminD analogue for the topical treatment of psoriasis; and Restoraderm®, afoam-based, topical dermal drug delivery system, which is currently informulation  development.

Our marketed dermatology products are: Oracea;Pandel®, a prescription corticosteroid we licensed from Altana, Inc. inMay 2002; AlcortinTM, a prescription topical antifungal steroidcombination; and NovacortTM, a prescription topical steroid and anesthetic. InJune 2005, we executed a Promotion and Cooperation Agreement with Primus PharmaceuticalsInc., or Primus, to market Alcortin and Novacort to dermatologists.  On February 1, 2007, we received writtennotice of termination of the Sublicense Agreement relating to Pandel. EffectiveNovember 1, 2007 we will no longer generate sales from the Pandel product.

Our original dental product, Periostat®, is anorally-administered, prescription pharmaceutical product that was approved bythe FDA in September 1998 for the treatment of adult periodontitis. On May 20,2005, we terminated our dental sales force and promotional activities forPeriostat following the introduction of a third party generic version of theproduct. We also discontinued the promotion of our other dental products on May20, 2005. We continue to generate sales from Periostat and three other dentalproducts, which include Atridox®, Atrisorb FreeFlow® and Atrisorb-D®, alsoreferred to as the Atrix Products, and are each licensed from Tolmar Inc., asubsidiary of Tecnofarma, S.A.  EffectiveNovember 14, 2007, our License Agreement with Tolmar, Inc. will terminate andwe will no longer generate sales from the Atrix Products.

In addition to our marketed products, we have apipeline of product candidates in clinical and preclinical development. Theseproducts are based on our proprietary platform technologies, IMPACSTM, SansRosa®and Restoraderm or are licensed from third parties.

We were founded in 1992 and completed an initialpublic offering of our common stock in 1996. Although we achieved net incomefor the years ended December 31, 2004, 2003 and 2002, we have incurred lossesin every other year since inception and have an accumulated deficit of $132.3million at June 30, 2007. We do not expect to generate a profit for the yearending December 31, 2007.

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**Our Technology**

IMPACS (Inhibitors of Multiple Proteases AndCytokineS) are a group of compounds that demonstrate a range ofanti-inflammatory activities as well as the ability to inhibit the breakdown ofconnective tissue. Periostat and Oracea are our first FDA-approved IMPACSproducts. incyclinide is an IMPACS compound currently in clinical developmentfor the treatment of acne and rosacea. Our IMPACS technology is licensed on aperpetual basis from the Research Foundation of the State University of NewYork at Stony Brook, or SUNY. SUNY also conducts research and development onother potential applications of this technology on a project basis.

Our SansRosa technology, which we acquired inconnection with the acquisition of SansRosa Pharmaceutical Development Inc., orSansRosa, in December 2005,****is aclass of compounds that have shown promise in reducing the redness associatedwith rosacea, and we intend to formulate and develop a topical treatment forrosacea based on one or more of these compounds.

Our Restoraderm technology is a proprietary,foam-based, topical drug delivery technology that originated from a Swedishcollaborator. We have acquired all rights, title and interest to theRestoraderm technology. We have formulated various prescription and over thecounter products based on the Restoraderm technology. We do not currently havea timetable for either the initiation of clinical development or the launch ofany Restoraderm products.

Our becocalcidiol product candidate uses technologycovered by various patents and patent applications licensed from QuatRxPharmaceuticals Company, or QuatRx, pursuant to a Sub-License Agreement, or theSub-License Agreement.

**SignificantRecent Developments**

On March 29, 2007, we announced that we had commencedenrollment of patients in a 40 mg cohort of our Phase II double-blinded,placebo-controlled, dose-finding clinical trial to determine the appropriatedose for Phase III testing of incyclinide in the treatment of acne. The studyprotocol provides that the cohort would enroll 100 patients withmoderate-to-severe acne at thirteen investigational centers across the UnitedStates and that the double-blinded, placebo-controlled study would evaluate adaily 40 mg dose of incyclinide over a 12 week period with a 4-week follow up. OnMay 2, 2007, we learned that one patient had experienced apparent significantphoto-toxicity, a known side effect of tetracyclines, while participating inthe 40 mg cohort and we suspended enrollment of all new patients in thisstudy.  On May 7, 2007, we learned ofanother patient who had experienced apparent photo-toxicity and we announcedthat we had discontinued treatment of all enrolled patients.  Following further investigation, we expect tomeet with the FDA to discuss the ongoing development program for incyclinide.

On May 14, 2007, wereceived a written notice from Tolmar Inc., the successor-in-interest to eachof Atrix Laboratories, Inc. and QLT USA, Inc., regarding termination of ourLicense Agreement, or the License Agreement, with Tolmar effective as ofNovember 14, 2007.  Under the LicenseAgreement, we obtained the right to market, sell and distribute the AtrixProducts to the United States dental community. In May 2005, we discontinued all direct selling and promotionalactivities for the Atrix Products. Pursuant to an amendment to the License Agreement dated February 22,2006 by and between us and QLT USA, Inc., or the Amendment, in exchange for theelimination of annual minimum expenditures for advertising and promotionalactivities, we agreed to continue to sell the Atrix Products through ourdistributor and pay an increased royalty on net sales and an increased transferprice.  The Amendment also extended the term of the License Agreementthrough December 31, 2007 and provided that either party could terminate theLicense Agreement, with or without cause, upon six months prior written notice.

On May 15, 2007, weentered into the Sub-License Agreement with QuatRx to develop and commercializebecocalcidiol, a patented Vitamin D analogue developed by QuatRx that iscurrently in clinical development for the topical treatment of mild to moderatepsoriasis.  The Sub-License Agreementprovides us with an exclusive right, with the right to grant sublicenses, undervarious patents, patent applications and potential future patent applicationsto develop and sell products containing becocalcidiol, or the Products, for thetopical treatment psoriasis and other skin diseases.  The license granted under the Sub-LicenseAgreement is worldwide in coverage with the exception of Japan.  In exchange for the license, we paid QuatRxan upfront fee of $1.5 million and assumed all further costs of developingbecocalcidiol for the topical treatment of skin diseases.  We also agreed to pay QuatRx additional feesupon the achievement of certain development and sales milestones, including$1.5 million when the first patient enrolls in a Phase III trial, $2.0 millionwhen a new drug application, or NDA, for a product is accepted for review bythe FDA and $3.0 million when an NDA is approved. 

16

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Additional fees will be paid upon achievement ofcertain commercial milestones.  Inaddition, we agreed to make royalty payments to QuatRx based on annual futureproduct sales during country-specific royalty terms, each extending until thelater of (i) the expiration or invalidity of the last QuatRx-owned or licensedpatent in the country covering the topical use of becocalcidiol to treat skindiseases, or (ii) ten years from the first commercial sale in the country ofProducts sold by us under the license.

On May 22, 2007, weprovided written notice of termination to Oncology Therapeutic Networks, orOTN, the successor-in-interest to National Specialty Services, Inc., or NSS, ofthe our Wholesale Service Agreement with NSS, executed in February 2002 andeffective as of November 1, 2001, as amended, or the Wholesale Agreement. The notice provides for termination of the Wholesale Agreement effective on orabout November 14, 2007.  Under theWholesale Agreement, OTN acts as a non-exclusive authorized distributor of theAtrix Products OTN provides certain additional services, including marketing,sales detail report production and contract administration.

On June 19, 2007, our patent application No.11/061/866 issued as Patent No. 7,232,572, or the 572 Patent.  This patent covers the use of tetracyclinesin a sub-antibiotic amount, including Oracea specifically for the treatment ofpapules and pustules associated with rosacea. The USPTO published a notice ofallowance of the 572 Patent in February 2007.

**Results ofOperations**

*Comparisonof the Three Months Ended June 30, 2007 and June 30, 2006*

**Revenues**
| ** **                           | ** ** | ** ** | ** ** | ** ** | ** ** | **Change** | ** ** |
|--------------------------------------|------------|------------|------------|------------|------------|------------|------------|
| **(dollars in thousands)** | ** ** | **2007**   | ** ** | **2006**   | ** ** | **$**      | ** ** | **%** | ** ** |
| Net Oracea  Product Sales            |       | $          | 13,090     |       | $          | —     |       | $ | 13,090 |   | N/A |   |
| Other Net  Product Sales             |       | 2,931      |       | 3,352      |       | (421       | )          | (12.6 | )% |
| Total Net Product Sales              |       | 16,021     |       | 3,352      |       | 12,669     |       | 378.0 | % |
| Contract  Revenues                   |       | 256        |       | 369        |       | (113       | )          | (30.6 | )% |
| License Revenues                     |       | 26         |       | 9          |       | 17         |       | 188.9 | % |
| Grant Revenue                        |       | 61         |       | 62         |       | (1         | )          | (1.6 | )% |
| Total Revenues                       |       | $          | 16,364     |       | $          | 3,792      |       | $ | 12,572 |   | 331.5 | % |

 

During the three months ended June 30, 2007, total netproduct sales which included net sales of Oracea, Pandel, Periostat and theAtrix Products, increased $12.7 million, or 378.0% due primarily to sales fromOracea, which was launched in July 2006. Net revenues from dermatologicalproducts were 91.0% of total net revenues in the three months ended June 30,2007 compared to 45.0% for the three months ended June 30, 2006. Totaldeductions from gross sales for estimated product returns, trade cash discounts,managed care rebates, government and patient rebates and wholesale distributionfees for Oracea were approximately 15.5% of gross sales during the three monthsended June 30, 2007.  Prescriptions forOracea were approximately 97,400 during the three months ended June 30, 2007,representing a 24% increase in prescriptions compared to the three months endedMarch 31, 2007.

Effective November 1, 2007, our Sublicense Agreementwith Altana Inc. will terminate and we will no longer generate other net productsales from the Pandel product.  EffectiveNovember 14, 2007, our License Agreement with Tolmar, Inc. will terminate andwe will no longer generate sales from the Atrix Products.

**Cost ofProduct Sales**

Cost of product sales forthe three months ended June 30, consist of the following:

17

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| **Cost of Product Sales** | ** ** | ** ** | ** ** | ** ** | ** ** | **Change** | ** ** |
|------------------------------------------|------------|------------|------------|------------|------------|------------|------------|
| **(dollars in thousands)**     | ** ** | **2007**   | ** ** | **2006**   | ** ** | **$**      | ** ** | **%** | ** ** |
| Manufacturing  Costs (1)                 |       | $          | 854        |       | $          | 601        |       | $ | 253 |   | 42.1 | % |
| Product  Royalties (2)                   |       | 1,301      |       | 423        |       | 878        |       | 207.6 | % |
| Amortization of  Licensing Fees          |       | 101        |       | 67         |       | 34         |       | 50.7 | % |
| Cost of Product Sales                    |       | $          | 2,256      |       | $          | 1,091      |       | $ | 1,165 |   | 106.8 | % |
| Percent of Net Product  Sales            |       | 14.1       | %          | 32.5       | %          |       |       |   |   |

----

(1)             Includescontract manufacturing costs (Periostat and Oracea), transfer price (Pandel andthe Atrix Products), costs associated with excess inventories, if any, overheadcosts and internal costs. Four product lines, Oracea, Pandel, Periostat and theAtrix Products are included in cost of product sales for the three months endedJune 30, 2007 compared to three product lines, Pandel, Periostat and the AtrixProducts for the three months ended June 30, 2006.

