**UNITED STATES**

**SECURITIES AND EXCHANGE COMMISSION**

**Washington, DC 20549**

** **

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** **

**FORM 10-Q**

** **

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

 

**For the quarterly period ended March 31, 2007**

 

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

 

**For the transition periodfrom     to     **

 

**Commission File Number 0-28308**

 

**CollaGenex Pharmaceuticals, 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 Telephone Number, Including Area Code)

 

Indicate by check mark whether the registrant:  (1) has filed all reports required to befiled by Section 13 or 15(d) of the Securities Exchange Actof 1934 during the preceding 12 months (or for such shorter periodthat the registrant was required to file such reports), and (2) has beensubject to such filing requirements for the past 90 days.

Yes:   x      No:   o

 

Indicate by check mark whether the registrant is alarge accelerated filer, an accelerated filer or a non-accelerated filer. Seedefinition of “accelerated filer and large accelerated filer” in Rule 12b-2of the Exchange Act.  (Check one):

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

 

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

Yes:   o      No:   x

 

Indicate the number of shares outstanding of each ofthe issuer’s classes of common stock as of May 1, 2007:

| Class                       | ** ** | **Number of Shares** |
|-----------------------------|------------|----------------------|
| Common Stock $.01 par value |       | 21,316,591           |

 

 

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**COLLAGENEX PHARMACEUTICALS, INC.**

**TABLEOF CONTENTS**
|                                             | ** ** | ** **                                                                                                       | ** ** | **Page** | ** ** |
|---------------------------------------------|------------|------------------------------------------------------------------------------------------------------------------|------------|----------|------------|
| PART I.    FINANCIAL  INFORMATION |       |                                                                                                             |       |
| Item 1.                                     |       | Financial Statements (unaudited)                                                                                 |       |     |       |
|                                        |       | Condensed Consolidated Balance Sheets as of March 31,  2007 and  December 31, 2006 (unaudited)                   |       |     |       |
|                                        |       | Condensed Consolidated Statements of Operations for  the Three Months Ended  March 31, 2007 and 2006 (unaudited) |       |     |       |
|                                        |       | Condensed Consolidated Statements of Cash Flows for  the Three Months Ended  March 31, 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 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®, LytraTM,Periostat-MRTM, SansRosaTM, UnorthodoxyTM, UnorthodoxycyclineTM, AprecinTM, 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**CondensedConsolidated Balance SheetsMarch 31, 2007 and December 31, 2006(dollars in thousands, except share data)(unaudited)
| ** **                                                                                                                                                                                                                                                                                         | ** ** | **March 31,  2007** | ** ** | **December 31,  2006** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------------|------------|-----------------------------|------------|
| **Assets**                                                                                                                                                                                                                                                                                         | ** ** | ** **               | ** ** | ** **                  | ** ** |
| Current assets:                                                                                                                                                                                                                                                                                    |       |                     |       |                        |       |
| Cash and cash  equivalents                                                                                                                                                                                                                                                                         |       | $                        | 31,032     |                        | $          | 46,493 |   |
| Short-term  investments                                                                                                                                                                                                                                                                            |       | 28,058                   |       | 19,337                      |       |
| Accounts  receivable, net of allowances of $241 and $187 at March 31, 2007 and December  31, 2006, respectively                                                                                                                                                                                    |       | 8,301                    |       | 6,071                       |       |
| Licensing fee  receivable from Medigene                                                                                                                                                                                                                                                            |       | 1,055                    |       | —                      |       |
| Inventories                                                                                                                                                                                                                                                                                        |       | 2,353                    |       | 1,959                       |       |
| Prepaid expenses  and other current assets                                                                                                                                                                                                                                                         |       | 3,072                    |       | 2,416                       |       |
| Total current  assets                                                                                                                                                                                                                                                                              |       | 73,871                   |       | 76,276                      |       |
| Equipment and leasehold  improvements, net                                                                                                                                                                                                                                                         |       | 1,460                    |       | 1,008                       |       |
| Intangible assets, net                                                                                                                                                                                                                                                                             |       | 1,788                    |       | 1,882                       |       |
| Other assets                                                                                                                                                                                                                                                                                       |       | 41                       |       | 41                          |       |
| Total assets                                                                                                                                                                                                                                                                                       |       | $                        | 77,160     |                        | $          | 79,207 |   |
| ** **                                                                                                                                                                                                                                                                                         |       |                     |       |                        |       |
| **Liabilities  and Stockholders’ Equity**                                                                                                                                                                                                                                                     |       |                     |       |                        |       |
| Current liabilities:                                                                                                                                                                                                                                                                               |       |                     |       |                        |       |
| Accounts payable                                                                                                                                                                                                                                                                                   |       | $                        | 7,110      |                        | $          | 9,066 |   |
| Accrued expenses                                                                                                                                                                                                                                                                                   |       | 5,341                    |       | 7,574                       |       |
| Total current  liabilities                                                                                                                                                                                                                                                                         |       | 12,451                   |       | 16,640                      |       |
| Deferred  licensing revenue                                                                                                                                                                                                                                                                        |       | 5,300                    |       | —                      |       |
| Other  non-current liabilities                                                                                                                                                                                                                                                                     |       | 238                      |       | 265                         |       |
| Total  liabilities                                                                                                                                                                                                                                                                                 |       | 17,989                   |       | 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 March 31,  2007 and December 31, 2006 (liquidation value of $20,000 at March 31,  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 March 31, 2007 and December 31, 2006                                                                                                                                                 |       | —                   |       | —                      |       |
| Common stock,  $0.01 par value; 75,000,000 shares authorized and 21,277,029 and 21,191,724  shares issued and outstanding at March 31, 2007 and December 31, 2006,  respectively                                                                                                                   |       | 213                      |       | 212                         |       |
| Additional  paid-in capital                                                                                                                                                                                                                                                                        |       | 186,951                  |       | 185,581                     |       |
| Accumulated  other comprehensive income                                                                                                                                                                                                                                                            |       | 3                        |       | 7                           |       |
| Accumulated  deficit                                                                                                                                                                                                                                                                               |       | (127,998                 | )          | (123,500                    | )          |
| Total  stockholders’ equity                                                                                                                                                                                                                                                                   |       | 59,171                   |       | 62,302                      |       |
| Total liabilities and  stockholders’ equity                                                                                                                                                                                                                                                   |       | $                        | 77,160     |                        | $          | 79,207 |   |

 

See accompanyingnotes to unaudited condensed consolidated financial statements.

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**COLLAGENEXPHARMACEUTICALS, INC.**

**AND SUBSIDIARIES**

CondensedConsolidated Statements of Operations

For the Three Months Ended March31, 2007 and 2006

(amounts in thousands, except shareand per share data)

(unaudited)

 
| ** **                                                                                                       | ** ** | **Three Months Ended March 31,** | ** ** |
|------------------------------------------------------------------------------------------------------------------|------------|------------------------------------------------------|------------|
| ** **                                                                                                       | ** ** | **2007**                                             | ** ** | **2006** | ** ** |
| Revenues:                                                                                                        |       |                                                 |       |   |   |
| Net product  sales                                                                                               |       | $                                                    | 13,954     |   | $ | 3,341 |   |
| Contract  revenues                                                                                               |       | 210                                                  |       | 252 |   |
| License revenues                                                                                                 |       | 20                                                   |       | 23 |   |
| Grant revenues                                                                                                   |       | 90                                                   |       | 105 |   |
| Total revenues                                                                                                   |       | 14,274                                               |       | 3,721 |   |
| Operating expenses:                                                                                              |       |                                                 |       |   |   |
| Cost of product  sales                                                                                           |       | 2,236                                                |       | 895 |   |
| Research and development                                                                                         |       | 4,847                                                |       | 3,713 |   |
| Selling, general  and administrative                                                                             |       | 12,469                                               |       | 8,511 |   |
| Total operating  expenses                                                                                        |       | 19,552                                               |       | 13,119 |   |
| Operating loss                                                                                                   |       | (5,278                                               | )          | (9,398 | ) |
| Other income (expense):                                                                                          |       |                                                 |       |   |   |
| Interest income                                                                                                  |       | 844                                                  |       | 546 |   |
| Interest expense                                                                                                 |       | (8                                                   | )          | — |   |
| Net loss                                                                                                         |       | (4,442                                               | )          | (8,852 | ) |
| Preferred stock  dividend                                                                                        |       | 514                                                  |       | 464 |   |
| Net loss allocable to  common stockholders                                                                       |       | $                                                    | (4,956     | ) | $ | (9,316 | ) |
|                                                                                                             |       |                                                 |       |   |   |
| Net loss per basic and  diluted share allocable to common stockholders                                           |       | $                                                    | (0.23      | ) | $ | (0.54 | ) |
|                                                                                                             |       |                                                 |       |   |   |
| Weighted average shares used in computing net loss per basic and  diluted share allocable to common stockholders |       | 21,246,853                                           |       | 17,348,984 |   |

 

See accompanyingnotes to unaudited condensed consolidated financial statements.