(2)             Underour license agreement with SUNY, covering Periostat and Oracea, we are entitledto deduct prior legal costs incurred to defend its patents from current andfuture royalties due SUNY on net sales of products based on SUNYtechnology.   During the three monthsended June 30, 2007, we recorded $216 in product royalty expense and creditedlegal expense for $216 related to previously expensed legal fees. Accordingly,$216 was deducted from royalty payments earned by SUNY during the three monthsended June 30, 2007.  (see Note 9)

Cost of product sales increased $1.2 million duringthe three months ended June 30, 2007 compared to the three months ended June30, 2006 due to the addition of Oracea sales. Cost of product sales as apercent of net product sales  was 14.1%for the three months ended June 30, 2007 and 32.5% for the three months endedJune 30, 2006. The decrease in the cost of product sales as a percent of netproduct sales during the three months ended June 30, 2007 is due to theaddition of Oracea sales, which have higher gross margins than our otherproducts.

**Researchand Development**

**Research and development for the three months ended June30, consist of the following:**
| **Research and Development** | ** ** | ** ** | ** ** | ** ** | ** ** | **Change** | ** ** |
|----------------------------------------|------------|------------|------------|------------|------------|------------|------------|
| **(dollars in thousands)**   | ** ** | **2007**   | ** ** | **2006**   | ** ** | **$**      | ** ** | **%** | ** ** |
| incyclinide                            |       | $          | 1,893      |       | $          | 1,467      |       | $ | 426 |   | 29.0 | % |
| COL-118                                |       | 1,270      |       | 148        |       | 1,122      |       | 758.1 | % |
| Oracea                                 |       | 719        |       | 405        |       | 314        |       | 77.5 | % |
| becocalcidiol                          |       | 1,500      |       | —     |       | 1,500      |       | N/A |   |
| Internal and  Other Costs (1)          |       | 1,460      |       | 862        |       | 598        |       | 69.4 | % |
| Total Research  and Development        |       | $          | 6,842      |       | $          | 2,882      |       | $ | 3,960 |   | 137.4 | % |

----

(1)             Includespersonnel costs, stock option expense, regulatory compliance costs and otherproject development costs and other departmental costs.

Research and development expenses consist primarily ofcosts incurred for services and materials for drug development, manufacturingand formulation enhancements, clinical trials, purchased in-process researchand development, statistical analysis and report writing and regulatorycompliance costs (including drug approval submission and filing fees).

Research and development expenses increased $4.0million, or 137.4 %, during the three months ended June 30, 2007, due primarilyto costs associated with Phase II studies of COL-118 for the treatment oferythema, Phase II dose-finding studies of incyclinide for the treatment ofrosacea, upfront sublicense agreement fees for becocalcidiol and higherinternal personnel and overhead costs.

We estimate that if incyclinide is developed to thepoint of commercialization for both acne and rosacea indications, theadditional formulation and clinical development expenses and milestone feesexpected to be incurred to product 

18

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commercialization would be between $15 million and $20million.  We estimate that futuredevelopment and clinical costs associated with COL-118 will be approximately**$**15 to $20 million.** **Itis premature to estimate future development and clinical costs forbecocalcidiol. We are currently conducting formulation and stability work onproducts incorporating our Restoraderm technology, and we are reviewing productoptions and the timetable associated with clinical development orcommercialization.

**Selling,General and Administrative**

**Selling, general and administrativefor the three months ended June 30, consist of the following:**
| **Selling, General and Administrative** | ** ** | ** ** | ** ** | ** ** | ** ** | **Change** | ** ** |
|--------------------------------------------------------|------------|------------|------------|------------|------------|------------|------------|
| **(dollars in thousands)**                   | ** ** | **2007**   | ** ** | **2006**   | ** ** | **$**      | ** ** | **%** | ** ** |
| Marketing  Expense                                     |       | $          | 5,427      |       | $          | 3,407      |       | $ | 2,020 |   | 59.3 | % |
| Selling Expense                                        |       | 3,997      |       | 3,964      |       | 33         |       | 0.8 | % |
| Corporate &  Administrative Expense                |       | 2,335      |       | 2,051      |       | 284        |       | 13.8 | % |
| Stock Option  Expense                                  |       | 562        |       | 764        |       | (202       | )          | (26.4 | )% |
| Total Selling,  General and Administrative             |       | $          | 12,321     |       | $          | 10,186     |       | $ | 2,135 |   | 21.0 | % |

 

Marketing expenses include personnel salaries andbenefits, managed care expenses and market research, advertising andpromotional expenses related to Oracea, the Primus products and Pandel.

Selling expenses include personnel salaries andbenefits, direct selling expenses and sales training expenses.

Corporate and administrative expenses includepersonnel salaries and benefits professional, legal and consulting fees,insurance, general office expenses, business development expenses andaccounting expenses.

Selling, general and administrative expenses increasedapproximately $2.1 million, or 21.0%, during the three months ended June 30,2007, mainly due to higher promotion costs for Oracea, which was launched inJuly 2006. During the three months ended June 30, 2007 personnel costs relatedto selling, general and administrative functions increased by approximately$500,000 as compared to similar personnel costs during the three months endedJune 30, 2006. During the three months ended June 30, 2007, stock option expensedecreased approximately $202,000 due primarily to the $186,000 ofperformance-based awards amortized during the three months ended June 30,2006.  Such options were fully amortizedat December 31, 2006.

**InterestIncome (Expense)**
| **Interest Income (Expense)** | ** ** | ** ** | ** ** | ** ** | ** ** | **Change** | ** ** |
|-----------------------------------------|------------|------------|------------|------------|------------|------------|------------|
| **(dollars in thousands)**    | ** ** | **2007**   | ** ** | **2006**   | ** ** | **$**      | ** ** | **%** | ** ** |
| Interest Income                         |       | $          | 778        |       | $          | 490        |       | $ | 288 |   | 58.8 | % |
| Interest Expense                        |       | $          | (8         | )          | $          | —     |       | $ | (8 | ) | N/A |   |
| Total Other  Income (Expense)           |       | $          | 770        |       | $          | 490        |       | $ | 280 |   | 57.1 | % |

 

Interest income increased $288,000, or 58.8%,primarily due to higher average investment balances and yields for the sixmonths ended June 30, 2007 compared to the comparable period in 2006.

Interest expense of $8,000 for the three months endedJune 30, 2007 is due to the capital lease for computer equipment entered intoJuly 2006.

**PreferredStock Dividend**

Preferred stock dividends included in net lossallocable to common stockholders were $514,000 during the three months endedJune 30, 2007 and $464,000 during the three months ended June 30, 2006.

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Such preferred stock dividends are the result of ourobligations in connection with the issuance of our Series D CumulativeConvertible Preferred Stock, or the Series D Stock, in May 1999.  On December 15, 2005, we executed aRestructuring and Exchange Agreement with each of the holders of ouroutstanding Series D Stock, pursuant to which, among other things, the Series Dstockholders agreed to effect an exchange, whereby we exchanged all 200,000outstanding shares of our Series D Stock for 200,000 shares of our Series D-1Cumulative Convertible Preferred Stock, or the Series D-1 Stock.

Pursuant to the terms of our Series D-1 Stock, theholders of the Series D-1 Stock are entitled to dividends payable in cash at acurrent rate of 11.0% per annum, which are declared and paid every sixmonths.  The annual dividend rateincreases by 1.0% per annum on May 19, 2008 and each subsequent anniversarythereof until the earlier of the date that all of the shares of Series D-1 Stockare (i) converted into shares of common stock, or (ii) redeemed.

*Comparisonof the Six Months Ended June 30, 2007 and June 30, 2006*

**Revenues**
| **Revenues**                         | ** ** | ** ** | ** ** | ** ** | ** ** | **Change** | ** ** |
|--------------------------------------|------------|------------|------------|------------|------------|------------|------------|
| **(dollars in thousands)** | ** ** | **2007**   | ** ** | **2006**   | ** ** | **$**      | ** ** | **%** | ** ** |
| Net Oracea Product  Sales            |       | $          | 24,197     |       | $          | —     |       | $ | 24,197 |   | N/A |   |
| Other Net Product Sales              |       | 5,778      |       | 6,693      |       | (915       | )          | (13.7 | )% |
| Total Net  Product Sales             |       | 29,975     |       | 6,693      |       | 23,282     |       | 347.9 | % |
| Contract Revenues                    |       | 467        |       | 621        |       | (154       | )          | (24.8 | )% |
| License Revenues                     |       | 45         |       | 32         |       | 13         |       | 40.6 | % |
| Grant Revenue                        |       | 151        |       | 167        |       | (16        | )          | (9.6 | )% |
| Total Revenues                       |       | $          | 30,638     |       | $          | 7,513      |       | $ | 23,125 |   | 307.8 | % |

 

Duringthe six months ended June 30, 2007, total net product sales which included netsales of Oracea, Pandel, Periostat and the Atrix Products, increased $23.3million, or 347.9%, due primarily to sales from Oracea, which was launched inJuly 2006. Net revenues from dermatological products were 90% of total netrevenues in the six months ended June 30, 2007 compared to 41% for the sixmonths ended June 30, 2006. Total deductions from gross sales for estimatedproduct returns, trade cash discounts, managed care rebates, government andpatient rebates and wholesale distribution fees for Oracea were approximately13.9% of gross sales during the six months ended June 30, 2007.   Prescriptions for Oracea were approximately175,900 during the six months ended June 30, 2007.

 Effective November 1, 2007, our SublicenseAgreement with Altana Inc. will terminate and we will no longer generate othernet product sales from the Pandel product. Effective November 14, 2007, our License Agreement with Tolmar, Inc. willterminate and we will no longer generate sales from the Atrix Products.

**Cost ofProduct Sales**

Cost of product sales forthe six months ended June 30, consist of the following:
| **Cost of Product Sales** | ** ** | ** ** | ** ** | ** ** | ** ** | **Change** | ** ** |
|------------------------------------------|------------|------------|------------|------------|------------|------------|------------|
| **(dollars in thousands)**     | ** ** | **2007**   | ** ** | **2006**   | ** ** | **$**      | ** ** | **%** | ** ** |
| Manufacturing Costs (1)                  |       | $          | 1,756      |       | $          | 1,039      |       | 717 |   | 69.0 | % |
| Product Royalties (2)                    |       | 2,540      |       | 813        |       | $          | 1,727      |   | 212.4 | % |
| Amortization of  Licensing Fees          |       | 196        |       | 134        |       | 62         |       | 46.3 | % |
| Cost of Product  Sales                   |       | $          | 4,492      |       | $          | 1,986      |       | $ | 2,506 |   | 126.2 | % |
| Percent of Net Product Sales             |       | 15.0       | %          | 29.7       | %          |       |       |   |   |

 

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(1)          Includescontract manufacturing costs (Periostat and Oracea), transfer price (Pandel andthe Atrix Products), costs associated with excess inventories, if any, overheadcosts and internal costs. Four product lines, Oracea, Pandel, Periostat and theAtrix Products are included in cost of product sales for the six months endedJune 30, 2007 compared to three product lines, Pandel, Periostat and the AtrixProducts for the six months ended June 30, 2006.

(2)          Underour license agreement with SUNY, covering Periostat and Oracea, we are entitledto deduct prior legal costs incurred to defend its patents from current andfuture royalties due SUNY on net sales of products based on SUNYtechnology.   During the six months endedJune 30, 2007, we recorded $549 in product royalty expense and credited legalexpense for $549 related to previously expensed legal fees. Accordingly, $549was deducted from royalty payments earned by SUNY during the six months endedJune 30, 2007.  (see Note 9)

Cost of productsales increased $2.5 million during the six months ended June 30, 2007 comparedto the six months ended June 30, 2006 due to the addition of Oracea sales. Costof product sales as a percent of net product sales  was 15.0% for the six months ended June 30,2007 and 29.7% for the six months ended June 30, 2006. The decrease in the costof product sales as a percent of net product sales during the six months endedJune 30, 2007 is due to the addition of Oracea sales, which have higher grossmargins than our other products.