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**COLLAGENEXPHARMACEUTICALS, INC.**

**AND SUBSIDIARIES**

Condensed Consolidated Statements of Cash Flows

For the Three Months Ended March31, 2007 and 2006

(dollars in thousands)

(unaudited)

 
| ** **                                                                   | ** ** | **Three Months Ended March 31,** | ** ** |
|------------------------------------------------------------------------------|------------|------------------------------------------------------|------------|
| ** **                                                                   | ** ** | **2007**                                             | ** ** | **2006** | ** ** |
| Cash flows from operating  activities:                                       |       |                                                 |       |   |   |
| Net loss                                                                     |       | $                                                    | (4,442     | ) | $ | (8,852 | ) |
| Adjustments to  reconcile net loss to net cash used in operating activities: |       |                                                 |       |   |   |
| Stock-based  compensation                                                    |       | 631                                                  |       | 793 |   |
| Depreciation and  amortization expense                                       |       | 236                                                  |       | 124 |   |
| Accounts  receivable provisions                                              |       | 54                                                   |       | 11 |   |
| Charge for  in-process research and development                              |       | 250                                                  |       | 200 |   |
| Changes in  operating assets and liabilities:                                |       |                                                 |       |   |   |
| Accounts  receivable                                                         |       | (2,284                                               | )          | (121 | ) |
| Inventories                                                                  |       | (394                                                 | )          | (129 | ) |
| Prepaid expenses  and other current assets                                   |       | (656                                                 | )          | (360 | ) |
| Accounts payable                                                             |       | (1,956                                               | )          | (1,696 | ) |
| Accrued expenses                                                             |       | (1,288                                               | )          | (927 | ) |
| Other  non-current liabilities                                               |       | (6                                                   | )          | (57 | ) |
| Deferred  licensing revenue                                                  |       | 4,245                                                |       | — |   |
| Net cash used in  operating activities                                       |       | (5,610                                               | )          | (11,014 | ) |
|                                                                         |       |                                                 |       |   |   |
| Cash flows from  investing activities:                                       |       |                                                 |       |   |   |
| Capital  expenditures                                                        |       | (594                                                 | )          | (151 | ) |
| Purchase of  in-process research and development                             |       | (250                                                 | )          | (200 | ) |
| Purchase of  short-term investments                                          |       | (18,050                                              | )          | (12,240 | ) |
| Sale or maturity  of short-term investments                                  |       | 9,325                                                |       | 9,050 |   |
| Net cash used in  investing activities                                       |       | (9,569                                               | )          | (3,541 | ) |
|                                                                         |       |                                                 |       |   |   |
| Cash flows from  financing activities:                                       |       |                                                 |       |   |   |
| Net proceeds  from issuance of common stock                                  |       | —                                               |       | 11,594 |   |
| Net proceeds  from the exercise of stock options                             |       | 739                                                  |       | 525 |   |
| Payment of  preferred dividends                                              |       | (1,000                                               | )          | (900 | ) |
| Principal  payments on capital leases                                        |       | (21                                                  | )          | — |   |
| Net cash (used  in) provided by financing activities                         |       | (282                                                 | )          | 11,219 |   |
| Net decrease in  cash and cash equivalents                                   |       | (15,461                                              | )          | (3,336 | ) |
| Cash and cash  equivalents at beginning of period                            |       | 46,493                                               |       | 26,219 |   |
| Cash and cash  equivalents at end of period                                  |       | $                                                    | 31,032     |   | $ | 22,883 |   |
| Supplemental disclosure  of-cash flow information:                           |       |                                                 |       |   |   |
| Cash paid for  interest                                                      |       | $                                                    | 8          |   | $ | — |   |
| Reversal of  liability for UK income tax payable (see Note 1)                |       | $                                                    | 945        |   | $ | — |   |
| Unpaid license fee from  MediGene                                            |       | $                                                    | 1,055      |   | $ | — |   |

 

See accompanyingnotes to unaudited condensed consolidated finanical statements.

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**COLLAGENEXPHARMACEUTICALS, INC.AND SUBSIDIARIES**

**NOTES TO CONDENSED CONSOLIDATEDFINANCIAL STATEMENTSMarch 31, 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 March 31, 2007,the results of operations for the three months ended March 31, 2007 and 2006,and the cash flows for the three months ended March 31, 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 and 

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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 recognizing product sales. The Company only accepts returns of damaged or expired products. Thereturn allowance, when estimatable, is based on an analysis of the historicalreturns of the product and the Company considers current end user demand andwholesale and retail inventory levels. If product returns are not estimatable,the Company defers revenue recognition for all outstanding products in thewholesale and retail channel that is subject to return. Chargebacks, wholesaledistribution fees and rebates are based on an analysis of the applicableagreements and historical experience. In addition, the Company also considersthe volume and price of the product in the channel, trends in wholesaler andretailer inventory levels, conditions that might affect end-user demand (suchas generic competition) and other relevant factors.