**Researchand Development**

**Research and development for the six months ended June 30,consist of the following:**
| **Research and Development** | ** ** | ** ** | ** ** | ** ** | ** ** | **Change** | ** ** |
|----------------------------------------|------------|------------|------------|------------|------------|------------|------------|
| **(dollars in thousands)**   | ** ** | **2007**   | ** ** | **2006**   | ** ** | **$**      | ** ** | **%** | ** ** |
| incyclinide                            |       | $          | 3,769      |       | $          | 2,911      |       | $ | 858 |   | 29.5 | % |
| COL-118                                |       | 2,427      |       | 375        |       | 2,052      |       | 547.2 | % |
| Oracea                                 |       | 1,407      |       | 1,692      |       | (285       | )          | (16.8 | )% |
| becocalcidiol                          |       | 1,500      |       | —     |       | 1,500      |       | N/A |   |
| Internal and  Other Costs (1)          |       | 2,586      |       | 1,617      |       | 969        |       | 59.9 | % |
| Total Research  and Development        |       | $          | 11,689     |       | $          | 6,595      |       | $ | 5,094 |   | 77.2 | % |

----

(1)             Includespersonnel costs, stock option expense, regulatory compliance costs and otherproject development costs and other departmental costs.

Research and development expenses consist primarily ofcosts incurred for services and materials for drug development, manufacturingand formulation enhancements, clinical trials, purchased in-process researchand development, statistical analysis and report writing and regulatorycompliance costs (including drug approval submission and filing fees).

Research and development expenses increased $5.1million, or 77.2%, during the six months ended June 30, 2007, due primarily tocosts associated with Phase II studies of COL-118 for the treatment oferythema, Phase II dose-finding studies of incyclinide for the treatment ofrosacea and acne, upfront sublicense agreement fees for becocalcidiol andhigher internal personnel and overhead costs.

 We estimatethat if incyclinide is developed to the point of commercialization for bothacne and rosacea indications, the additional formulation and clinicaldevelopment expenses and milestone fees expected to be incurred to productcommercialization would be between $15 million and $20 million. We estimatethat future development and clinical costs associated with COL-118 will beapproximately**$**15 to $20 million.** **It is premature to estimatefuture development and clinical costs for becocalcidiol. We are currentlyconducting formulation and stability work on products incorporating ourRestoraderm technology, and we are reviewing product options and the timetableassociated with clinical development or commercialization.

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**Selling,General and Administrative**

**Selling, general and administrative for the six monthsended June 30, consist of the following:**
| **Selling, General and Administrative** | ** ** | ** ** | ** ** | ** ** | ** ** | **Change** | ** ** |
|--------------------------------------------------------|------------|------------|------------|------------|------------|------------|------------|
| **(dollars in thousands)**                   | ** ** | **2007**   | ** ** | **2006**   | ** ** | **$**      | ** ** | **%** | ** ** |
| Marketing  Expense                                     |       | $          | 10,930     |       | $          | 5,924      |       | $ | 5,006 |   | 84.5 | % |
| Selling Expense                                        |       | 8,118      |       | 7,209      |       | $          | 909        |   | 12.6 | % |
| Corporate &  Administrative Expense                |       | 4,664      |       | 4,106      |       | $          | 558        |   | 13.6 | % |
| Stock Option  Expense                                  |       | 1,078      |       | 1,458      |       | $          | (380       | ) | (26.1 | )% |
| Total Selling,  General and Administrative             |       | $          | 24,790     |       | $          | 18,697     |       | $ | 6,093 |   | 32.6 | % |

 

Marketing expenses include personnel salaries andbenefits, managed care expenses and market research, advertising and promotionalexpenses related to Oracea, the Primus products and Pandel.

Selling expenses include personnel salaries andbenefits, direct selling expenses and sales training expenses.

Corporate and administrative expenses includepersonnel salaries and benefits professional, legal and consulting fees,insurance, general office expenses, business development expenses andaccounting expenses.

Selling, general and administrative expenses increasedapproximately $6.1 million, or 32.6%, during the six months ended June 30,2007, mainly due to higher promotion costs for Oracea, which was launched inJuly 2006. During the six months ended June 30, 2007 personnel costs related toselling, general and administrative functions increased by approximately $1.3million as compared to similar personnel costs during the six months ended June30, 2006. During the six months ended June 30, 2007, stock option expensedecreased approximately $380,000 due primarily to the $378,000 ofperformance-based awards amortized during the six months ended June 30,2006.  Such options were fully amortizedat December 31, 2006.

**InterestIncome (Expense)**
| **Interest Income (Expense)** | ** ** | ** ** | ** ** | ** ** | ** ** | **Change** | ** ** |
|-----------------------------------------|------------|------------|------------|------------|------------|------------|------------|
| **(dollars in thousands)**    | ** ** | **2007**   | ** ** | **2006**   | ** ** | **$**      | ** ** | **%** | ** ** |
| Interest Income                         |       | $          | 1,621      |       | $          | 1,036      |       | $ | 585 |   | 56.5 | % |
| Interest Expense                        |       | (16        | )          | —     |       | (16        | )          | N/A |   |
| Total Other  Income (Expense)           |       | $          | 1,605      |       | $          | 1,036      |       | $ | 569 |   | 54.9 | % |

 

Interest income increased $585,000, or 56.5%,primarily due to higher average investment balances and yields for the sixmonths ended June 30, 2007 compared to the comparable period in 2006.

**Interestexpense of $16,000 for the six months ended June 30, 2007 is due to the capitallease for computer equipment entered into July 2006.**

**PreferredStock Dividend**

Preferred stock dividends included in net lossallocable to common stockholders were $1.0 million during the six months endedJune 30, 2007 and $928,000 during the six months ended June 30, 2006.

Such preferred stock dividends are the result of ourobligations in connection with the issuance of our Series D Stock in May1999.  On December 15, 2005, we executeda Restructuring and Exchange Agreement with each of the holders of ouroutstanding Series D Stock, pursuant to which, among other things, the Series Dstockholders agreed to effect an exchange, whereby we exchanged all 200,000outstanding shares of our Series D Stock for 200,000 shares of our Series D-1Stock.

Pursuant to the terms of our Series D-1 Stock, theholders of the Series D-1 Stock are entitled to dividends payable in cash at acurrent rate of 11.0% per annum, which are declared and paid every sixmonths.  The annual dividend rate

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increases by 1.0% per annum on May 19, 2008 and eachsubsequent anniversary thereof until the earlier of the date that all of theshares of Series D-1 Stock are (i) converted into shares of common stock, or(ii) redeemed.

**Liquidity andCapital Resources**

***CashRequirements/Sources and Uses of Cash***

We require cash to fund our operating expenses,capital expenditures and dividend payments on our outstanding Series D-1Stock.  We have historically funded ourcash requirements primarily through the following:

·                  Public offeringsand private placements of our preferred and common stock;

·                  Cash flows fromoperations; and

·                  Exercise ofstock options and warrants.

We believe that other key factors that could affectour internal and external sources of cash are:

·                  The cost ofcommercialization activities, including product marketing and sales;

**·****                **Thesuccessful commercialization of Oracea and its acceptance by managed careorganizations and other third party payors;

·                  The success ofour dermatology franchise;

·                  The success ofour prosecution of our patent applications related to chemically modifiedtetracyclines, including incyclinide, for the treatment of acne and acne rosacea;

·                  The success ofour prosecution of our patent applications related to the SansRosa technologyand the use of COL-118 for the treatment of erythema;

·                  Receipt andmaintenance of marketing approvals from the FDA and similar foreign regulatoryauthorities for our product candidates;

·                  The success ofour preclinical, clinical and development programs;

·                  Revenues andprofits from sales of Oracea, Pandel, Periostat, and our other productcandidates, as well as the products we co-promote;

·                  The terms and conditionsof our outstanding Series D-1 Stock;

·                  Our ability to continue to meet thecovenant requirements under our amended revolving credit facility with SiliconValley Bank, or SVB;

·                  The costsinvolved in preparing, filing, prosecuting, maintaining and enforcing patentclaims and other patent-related costs, including potential litigation costs andthe results of such litigation;

·                  The extent towhich we acquire or invest in businesses, products and technologies;

·                  The success ofour application for European Union marketing authorization, for Oracea and inturn the success of MediGene AG, our foreign marketing partner for Oracea, incommercializing Oracea in the European Union;

 

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·                  The costsinvolved in obtaining and maintaining regulatory approvals and clearancesrequired to market and sell our products; and

·                  The receptivityof the capital markets to any future financings.

On May 15, 2007, we entered into the Sub-LicenseAgreement with QuatRx to develop and commercialize becocalcidiol, a patentedVitamin D analogue developed by QuatRx that is currently in clinical developmentfor the topical treatment of mild to moderate psoriasis.  The Sub-License Agreement provides us with anexclusive right, with the right to grant sublicenses, under various patents,patent applications and potential future patent applications to develop andsell products containing becocalcidiol, or the Products, for the topicaltreatment psoriasis and other skin diseases. The license granted under the Sub-License Agreement is worldwide incoverage with the exception of Japan.  Inexchange for the license, we paid QuatRx an upfront fee of $1.5 million andassumed all further costs of developing becocalcidiol for the topical treatmentof skin diseases.  We have also agreed topay QuatRx additional fees upon the achievement of certain development andsales milestones, including $1.5 million when the first patient enrolls in aPhase III trial, $2.0 million when an NDA for a product is accepted for reviewby the FDA and $3.0 million when an NDA is approved. Additional fees will bepaid upon achievement of certain commercial milestones.   In addition, we agreed to make royaltypayments to QuatRx based on annual future product sales during country-specificroyalty terms, each extending until the later of (i) the expiration orinvalidity of the last QuatRx-owned or licensed patent in the country coveringthe topical use of becocalcidiol to treat skin diseases, or (ii) ten years fromthe first commercial sale in the country of Products sold by us under thelicense.

On December 18, 2006, we executed a Product Licenseand Supply Agreement with MediGene AG, a corporation existing under the laws ofGermany, for the marketing rights to Oracea. Under the Product License andSupply Agreement, effective January 1, 2007, MediGene receives the right tomanufacture, register, market and sell Oracea in the European Union, certaincontiguous countries and Russia. MediGene may exercise its right to manufactureOracea at any time during the term of the agreement, upon twelve months noticeto us. During the six months ended June 30, 2007, we received an upfrontnon-refundable fee of $5.0 million. Additionally, we may be entitled to an additional $7.5 million inmilestone payments upon the achievement of certain annual salesthresholds.  In addition, we will receivean agreed upon transfer price and a royalty of 12% of annual net sales up to$10 million and 15% of annual net sales in excess of $10 million in thespecified territories.

In November 2006, we raised $42.5 million in a publicoffering, net of placement agency fees and all related offering expenses.  In December 2005 and January 2006, we raised$15.5 million and $11.6 million, respectively, in a public offering, net ofplacement agency fees and all related offering expenses.

On October 9, 2006, we entered into a Sixth LoanModification Agreement with SVB, or the Modification Agreement.  Pursuant to the terms of the ModificationAgreement the expiration date of the credit facility has been extended toOctober 9, 2008.  Under the amendedcredit facility, we may borrow up to the lesser of (i) $10.0 million or (ii)80% of eligible receivables plus certain specified amounts, subject toreduction during the period October 9, 2006 through December 31, 2007.  The amount available to us is reduced by anyoutstanding letters of credit that may be issued under the amended creditfacility in amounts totaling up to $2.0 million. As we pay down amounts underany letter of credit, the amount available to us under the credit facilityincreases.  We are not obligated to drawdown any amounts under the amended credit facility and any borrowings shallbear interest, payable monthly, at SVB’s prime rate, or 8.25%, at June 30,2007. Under the Modification Agreement, we are charged an unused line creditfee of 0.25% per annum. In addition, under the amended credit facility, we aresubject to financial covenants that require us to maintain certain minimumliquidity and tangible net worth levels on a quarterly basis.  During the six months ended June 30, 2007 and2006, our unused line of credit fee was $24,000 and $13,000 respectively. As ofJune 30, 2007, we had no borrowings outstanding.

At June 30, 2007,we had cash, cash equivalents and short-term investments of approximately $58.0million compared to the approximately $65.8 million balance at December 31,2006.  This decrease is primarily aresult of cash used in operations of approximately $5.8 million during the sixmonths ended June 30, 2007.  Inaccordance with investment guidelines approved by our Board of Directors, cashbalances in excess of those required to fund operations have been invested ingovernment notes, commercial paper, certificates of deposit and money marketfunds.  Our working capital at June 30,2007 was $59.1 million compared to $59.6 million at December 31, 2006.  During the six months ended June 30, 2007, weinvested $686,000 in capital expenditures and $2.2 million for in-processresearch and development, paid $1.0

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million in cash dividends to the holders of our SeriesD-1 Stock and received proceeds of $1.9 million from the exercise of commonstock options and warrants. During the six months ended June 30, 2007 we alsoinvested approximately $17.3 million in short-term investments (net ofmaturities).

We anticipate that our (i) current cash, cashequivalents and short-term investments at June 30, 2007, (ii) the availabilityof funds from our line of credit with SVB and (iii) our ability to controlvariable spending, will be sufficient to fund our operations through at least2008.****In addition, we may also finance ourcash needs through public or private equity offerings, debt financings,corporate collaboration or licensing arrangements.  However, there is no assurance that thesefinancing alternatives will be available on attractive terms, if at all, whenneeded, or in amounts sufficient to fund our operations.  Our forecast of the period of time throughwhich our financial resources will be adequate to support our operations is aforward-looking statement that involves risks and uncertainties, and actualresults could vary materially.

***Cash Flows/CashManagement***

Cash, cash equivalentsand short-term investments at June 30, 2007 were $58.0 million representing 75%of total assets compared to $65.8 million, representing 83% of total assets atDecember 31, 2006.

The change in cash and cash equivalents for the threemonths ended June 30, are as follows:

| (dollars in millions)            | ** ** | **2007** | ** ** | **2006** | ** ** |
|--------------------------------------------|------------|----------|------------|----------|------------|
| Net cash used in  operating activities     |       | $        | (5.8       | )        | $          | (18.4 | ) |
| Net cash used in  investing activities     |       | (20.2    | )          | (3.6     | )          |
| Net cash  provided by financing activities |       | 0.9      |       | 11.7     |       |
| Net decrease in cash  and cash equivalents |       | $        | (25.1      | )        | $          | (10.3 | ) |

 

Working capital at June 30, 2007 was $59.1 millioncompared to $59.6 million at December 31, 2006.

***Net Cash Used in OperatingActivities***

Net cash used in operating activities was $5.8million, including an $8.7 million net loss, and a $5.0 million payment fromMediGene, during the six months ended June 30, 2007 compared to net cash usedof $18.4 million, including an $18.7 million net loss for the six months endedJune 30, 2006.  Cash flows from operationscan vary significantly due to various factors including the timing of paymentsmade to our vendors, including research and development vendors, vendor paymentterms, customer mix and customer payment terms. Our accounts receivable balanceat June 30, 2007 increased compared to the balance at December 31,2006 primarily as a result of increased Oracea sales.

***Net Cash Used in InvestingActivities***

Net cash used in investing activities was $20.2million for the six months ended June 30, 2007, compared to $3.6 million forthe six months ended June 30, 2006.  Thechange is due primarily to $17.1 million in additional purchases of short-terminvestments, a $2.0 million increase in purchases of in-process research anddevelopment, a $506,000 increase in capital expenditures and a $3.0 million decreasein sale or maturity of short-term investments in the six months ended June 30,2007.

***Net Cash Provided By FinancingActivities***

Net cash provided by financing activities wasapproximately $903,000 for the six months ended June 30, 2007, compared to netcash provided by financing activities of $11.7 million for the six months endedJune 30, 2006. The change is due primarily to proceeds from issuance of commonstock that occurred in January 2006.

***ContractualObligations***

Our major outstanding contractual obligations relateto cash dividends on our outstanding Series D-1 Stock, operating leasesfor our office space, operating lease for commercial vehicles to be used bycertain members of our sales

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force and a capital lease for computer equipment.  The disclosures relating to our contractualobligations in our Annual Report on Form 10-K for the year ended December 31,2006 have not materially changed since we filed that report.

***CriticalAccounting Policies and Estimates***

Management’s discussion and analysis of its financialposition and results of operations are based upon our consolidated financialstatements, which have been prepared in accordance with accounting principlesgenerally accepted in the United States of America.  The preparation of these consolidatedfinancial statements requires management to make judgments and estimates thataffect the reported amounts of assets, liabilities, revenues and expenses andrelated disclosure of contingent assets and liabilities.  Management believes the critical accountingpolicies and areas that require the most significant judgments and estimates tobe used in the preparation of the consolidated financial statements pertain torevenue recognition, stock-based compensation and the valuation of deferredtaxes, intangible assets and inventory.

***RevenueRecognition***

We generally recognize revenues for product sales uponshipment to wholesale customers, net of estimated returns and estimates forchargebacks, applicable wholesale distribution fees and rebates provided thatcollection was probable and no significant obligations remained. Following thelaunch of a third party generic competitor to Periostat in May 2005 andcommencing with the second quarter of 2005, we began recognizing Periostatsales revenue based on product sales to end-users, which are estimated usingprescription dispensing data generated by an independent prescription trackingservice.  While we do not independentlyverify the prescription dispensing data, we do analyze shipments and estimatesof channel inventory to determine if the prescription dispensing data isconsistent with our records. As of June 30, 2007, we have a liability of$489,000 for potential Periostat product returns in accrued expenses on theConsolidated Balance Sheet for estimated returns prior to the change to aprescription based revenue recognition model.

We record sales discounts, allowances and returns uponrecognizing product sales. We only accept unopened returns of damaged orexpired products. The return allowance, when estimatable, is based on ananalysis of the historical returns of the product and similar products and weconsider current end user demand and wholesale and retail inventory levels. Ifproduct returns are not estimatable, we defer revenue recognition for all outstandingproducts in the wholesale and retail channel that is subject to return.Pursuant to an agreement with one major customer, product returns are notpermitted.  Chargebacks, wholesaledistribution fees and rebates are based on an analysis of the applicableagreements and historical experience. In addition, we also consider the volumeand price of the product in the channel, trends in wholesaler and retailerinventory levels, conditions that might affect end-user demand (such as genericcompetition) and other relevant factors.

The following chartdetails the activity in the reserves discussed above during the six monthsended June 30, 2007 and 2006:

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| **Six Months Ended**            | ** ** | **Balance**           | ** ** | **Current Provision**             | ** ** | **Actual Returns or**       | ** ** | ** **                  | ** ** |
|-------------------------------------------|------------|-----------------------|------------|----------------------------------------|------------|---------------------------------------|------------|-----------------------------|------------|
| **June 30, 2006**               | ** ** | **December 31,** | ** ** | **Related to Sales in** | ** ** | **Credits Issued in ** | ** ** | **Balance**                 | ** ** |
| **(dollars in thousands)**      | ** ** | **2005**              | ** ** | **First Six Months**         | ** ** | **First Six Months**        | ** ** | **June 30, 2006** | ** ** |
| Accounts  receivable allowances:          |       |                  |       |                                   |       |                                  |       |                        |       |
| Chargebacks                               |       | $                     | 78         |                                   | $          | 802                                   |       | $                           | (806       | ) | $ | 74 |   |
| Cash discounts                            |       | 26                    |       | 159                                    |       | (148                                  | )          | 37                          |       |
| Total                                     |       | $                     | 104        |                                   | $          | 961                                   |       | $                           | (954       | ) | $ | 111 |   |
|                                      |       |                  |       |                                   |       |                                  |       |                        |       |
| Accounts  payable/Accrued expenses:       |       |                  |       |                                   |       |                                  |       |                        |       |
| Patient rebates                           |       | $                     | —     |                                   | $          | —                                |       | $                           | —     |   | $ | — |   |
| Product returns (excluding Periostat) (1) |       | 98                    |       | 93                                     |       | (105                                  | )          | 86                          |       |
| Government rebates                        |       | 158                   |       | 220                                    |       | (250                                  | )          | 128                         |       |
| Wholesale distribution fees               |       | 80                    |       | 109                                    |       | (107                                  | )          | 82                          |       |
| Total                                     |       | $                     | 336        |                                   | $          | 422                                   |       | $                           | (462       | ) | $ | 296 |   |

 
| **Six Months Ended**            | ** ** | **Balance**           | ** ** | **Current Provision**             | ** ** | **Actual Returns or**       | ** ** | ** **                  | ** ** |
|-------------------------------------------|------------|-----------------------|------------|----------------------------------------|------------|---------------------------------------|------------|-----------------------------|------------|
| **June 30, 2007**               | ** ** | **December 31,** | ** ** | **Related to Sales in** | ** ** | **Credits Issued in ** | ** ** | **Balance**                 | ** ** |
| **(dollars in thousands)**      | ** ** | **2006**              | ** ** | **First Six Months**         | ** ** | **First Six Months**        | ** ** | **June 30, 2007** | ** ** |
| Accounts  receivable allowances:          |       |                  |       |                                   |       |                                  |       |                        |       |
| Chargebacks                               |       | $                     | 73         |                                   | $          | 662                                   |       | $                           | (657       | ) | $ | 78 |   |
| Cash discounts                            |       | 114                   |       | 819                                    |       | (721                                  | )          | 212                         |       |
| Total                                     |       | $                     | 187        |                                   | $          | 1,481                                 |       | $                           | (1,378     | ) | $ | 290 |   |
|                                      |       |                  |       |                                   |       |                                  |       |                        |       |
| Accounts  payable/Accrued expenses:       |       |                  |       |                                   |       |                                  |       |                        |       |
| Patient rebates                           |       | $                     | 78         |                                   | $          | 1,495                                 |       | $                           | (1,156     | ) | $ | 417 |   |
| Product returns (excluding Periostat) (1) |       | 384                   |       | 563                                    |       | (178                                  | )          | 769                         |       |
| Government rebates                        |       | 80                    |       | 113                                    |       | (122                                  | )          | 71                          |       |
| Managed care rebates                      |       | —                |       | 272                                    |       | (12                                   | )          | 260                         |       |
| Wholesale distribution fees               |       | 296                   |       | 1,075                                  |       | (753                                  | )          | 618                         |       |
| Total                                     |       | $                     | 838        |                                   | $          | 3,518                                 |       | $                           | (2,221     | ) | $ | 2,135 |   |

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(1)             Thereturns provision for Periostat was $489,000 at June 30, 2007 and $744,000 atJune 30, 2006 and is comprised of a reserve for all estimated outstandingwholesale and retail inventory subject to return, due to an inability toestimate returns*.*

***Contractand License Revenues***

Non-refundable, up-front contract and license fees aredeferred and amortized to revenue over the related performance period. Weestimate the performance period based on the specific terms of each of thelicense or contract agreements. We recognize periodic payments over the periodthat we perform the related activities under the terms of the agreements.Revenue resulting from the achievement of milestone events stipulated in theagreements is recognized when the milestone is achieved if reliable, verifiableand objectively determinable evidence of fair value is established.  If such evidence of fair value cannot beestablished the total revenue resulting from such agreements will be recognizedover the total performance period of such agreement.

Pursuant to the Promotion and Cooperation Agreementwith Primus contract revenues for Alcortin, a prescription topical antifungalsteroid combination, and Novacort, a prescription topical steroid andanesthetic, are fee-based arrangements where contract revenue is earned asprescriptions are filled and recognized as a percentage of the gross profitearned by Primus.  We do not take titleto the inventory sold by Primus under the Promotion Agreement.

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On December 18, 2006, we executed a License and SupplyAgreement with MediGene AG, a corporation existing under the laws of Germany,that became effective on January 1, 2007. Under this agreement, MediGene has the right to manufacture, register,market and sell Oracea in the European Union, certain contiguous countries andRussia. MediGene may exercise its right to manufacture Oracea at any timeduring the term of the agreement, upon twelve months notice to us. During thesix months ended June 30, 2007, we classified the up front non-refundable feeof $5.0 million as non-current deferred licensing revenue.  Additionally, we may be entitled to anadditional $7.5 million in milestone payments upon the achievement of certainannual sales thresholds achieved by MediGene. In addition, we will receive anagreed upon transfer price and a royalty of 12% of annual net sales up to $10.0million and 15% of annual net sales in excess of $10.0 million in the specifiedterritories.

***GrantRevenues***

During 2005, we received a grant from the NationalInstitutes of Health, or NIH, to fund additional research by us and ourcollaborators on the potent anti-inflammatory effects of incyclinide.  We expense such research expenditures as theyare incurred and recognize grant revenue when earned for the portion of theexpenditures that are reimbursable by the NIH. We recognized $61 and $151 in grant revenues for the three and sixmonths ended June 30, 2007 and $62 and $167 in grant revenues for the three andsix months ended June 30, 2006.

***Deferred Taxes***

In assessing the realizability of deferred tax assets,we consider the likelihood that part or all of the deferred tax assets will notbe realized.  This assessment requiressignificant judgment and estimates. The ultimate realization of the deferredtax assets is dependent upon the generation of future taxable income during theperiod in which those temporary differences become deductible. We consider ourhistory of losses, scheduled reversal of deferred tax assets and liabilities, deferredtax planning strategies, if any, and projected future taxable income over theperiods in which the deferred tax asset items are deductible. The Tax ReformAct of 1986 contains provisions that may limit the net operating loss andresearch and experimentation credit carryforwards available to be used in anygiven year upon the occurrence of certain events, including significant changesin ownership interest. We have incurred a net loss for the years ended December31, 2006 and 2005, and uncertainty regarding our future profitability hasprevented us from reaching the “more likely than not” conclusion required underthe applicable literature to recognize deferred tax assets on our ConsolidatedBalance Sheet. Accordingly, the net deferred tax assets are fully offset by avaluation allowance at June 30, 2007 and December 31, 2006.

***Intangible Assets***

***Acquired product rights and Oracea milestone fees are statedat cost, amortized over the shorter of the estimated useful life of theproducts or the contract term under which such rights have been licensed, usingthe straight-line method.  Amortizationof acquired product rights and Oracea milestone fees are charged to cost ofproduct sales.***

We are required to test for asset impairment ofacquired product rights and Oracea milestone fees whenever events orcircumstances indicate that the carrying value of an asset may not berecoverable. We apply Statement of Financial Accounting Standards, or SFAS No.144, “*Accounting for the Impairment orDisposal of Long-Lived Assets*,” in order to determine whether or notan asset is impaired. This standard requires an impairment analysis whenindicators of impairment are present. When such indicators are present, thestandard indicates that if the sum of the future expected cash flows from theasset, undiscounted and without interest charges, are less than the carryingvalue, asset impairment must be recognized in the financial statements.  The amount of the impairment is thedifference between the fair value of the asset and the carrying value of theasset.

In making future cash flow analyses of our intangibleassets we make assumptions relating to: (i) the intended use of the product and the expected future cash flowsresulting directly from such use; (ii) generic competitor activities andregulatory initiatives that affect our products; and (iii) customer preferencesand expected managed care reimbursement.

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***Inventories***

Inventories are stated at the lower of cost ormarket.  Cost is determined using thefirst-in, first-out method.  Criticalaccounting estimates and assumptions related to inventory carrying values areevaluated periodically and consider the saleable quantities of inventory versusquantities of inventory on-hand.

We classify direct manufacturing costs relating toinventory and samples manufactured in advance of a new product launch asresearch and development expense until such time as we receive an approvalletter from the FDA for a new product. Following FDA approval of the product,we capitalize any inventory costs relating to that product that were notpreviously expensed.

***Researchand Development***

Research and productdevelopment costs are expensed as incurred. Research and development expenses consist primarily of personnel costsand funds paid to third parties for the provision of services and materials fordrug development, manufacturing and formulation enhancements, clinical trials(including post FDA-approval, clinical trials), statistical analysis and reportwriting and regulatory compliance costs, including governmental filing fees.

As described above, some of our research anddevelopment is conducted by third parties, including contract research anddevelopment service providers. At the end of each quarter, we compare thepayments made to each service provider to the estimated progress towardcompletion of the research or development objectives.  Such estimates are subject to change asadditional information becomes available. Depending on the timing of paymentsto the service providers and the progress that we estimate has been made as aresult of service provided, we may record net prepaid or accrued expenserelating to these costs.

Costs to acquire in-process research and developmentprojects and technologies which have not achieved technical feasibility at thedate of acquisition are expensed as research and development expense asincurred.  We expensed $1,932 and $2,182of in-process research and development for the three and six months ended June30, 2007 and $200 for the three and six months ended June 30, 2006.

***Stock-BasedCompensation***

 We recognizethe fair value of stock-based compensation awards in our consolidated financialstatements using the modified prospective method. We apply the Black-Scholesoption pricing model to determine the fair value of stock options on the dateof grant, and we estimate key assumptions that are important elements in themodel, such as the expected stock-price volatility and expected stock optionlife. Our estimates of these important assumptions and expected forfeiturerates are based on historical data and judgment regarding market trends andfactors. These estimates are not intended to predict actual future events orthe value ultimately realized by individuals who receive equity awards.

Critical accounting estimates and the relatedassumptions are evaluated periodically as conditions warrant, and changes tosuch estimates are recorded as new information or changed conditions requirerevision.

***AccountingChange***

In July 2006, the Financial Accounting StandardsBoard, or FASB,  issued FASBInterpretation No. 48, *Accounting for Uncertaintyin Income Taxes,* or FIN 48, which is applicable for fiscal yearsbeginning after December 15, 2006. FIN 48 clarifies the accounting foruncertainty in income taxes recognized in an enterprise’s financial statementsin accordance with SFAS No. 109, *Accounting for IncomeTaxes*. FIN 48 prescribes a recognition threshold and measurement forfinancial statement recognition and measurement of a tax position reported orexpected to be reported on a tax return. FIN 48 also provides guidance onderecognition, classification, interest and penalties, accounting in interimperiods, disclosure, and transition. On January 1, 2007, we adopted FIN 48.Prior to the adoption of FIN 48, our policy was to recognize tax benefits ofuncertain tax positions only if it was “probable” that the position would besustained. FIN 48 requires application of a “more likely than not” threshold tothe recognition and derecogntion of tax positions. As a result of the adoptionof FIN 48,

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retained earning increased in the amount of $945,000and accrued expenses decreased by the same amount as of January 1, 2007.

***RecentlyIssued Accounting Pronouncements***

In September 2006, theFASB issued Statement of Financial Accounting Standards, or SFAS No. 157, “*Fair Value Measurements*”, or SFAS157.  SFAS 157 clarifies the definitionof fair value, establishes a framework for measuring fair value and expands thedisclosures on fair value measurements. SFAS 157 is effective for us beginning January 1, 2008.  We are currently evaluating the impact, ifany, of SFAS 157 adoption on our consolidated financial statements.

In February 2007, the FASB issued SFAS No.159, *The Fair Value for Financials Assets and Financial Liabilities*.SFAS No.159 permits entities to choose to measure financial assets andliabilities, with certain exceptions, at fair value at specified electiondates.  A business entity shall reportunrealized gains and losses on items for which the fair value option has beenelected in earnings at each subsequent reporting date.  SFAS No. 159 is effective as of the beginningof an entity’s first fiscal year that begins after November 15, 2007.  We have not determined the impact, if any,SFAS No. 159 will have on its financial statements.

**Item 3.**                          Quantitativeand Qualitative Disclosures About Market Risk.

We had cash and cash equivalents and short-terminvestments at June 30, 2007 which are exposed to the impact of interest ratechanges and our interest income fluctuates as interest rates change.  Due to the short-term nature of ourinvestments in money market funds, the carrying values of our cash equivalentsapproximate their fair value at June 30, 2007. Our short-term investments incommercial paper, certificates of deposit and government notes are carried atfair value.

**Item 4.**                          Controlsand Procedures.

Our management, with the participation of our chiefexecutive officer and chief financial officer, evaluated the effectiveness ofthe Company’s disclosure controls and procedures as of June 30, 2007.  The term “disclosure controls and procedures,”as defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act, meanscontrols and other procedures of a company that are designed to ensure thatinformation required to be disclosed by a company in the reports that it filesor submits under the Exchange Act is recorded, processed, summarized andreported, within the time periods specified in the SEC’s rules and forms.  Disclosure controls and procedures include,without limitation, controls and procedures designed to ensure that informationrequired to be disclosed by a company in the reports that it files or submitsunder the Exchange Act is accumulated and communicated to the company’smanagement, including its principal executive and principal financial officersas appropriate to allow timely decisions regarding required disclosure.  Our management recognizes that any controlsand procedures, no matter how well designed and operated, can provide onlyreasonable assurance of achieving their objectives and management necessarilyapplies its judgment in evaluating the cost-benefit relationship of possiblecontrols and procedures.  Based on theevaluation of our disclosure controls and procedures as of June 30,  2007, our chief executive officer and chieffinancial officer concluded that, as of such date, our disclosure controls andprocedures were effective at the reasonable assurance level.

No change in our internal control over financialreporting (as defined in Rules 13a-15(f) and 15d-15(f) underthe Exchange Act) occurred during the fiscal quarter ended June 30, 2007 thathas materially affected, or is reasonably likely to materially affect, ourinternal control over financial reporting.

 

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**PART II.  OTHER INFORMATION**

**Item 1A.**                 Risk Factors

*Statements contained or incorporatedby reference in this Quarterly Report on Form 10-Q that are not based onhistorical fact are “forward-looking statements” within the meaning of thePrivate Securities Litigation Reform Act of 1995, Section 27A of the SecuritiesAct of 1933, as amended, and Section 21E of the Securities Exchange Act of1934, as amended.  These forward-lookingstatements regarding future events and our future results are based on currentexpectations, estimates, forecasts, and projections and the beliefs andassumptions of our management including, without limitation, our expectationsregarding revenues, results of operations, selling, general and administrativeexpenses, research and development expenses, the sufficiency of our cash forfuture operations, and the success of our preclinical, clinical and developmentprograms and our dermatology franchise. Forward-looking statements may be identified by the use offorward-looking terminology such as “believe,” “could increase the likelihood,”“hope,” “target,” “project,” “goals,” “potential,” “predict,” “might,” “expect,”“intend,” “is planned,” “should,” “will enable,” “would be expected,” “lookforward,” “may provide,” “would,” “may,” “could,” “will,” “expect,” “estimate,”“anticipate,” “continue,” or similar terms, variations of such terms or thenegative of those terms.*

*We cannot assure investors that ourassumptions and expectations will prove to have been correct.  Important factors could cause our actualresults to differ materially from those indicated or implied by forward-lookingstatements.  Such factors that couldcause or contribute to such differences include those factors discussed below.  We undertake no intention or obligation toupdate or revise any forward-looking statements, whether as a result of newinformation, future events or otherwise. If any of the following risks actually occur, our business, financialcondition, results of operations or liquidity would likely suffer.*

The following discussion includes three revised riskfactors (“Ifwe are not able to obtain and enforce patent protection for Oracea or our otherdiscoveries, our ability to commercialize our product candidates successfullywill be harmed and we may not be able to operate our business profitably”,  “We may be unable to raise additional capital ifneeded, which would force us to delay, reduce or eliminate our productdevelopment programs and commercialization efforts” and “We cannot assureyou that our clinical trials will be completed in a timely manner or will meetagreed upon end-points”) that reflect developments subsequent to thediscussion of risk factors included in our most recent Annual Report on Form10-K.

***We are dependingheavily on the commercial success of Oracea.  If we are unable tocommercialize Oracea successfully our business will be materially harmed.***

We have invested a significant portion of our recentefforts and financial resources in the development of Oracea for the treatmentof rosacea.  Our ability to generate substantial product revenues fromOracea will depend heavily on the successful commercialization of Oracea.  While we have generated revenue from Oraceasince the product’s July 2006 launch, it is premature to determine the futuresuccess and growth, if any, of the Oracea product brand.  The success ofOracea will depend primarily on the acceptance of the product by patients, themedical community and third party payors.

Although we currently derive additional revenue frommarketing and/or selling other products other than Oracea (Periostat, the AtrixProducts, the Primus products and Pandel) our revenue and profitability in thenear future will depend on our ability to market and sell Oracea successfully.

***We cannot rely on regulatory protections to prevent theapproval of generic equivalents of our products.***

In connection with the regulatory approval process,some approved new drug products can obtain exclusivity that will preventgeneric versions of the products from entering the marketplace for a period oftime.  In the United States, marketexclusivity is available for new chemical entities and for significant changesin already approved drug products, such as a new use.

Market exclusivity is, however, not available to drugsthat contain an active ingredient that has already been approved as anantibiotic and marketed prior to 1998. On January 19, 2005, the United States District Court for the District

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of Columbia upheld the FDA’s application of thisprinciple to Periostat and determined that Periostat was not entitled to marketexclusivity because its active ingredient, doxycycline, had previously beenapproved as an antibiotic.  BecauseOracea also contains doxycycline as its active ingredient, it will also not beentitled to market exclusivity.

In the European Community regulatory marketexclusivity is a function of how long the competent authorities may determinethat data submitted in marketing approval applications may not be referenced byothers.  The period of so-called dataexclusivity to which a new product may be entitled can vary from eleven yearsto none at all.  This depends on how aproduct is classified and can turn on the application of regulatory standardsof which there has been no authoritative interpretation to date.  We cannot predict what period of dataexclusivity, if any, may be enjoyed by Oracea in the European Community.

With limited or no market exclusivity it could be moredifficult for us to prevent competitors from seeking approval for copies of ourproprietary products, and in such a case the value of such products would bematerially adversely affected.  Withoutmarket exclusivity, generic versions of our products could quickly gain marketentry if they meet regulatory approval criteria.  Thus, despite the FDA’s May 2006 approval ofOracea, because it will not be entitled to market exclusivity, third partiesmay enter the market which would materially harm our business.

***If we are not able to obtain and enforce patent protectionfor Oracea or our other discoveries, our ability to commercialize our productcandidates successfully will be harmed and we may not be able to operate ourbusiness profitably.***

Our success depends, in part, on our ability toprotect proprietary methods and technologies that we develop under the patentand other intellectual property laws of the United States and other countries,so that we can prevent others from using our inventions and proprietaryinformation.  However, we may not hold orobtain proprietary rights to some patents related to our current or futureproducts and technologies, and we may not, under relevant patent laws, beconsidered to be inventors of technologies we believe we have developed.

Because publications of discoveries in scientificliterature lag behind actual discoveries, and such publications may not come tolight despite diligent searches, we cannot be certain that we were the first tomake the inventions claimed in our issued patents or pending patentapplications.  Similarly, because patentapplications in the United States and many foreign jurisdictions are typicallynot published until 18 months after filing, or in some cases not at all, wecannot be certain that we were the first to make the inventions claimed or tofile for protection of the inventions set forth in our patentapplications.  As a result, we may not begranted additional patents or our existing patents may be found to beinvalid.  We may also be required to obtainlicenses under third-party patents to market our proposed products.  If licenses are not available to us onacceptable terms, or at all, we will not be able to market the affectedproducts.

Our strategy depends on our ability to identify ourdiscoveries rapidly and to seek patent protection for them.  This process is expensive and time consuming,and we may not be able to file and prosecute all necessary or desirable patentapplications at a reasonable cost or in a timely manner.  Despite our efforts to protect ourproprietary rights, unauthorized parties may be able to obtain and useinformation that we regard as proprietary. The issuance of a patent does not guarantee that it is valid orenforceable, so even if we obtain patents, they may not be valid or enforceableagainst third parties.  In addition, theissuance of a patent does not guarantee that we have the right to practice thepatented invention.  Third parties mayhave blocking patents that could be used to prevent us from marketing our ownpatented product and practicing our own patented technology.

Our pending patent applications may not result inissued patents, or may result in patents that do not cover our futureproducts.  The patent position ofpharmaceutical or biotechnology companies, including ours, is generallyuncertain and involves complex legal and factual considerations.  The standards which the USPTO and its foreigncounterparts use to grant patents are not always applied predictably oruniformly and can change.  There is alsono uniform, worldwide policy regarding the subject matter and scope of claims grantedor allowable in pharmaceutical or biotechnology patents.  The laws of some foreign countries do notprotect proprietary information to the same extent as the laws of the UnitedStates, and many companies have encountered significant problems and costs inprotecting their proprietary information in these foreign countries. Accordingly, we do not know the degree of future protection for our proprietaryrights or the breadth of claims allowed in any patents issued to us or toothers.  The allowance of broader claimsmay increase the incidence and cost of

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patent interference proceedings and/or oppositionproceedings.  On the other hand, theallowance of narrower claims may limit the value of our proprietary rights.

A number of our pending patent applications arerelated and include claims that are intended to cover Oracea and/orincyclinide.  However, our issued patentsrelating to Oracea, and if issued, our other patents relating to incyclinideand COL-118, may not contain claims sufficiently broad to protect us againstthird parties with similar products, or provide us with any competitiveadvantage.  Moreover, once issued, any ofour patents may be challenged, narrowed, invalidated or circumvented.  In addition, the patent rights in ourproducts that derive from claims under method of use patents may be hard toassert or enforce if medical professionals prescribe or dispense similar(including generic), though non-approved, doxycycline products for indicationscovered by our patents.  If our patents are invalidated or otherwiselimited, other companies will be better able to develop products andtechnologies that compete with ours, which could adversely affect ourcompetitive business position, business prospects and financial condition.

***We cannot assureyou that our pursuit of business in the dermatology market will be successful.***

We continue to implement our plans to expand into thedermatology market. In May 2006, the FDA approved Oracea for the treatment ofrosacea in adults, and in July 2006, we launched Oracea in the UnitedStates.  While we have begun to generaterevenue from Oracea sales in connection with the product’s July 2006trade-launch, it is premature to determine the future success and growth, ifany, of the Oracea product brand.  Wecontinue to seek additional product licensing opportunities to enhance ournear-term offerings to the dermatology market. Even if we succeed in ourefforts to identify and license additional products, it is not possible toguarantee that in licensed products will continue indefinitely to be availableto us.  For instance, on February 1, 2007we received written notice of termination of our agreement with Altana whichprovides for the termination of our rights in Pandel effective November 1,2007.

The dermatology market is very competitive and some ofour competitors have substantially greater resources than we have.  Our future success will depend on, amongother things, our ability to: (i) achieve market acceptance for any current orfuture dermatological offerings, including acceptance from managed care andsimilar organizations; (ii) hire and retain personnel with experience in thedermatology market; (iii) execute our business plan with respect to this marketsegment; and (iv) adapt to technical or regulatory changes.

At the same time, new product development is alengthy, complex and uncertain process that will require significant attentionand resources from management.  A productcandidate can fail at any stage of the development process due to, among other things,efficacy or safety concerns, the inability to obtain necessary regulatoryapprovals, the difficulty or excessive cost to manufacture and/or theinfringement of patents or intellectual property rights of others.  Furthermore, the sales of new products mayprove to be disappointing and fail to reach anticipated levels.  We therefore cannot assure you that we willbe successful in our pursuit of business in the dermatology market, or that wecan sustain any business in which we achieve initial success.

The success of our current technology platforms, andthat of any other future technology platforms we may purchase or in-license,will depend on the quality and integrity of the technologies licensed or soldto us.  Despite our due diligence and thesafeguards we have in place, we cannot guarantee the effectiveness or integrityof such technologies, nor can we be certain that others do not have interveningrights in such technologies.  If any ofour in-licensed technologies proved ineffective, or if a third partysuccessfully asserted any right to such technologies, our ability to developnew products and implement our strategies would be materially adverselyaffected.

***If we are not able to obtain required regulatory approvals,we will not be able to commercialize our product candidates, and our ability togenerate revenue will be materially impaired.***

Failure to obtain regulatory approval for a productcandidate will prevent us from commercializing the product candidate.  Other than Oracea and Periostat, we have notreceived regulatory approval to market any of our product candidates in anyjurisdiction.  We have only limitedexperience in filing and prosecuting the applications necessary to gainregulatory approvals.  Securing FDA andother comparable authority approval, requires the submission of extensive preclinical and clinical data,information about product manufacturing processes and inspection of facilitiesand supporting information to the FDA and other comparable authorities  for each therapeutic indication to establishthe product candidate’s

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safety and efficacy. Our future products may not be effective, may be only moderatelyeffective or may prove to have undesirable or unintended side effects,toxicities or other characteristics that may preclude our obtaining regulatoryapproval or prevent or limit commercial use.

The process of obtaining regulatory approvals isexpensive, often takes many years, if approval is obtained at all, and can varysubstantially based upon, among other things, the type, complexity and noveltyof the product candidates involved. Changes in the regulatory approval policy during the development period,changes in or the enactment of additional statutes or regulations, or changesin regulatory review for each submitted product application, may cause delaysin the approval or rejection of an application.

The FDA, and comparable authorities in othercountries, have substantial discretion in the approval process and may refuseto accept any application or may decide that our data is insufficient forapproval and require additional preclinical, clinical or other studies.  In addition, varying interpretations of thedata obtained from preclinical and clinical testing could influence how a productcandidate is classified and delay, limit or prevent regulatory approval of aproduct candidate.  Any regulatoryapproval we ultimately obtain may be limited or subject to restrictions orpost-approval commitments that render the product not commercially viable.  Regulatory approval in one jurisdiction isnot necessarily an indication of approvability in another jurisdiction.

Even if regulatory approval of a product is granted,the approval may be subject to limitations on the indicated uses for which theproduct may be marketed or to the conditions of approval, or containrequirements for costly post-marketing testing and surveillance to monitor thesafety or efficacy of the product.

***If we lose our solesupplier of doxycycline or our manufacturer of Oracea, our sales of Oracea willbe interrupted, halted or less profitable.***

We do not have the resources, facilities orcapabilities to manufacture any of our products or product candidates.  We have no current plans to establish amanufacturing facility.  We expect thatwe will be dependent, to a significant extent, on contract manufacturers forcommercial scale manufacturing of our products or product candidates inaccordance with regulatory standards.

We rely on Hovione International Limited, or Hovione,as our sole supplier of both doxycycline hyclate and doxycycline monohydrate,and have no back-up supplier at this time.  Doxycycline monohydrate is theactive ingredient in Oracea.  Hovione has two FDA-approved, validatedmanufacturing facilities that we believe will provide us with some protectionagainst supply interruption.  We are, however, seeking a back-up supplier,but there are relatively few alternative suppliers of doxycycline, and Hovioneproduces the majority of the doxycycline used in the United States. Our currentsupply agreement with Hovione does not cover the purchase of doxycyclinemonohydrate, which is the active ingredient in Oracea.  We are currentlyin discussions with Hovione to restructure our agreement so that it will coverdoxycycline monohydrate.  During the course of these discussions we havebeen purchasing doxycycline monohydrate on a purchase order by purchase orderbasis. The term of the supply agreement expires on May 14, 2008 andthereafter automatically renews for successive two-year periods unless, 90 daysprior to the expiration of any such periods, either party gives the other partywritten notice of termination.  In addition, in the event of a default,uncured for 90 days, the non-defaulting party can terminate the supplyagreement effective immediately at the end of such ninety-day period. Although Hovione maintains two manufacturing locations, if we are unable toprocure a commercial quantity of doxycycline from Hovione on an ongoing basisat a competitive price, if Hovione fails to comply with Good ManufacturingRequirements or if we cannot find a replacement supplier in a timely manner orwith favorable pricing terms, our costs may increase significantly and we mayexperience delays in the supply and sale of Oracea.

We entered into an agreement effective December 31,2005 with Cardinal Health PTS, (now known as Catalent Pharma Solutions, LLC)pursuant to which PTS has agreed to manufacture Oracea for us.  We intend to contract with additionalmanufacturers for the commercial manufacture of an Oracea capsule.  We believe, however, that it could take up toone year to validate successfully a secondary manufacturer.  We cannot be certain that we will be able toenter into additional agreements on acceptable terms, if at all.  In the event that we are unable to obtainsufficient quantities of doxycycline or Oracea on commercially reasonable termsor in a timely manner, our business, financial condition and results ofoperations would be materially adversely affected.

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***If the federalregulatory status of Alcortin or Novacort changes, we may be unable to continueto market one or both of these products.***

We market two products, Alcortin and Novacort, under aPromotion and Cooperation Agreement with Primus.  Sixty percent of sample product and promotioncosts and all sales force compensation related to our promotion of Alcortin andNovacort are funded by us. Primus is responsible for the manufacture ofAlcortin and Novacort and has not sought FDA approval for these productsbecause Primus believes that no approval is required.  We cannot be surethat FDA will not object to the lack of approval for these products. If the FDAwere to assert that these products required approval, it could at any time seekto take administrative or judicial actions which could prevent us frommarketing these products.  Our inability to market these products couldresult in a temporary or permanent loss of revenue, which may be partiallyoffset by a reduction in our promotional expenses related to these products.

***Our products couldbe subject to restrictions or withdrawal from the market and we may be subjectto penalties if we fail to comply with regulatory requirements. Both before andafter approval or clearance, we, our vendors and suppliers, our products andproduct candidates and our manufacturers are subject to extensive regulatoryrequirements.  Failure to comply with these requirements could subject usto administrative and judicial sanctions.***

Both before and after approval or clearance of ourproducts, we, our vendors and suppliers, products and product candidates andour manufacturers are subject to extensive regulatory requirements covering,among other things, manufacturing, advertising and promotion, labeling, adverseevent reporting, post-approval commitments, registration, record-keeping,export, and distribution of samples. Failure to comply with regulatory requirements may result in:

·                  restrictions onsuch products, manufacturers or manufacturing processes;

·                  warning letters;

·                  withdrawal ofthe products from the market;

·                  refusal toapprove pending applications or supplements to approved applications that wesubmit;

·                  recall;

·                  fines;

·                  suspension orwithdrawal of regulatory approvals;

·                  refusal topermit the import or export of our products;

·                  product seizure;and

·                  injunctions orthe imposition of civil or criminal penalties.

***We may be unable to raise additional capital if needed,which would force us to delay, reduce or eliminate our product developmentprograms and commercialization efforts.***

We expect that our research anddevelopment expenses will increase in connection with our ongoing activitiesand that we will incur significant commercialization expenses as we expand ourmarketing and sales efforts.  We will need additional funding to meetthese additional expenses and may be unable to raise capital when needed or onattractive terms, which would force us to delay, reduce or eliminate ourresearch and development programs and commercialization activities.  If we generate revenues and incur expenses atour anticipated levels, we anticipate that our current cash, cash equivalentsand short-term investments at June 30, 2007 will be sufficient to fund ouroperations through 2008.  However, our forecast of the period of timethrough which our financial resources will be adequate to support ouroperations involves risks and

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uncertainties, and actual results could varymaterially.  Our future funding requirements will depend on many factors,including:

·                  the cost of commercialization activities,including product marketing and sales;

·                  the successful commercialization of Oraceaand its acceptance by managed care organizations and other third party payors;

·                  the success ofour dermatology franchise;

·                  the success ofour prosecution of our patent applications related to chemically modifiedtetracyclines, including incyclinide for the treatment of acne and acnerosacea;

·                  the success ofour prosecution of our patent applications related to the SansRosa technologyand the use of COL-118 for the treatment of erythema associated with rosacea;

·                  receipt andmaintenance of marketing approvals from the FDA and similar foreign regulatoryauthorities for our product candidates;

·                  the success ofour preclinical, clinical and development programs;

·                  revenues andprofits from sales of Oracea, Pandel, Periostat, and our other productcandidates, as well as the products we co-promote;

·                  the terms andconditions of our Series D-1 Stock;

·                  our ability tocontinue to meet the covenant requirements under our amended revolving creditfacility with SVB;

·                  the costsinvolved in preparing, filing, prosecuting, maintaining and enforcing patentclaims and other patent-related costs, including potential litigation costs andthe results of such litigation;

·                  the extent towhich we acquire or invest in businesses, products and technologies;

·                  the success ofour application for European Union marketing authorization for Oracea and inturn the success of MediGene AG, our foreign marketing partner for Oracea, incommercializing Oracea in the European Union;

·                  the costsinvolved in obtaining and maintaining regulatory approvals and clearancesrequired to market and sell our products; and

·                  the receptivityof the capital markets to any future financings.

Until such time, if ever, as we can generatesubstantial product revenues, we expect to finance our cash needs throughpublic or private equity offerings, debt financings and corporate collaborationand licensing arrangements.  If we raise additional funds by issuingequity securities, our stockholders may experience dilution.  Debtfinancing, if available, may involve agreements that include covenants limitingor restricting our ability to take specific actions, such as incurringadditional debt, making capital expenditures or declaring dividends.  Anydebt financing or additional equity that we raise may contain terms, such asliquidation and other preferences that are not favorable to us or ourstockholders. If we raise additional funds through collaboration and licensingarrangements with third parties, it may be necessary to relinquish valuablerights to our technologies, research programs or products or grant licenses onterms that may not be favorable to us.

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***We cannot assureyou that our clinical trials will be completed in a timely manner or will meetagreed upon end-points.***

As part of our plans to expand into the dermatologymarket, we will need to conduct extensive testing of our products, pursuant toprotocols that measure end points agreed with the FDA or other regulatoryagencies.  We cannot guarantee that PhaseI, Phase II, or Phase III testing for our products in development will becompleted successfully within any specified period of time, if at all.  Many products that initially appear promisingare found, after clinical evaluation, not to be safe and effective.  Also, we, or the FDA, may suspend clinicaltrials at any time on various grounds, including a finding that the subjects orpatients are being exposed to an unacceptable health risk.

For instance, on May 2, 2007, we learned that onepatient had experienced apparent significant photo-toxicity, a known sideeffect of tetracyclines, while participating in the 40 mg cohort of ourPhase II dose ranging trial of incyclinide. We suspended enrollment of all new patients in this study as aresult.  On May 7, 2007, we learned ofanother patient who had experienced apparent photo-toxicity and we announcedthat we had discontinued treatment of all enrolled patients.  Following further investigation and analysisof data from both the acne and rosacea incyclinide studies, we expect to meetwith the FDA to discuss the ongoing development program of incyclinide.   It is not possible to predict the outcome ofthose discussions.

Delays in patient enrollment in clinical trials mayresult in increased costs and delays, which could have a harmful effect on ourability to develop products.

It may take several years to complete the testing of aproduct, and failure can occur at any stage of testing.  For example:

·                  interim resultsof preclinical or clinical studies do not necessarily predict their finalresults, and results in early studies might not be seen in later studies;

·                  potentialproducts that appear promising at early stages of development may ultimatelyfail for a number of reasons, including the possibility that the products maybe ineffective, less effective than products of our competitors or causeharmful side effects;

·                  any preclinicalor clinical test may fail to produce results satisfactory to the FDA or foreignregulatory authorities;

·                  preclinical andclinical data can be interpreted in different ways, which could delay, limit orprevent regulatory approval;

·                  we may not beable to manufacture the investigational or commercial product in sufficientquantity or quality or at acceptable cost;

·                  negative orinconclusive results from a preclinical study or clinical trial or adversemedical events during a clinical trial could cause a preclinical study orclinical trial to be repeated or a program to be terminated, even if otherstudies or trials relating to the program are successful;

·                  the FDA canplace a hold on a clinical trial if, among other reasons, it finds thatpatients enrolled in the trial are or would be exposed to an unreasonable andsignificant risk of illness or injury;

·                  we may encounterdelays or rejections based on changes in regulatory agency policies during theperiod in which we develop a drug or the period required for review of anyapplication for regulatory agency approval; and

·                  our clinicaltrials may not demonstrate the safety and efficacy needed for our products toreceive regulatory approval.

If we are required to conduct additional clinicaltrials or other studies beyond those that we currently contemplate, if we areunable to successfully complete our clinical trials or other studies or if theresults of these trials or studies are not positive or are only modestlypositive, we may be delayed in obtaining marketing approval, we may not be ableto obtain

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marketing approval or we may obtain approval forindications that are not as broad as intended. Our product development costs will also increase if we experience delaysin testing or approvals.  Significantclinical trial delays could allow our competitors to bring products to marketbefore we do and impair our ability to commercialize our products or potentialproducts.  If any of this occurs, ourbusiness will be materially harmed.

***If we infringe or are alleged to infringe intellectualproperty rights of third parties, it will adversely affect our business.***

Our research, development and commercializationactivities, as well as any product candidates or products resulting from theseactivities, may infringe or be claimed to infringe patents or patentapplications under which we do not hold licenses or other rights.  Third parties may own or control thesepatents and patent applications in the United States and abroad.  These third parties could bring claimsagainst us or our collaborators that would cause us to incur substantialexpenses and, if successful against us, could cause us to pay substantialdamages.  Further, if a patentinfringement suit were brought against us or our collaborators, we or theycould be forced to stop or delay research, development, manufacturing or salesof the product or product candidate that is the subject of the suit.

As a result of patent infringement claims, or in orderto avoid potential claims, we or our collaborators may choose or be required toseek a license from the third party and be required to pay license fees orroyalties or both.  These licenses maynot be available on acceptable terms, or at all.  Even if we or our collaborators were able toobtain a license, the rights may be nonexclusive, which could result in ourcompetitors gaining access to the same intellectual property.  Ultimately, we could be prevented fromcommercializing a product, or be forced to cease some aspect of our businessoperations, if, as a result of actual or threatened patent infringement claims,we or our collaborators are unable to enter into licenses on acceptableterms.  This could harm our businesssignificantly.

There has been substantial litigation and otherproceedings regarding patent and other intellectual property rights in thepharmaceutical and biotechnology industries. In addition to infringement claims against us, we may become a party toother patent litigation and other proceedings, including interferenceproceedings declared by the USPTO and opposition proceedings in the EuropeanPatent Office, regarding intellectual property rights with respect to ourproducts and technology.  The cost to usof any patent litigation or other proceeding, even if resolved in our favor,could be substantial.  Some of ourcompetitors may be able to sustain the costs of such litigation or proceedingsmore effectively than we can because of their substantially greater financialresources.  Uncertainties resulting fromthe initiation and continuation of patent litigation or other proceedings couldhave a material adverse effect on our ability to compete in the marketplace.  Patent litigation and other proceedings mayalso absorb significant management time.

***We depend uponthird party researchers and providers of clinical services to perform ascontractually required if we are to be successful in bringing new products tomarket.***

We do not have the ability independently to conductthe clinical trials required to obtain regulatory approval for ourproducts.  We rely on independentclinical investigators, contract research organizations and other third partyservice providers for successful execution of our clinical trials, but do notcontrol many aspects of their activities. We are responsible for ensuring that each of our clinical trials isconducted in accordance with the general investigational plan, protocols forthe trial and applicable regulatory requirements.  Moreover, the FDA requires us to comply withstandards, commonly referred to as Good Clinical Practices, for conducting andrecording and reporting the results of clinical trials to assure that data andreported results are credible and accurate and that the rights, integrity andconfidentiality of trial participants are protected.  Our reliance on third parties that we do notcontrol does not relieve us of these responsibilities and requirements.  Third parties may not, however, completeactivities on schedule, or may not conduct our clinical trials in accordancewith regulatory requirements or our stated protocols.  Furthermore the data that they generate maynot be accurate or may, in extreme cases, be fraudulent.

Our ability to bring our future products to marketdepends on the quality and integrity of the data we present to regulatoryauthorities in order to obtain marketing authorizations.  We cannot guarantee the authenticity oraccuracy of such data, nor can we be certain that such data has not beenfraudulently generated.  The failure ofthese third parties to carry out their obligations would materially adverselyaffect our ability to develop and market new products and implement ourstrategies.

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***We depend upon certain key relationships to generate much ofthe technology required to maintain our competitive position in themarketplace.***

Our IMPACS technology is licensed from SUNY, referredto herein as the SUNY License, and other academic and research institutionscollaborating with SUNY.  Under the SUNYLicense, we have an exclusive worldwide license to SUNY’s rights in certainpatents and patent applications to make and sell products employingtetracyclines to treat certain disease conditions.  The SUNY License imposes various payment andreporting obligations on us, and our failure to comply with these requirementspermits SUNY to terminate the SUNY License. If the SUNY License is terminated, we would lose our right to excludecompetitors from commercializing similar products, and we could be excludedfrom marketing the same products if SUNY licensed the underlying technology toa competitor after terminating the SUNY License.  The SUNY License is terminable by SUNY on 90days prior notice only upon our failure to make timely payments, reimbursementsor reports, if the failure is not cured by us within 90 days.  The termination of the SUNY License, or thefailure to obtain and maintain patent protection for our technologies, wouldhave a material adverse effect on our business, financial condition, liquidityand results of operations.

***If our products cause injuries, we may incur significantexpense and liability.***

Our business may be adversely affected by potentialproduct liability claims arising out of the testing, manufacturing andmarketing of Periostat, Oracea and other products developed by or for us or forwhich we have licensing or promotion and cooperation rights.  We continually evaluate the limits andadequacy of our product liability insurance coverage and currently have anaggregate of $10.0 million in product liability insurance coveringPeriostat, and Oracea, our product candidates and products for which we havelicensing or promotion and cooperation rights.

Our insurer has also notified us that our generalproduct liability policy will not cover claims arising from our past sales ofVioxx® to the extent such claims are made afterDecember 31, 2004.  This does not affectour rights under the Co-Promotion Agreement with Merck, which provides forindemnification of us by Merck against any claims arising from manufacturing ordesign defects in the Vioxx product or for which we, as the seller of theproduct, may be strictly liable as a seller of an inherently dangerous product.

Our insurance may not adequately protect us againstproduct liability claims.  Insufficientinsurance coverage or the failure to obtain indemnification from third partiesfor their respective liabilities may expose us to product liability claimsand/or recalls and could cause our business, financial condition and results ofoperations to decline.

***Our stock price ishighly volatile and, therefore, the value of your investment may fluctuatesignificantly.***

The market price of our common stock has fluctuatedand may continue to fluctuate as a result of variations in our quarterlyoperating results.  These fluctuationsmay be exaggerated if the trading volume of our common stock is low.  In addition, the stock market in general hasexperienced dramatic price and volume fluctuations from time to time.  These fluctuations may or may not be basedupon any business or operating results. Our common stock may experience similar or even more dramatic price andvolume fluctuations that may continue indefinitely.

The following table sets forth the high and low lastsale prices per share for our common stock for each of the quarters in theperiod beginning July 1, 2005 through June 30, 2007, as reported on the NASDAQGlobal Market:

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| Quarter Ended  | ** ** | **High** | ** ** | **Low** | ** ** |
|---------------------|------------|----------|------------|---------|------------|
| September 30, 2005  |       | $        | 9.95       |    | $          | 7.15 |   |
| December 31,  2005  |       | $        | 12.07      |    | $          | 8.50 |   |
|                |       |     |       |    |       |
| March 31, 2006      |       | $        | 14.80      |    | $          | 11.27 |   |
| June 30, 2006       |       | $        | 14.67      |    | $          | 10.52 |   |
| September 30,  2006 |       | $        | 13.22      |    | $          | 8.52 |   |
| December 31,  2006  |       | $        | 14.65      |    | $          | 11.35 |   |
|                |       |     |       |    |       |
| March 31, 2007      |       | $        | 15.58      |    | $          | 12.70 |   |
| June 30, 2007       |       | $        | 14.48      |    | $          | 9.91 |   |

 

**Item 4.**                          Submissionof Matters to a Vote of Security Holders.

Our Annual Meeting of Stockholders was held on May 23,2007.

There were present at the Annual Meeting in person orby proxy stockholders holding an aggregate of 19,791,277 shares of common stockand 184,299 shares of Series D-1 Stock, which shares of Series D-1 Stockaccount for an additional 1,651,424 shares of common stock on an as convertedto common stock basis, assuming for such purpose a conversion price of $11.16per share.  The results of the vote takenat the Annual Meeting with respect to the election of the nominees to be thecommon stock directors were as follows:
| **Common Stock Nominees** | ** ** | **For**           | ** ** | **Withheld**     | ** ** |
|-------------------------------------|------------|-------------------|------------|------------------|------------|
| Colin W. Stewart                    |       | 18,030,785 shares |       | 1,760,492 shares |       |
| Peter R.  Barnett, D.M.D.           |       | 18,169,289 shares |       | 1,621,988 shares |       |
| Robert C. Black                     |       | 18,180,289 shares |       | 1,610,988 shares |       |
| James E.  Daverman                  |       | 17,775,422 shares |       | 2,015,855 shares |       |
| Robert J. Easton                    |       | 18,027,810 shares |       | 1,763,467 shares |       |
| George M.  Lasezkay, Pharm.D., J.D. |       | 18,180,389 shares |       | 1,610,888 shares |       |
| W. James O’Shea                |       | 18,177,664 shares |       | 1,613,613 shares |       |

 

The results of the vote taken at the Annual Meetingwith respect to the election of the nominee to be the Series D-1 Director,Robert A. Beardsley, Ph.D., were as follows: 184,299 shares of Series D-1 Stockwere voted for the Series D-1 Stock nominee, with no shares voting against orabstaining.

A vote of the stockholders was also taken at theAnnual Meeting with respect to the proposal to issue greater than 2,900,814shares of common stock, if necessary, upon conversion of the outstanding sharesof Series D-1 Stock as required by NASDAQ Marketplace Rule 4350.  For the purposes of such vote, the holders ofshares of common stock voted together as a single class.  Of such shares, 9,207,512 shares voted infavor of such proposal, 2,758,500 shares were voted against such proposal and54,893 shares abstained from voting.

In addition, a vote of the stockholders was taken atthe Annual Meeting with respect to the proposal to ratify the selection by theAudit Committee of the appointment of KPMG LLP as the independent registeredpublic accounting firm of the Company for the fiscal year ending December 31,2007.  For the purpose of such vote, theholders of shares of common stock and the holders of Series D-1 Stock (on an asconverted to common stock basis) voted together as a single class.  Of such shares, 19,725,114 shares voted infavor of such proposal, 30,451 shares were voted against such proposal and 35,712shares abstained from voting.

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**Item 6.**                          Exhibits.

 
| 10.1† |   | Sub-License Agreement, dated May 15, 2007, by and  between the Company and QuatRx Pharmaceuticals Company. |
|------------|--------|------------------------------------------------------------------------------------------------------------|
| 31.1       |   | Certification pursuant to Section 302 of the  Sarbanes-Oxley Act of 2002.                                  |
| 31.2       |   | Certification pursuant to Section 302 of the  Sarbanes-Oxley Act of 2002.                                  |
| 32.1       |   | Certification Pursuant to 18 U.S.C. Section 1350.                                                          |

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†                     ConfidentialTreatment requested as to certain portions, which portions have been separatelyfiled with the Securities and Exchange Commission.

 

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**SIGNATURES**

Pursuant to therequirements of the Securities Exchange Act of 1934, the registrant has dulycaused this report to be signed on its behalf by the undersigned thereunto dulyauthorized.
|                             | CollaGenex Pharmaceuticals, Inc. |
|-----------------------------|----------------------------------|
|                        |                             |
|                        |                             |
| Date:  August  9, 2007 | By:                              | /s/ Colin W. Stewart |
|                        |                             | Colin W. Stewart |
|                        |                             | President and Chief Executive Officer |
|                        |                             | (Principal Executive Officer) |
|                        |                             |   |
|                        |                             |   |
| Date:  August  9, 2007 | By:                              | /s/ Nancy C. Broadbent |
|                        |                             | Nancy C. Broadbent |
|                        |                             | Chief Financial Officer (Principal |
|                        |                             | Financial and Accounting Officer) |

 

 

42

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