 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 antifungal steroidcombination and NovacortTM, aprescription 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 $90 and $105 in grant revenues during the three monthsended March 31, 2007 and 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 

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and report writing 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.

***Inventory***

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 FDA. Following FDA approval, the Company’s policyis to capitalize any inventory costs that were not previously recognized as aresearch and development expense.

***Share-BasedCompensation***

The Company recognizes the fair value of share-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 March 31, 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 gain onshort-term investments was $3 and $7 at March 31, 2007 and December 31, 2006.

***AccountingChange***

In July 2006, the FASB issued FASBInterpretation No. 48, *Accounting for Uncertaintyin Income Taxes,* or FIN 48, which is applicable for fiscal years beginningafter December 15, 2006. FIN 48 clarifies the accounting for uncertainty inincome taxes recognized in an enterprise’s financial statements in accordancewith 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 adopted FIN48. Prior to the adoption 

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*** ***

of FIN 48, the Company’s policy was to recognize tax benefitsof uncertain tax positions only if it was “probable” that the position would besustained.  FIN 48 requires applicationof a “more likely than not” threshold to the recognition and derecogntion oftax positions. As a result of the adoption of FIN 48, retained earningsincreased in the amount of $945 and accrued expenses decreased by the sameamount 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 toexamination. The Company’s policy is to record interest and penalties onuncertain tax positions as income tax expense. At March 31, 2007, the Company has no amounts recorded for uncertain taxpositions, interest or penalties in the accompanying consolidated financialstatements.

***RecentlyIssued Accounting Pronouncements***

In September 2006, the Financial Accounting StandardsBoard, or the FASB, issued Statement of Financial Accounting Standards, orSFAS, Statement No. 157, “*Fair ValueMeasurements*”, or SFAS 157. SFAS 157 clarifies the definition offair value, establishes a framework for measuring fair value and expands thedisclosures on fair value measurements. SFAS 157 is effective for the Company beginning January 1, 2008. TheCompany is currently evaluating the impact of SFAS 157 adoption on itsconsolidated 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.  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 Company invests its excess cash in money marketfunds with major U.S. financial institutions, commercial paper, certificates ofdeposit and government notes, based on its investment guidelines designed toprotect the safety and liquidity of these investments.

The Company currentlycontracts with a single source for the manufacturing of Oracea capsules andPeriostat tablets and has an agreement with a single company to supply theactive ingredient in Oracea and Periostat. A single company also provides all warehousing and distribution servicesto the Company.

Asindicated in the table below, three wholesalers accounted for 91% of netproduct sales for the three months ended March 31, 2007 and 93% for the threemonths ended March 31, 2006. The same three wholesalers accounted for 88% ofgross trade accounts receivable balance at March 31, 2007 and 94% at December31, 2006.

|                   | ** ** | **% of Net Product Sales** | ** ** |
|-------------------|------------|------------------------------------------------|------------|
| ** **        | ** ** | **Three Months Ended**               | ** ** |
| ** **        | ** ** | **March 31,**                             | ** ** | **March 31,** | ** ** |
| **Customer**      | ** ** | **2007**                                       | ** ** | **2006** | ** ** |
| Cardinal Health   |       | 41                                             | %          | 53 | % |
| McKesson          |       | 37                                             | %          | 26 | % |
| AmerisourceBergen |       | 13                                             | %          | 14 | % |
| Total             |       | 91                                             | %          | 93 | % |

 

 

|                   | ** ** | **% of Gross Trade Accounts** | ** ** |
|-------------------|------------|----------------------------------------------|------------|
| ** **        | ** ** | **Receivable Balance at**          | ** ** |
| ** **        | ** ** | **March 31,**                           | ** ** | **December 31,** | ** ** |
| **Customer**      | ** ** | **2007**                                     | ** ** | **2006** | ** ** |
| Cardinal Health   |       | 45                                           | %          | 58 | % |
| McKesson          |       | 36                                           | %          | 29 | % |
| AmerisourceBergen |       | 7                                            | %          | 7 | % |
| Total             |       | 88                                           | %          | 94 | % |

 

8

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The Company operates asone business that is managed by a single management team reporting to the chiefexecutive officer.  The Company does notprepare discrete financial information with respect to separate product orproduct candidate areas or by location and does not have separately reportablesegments. During each of the three months ended March 31, 2007 and March 31,2006, the Company’s total net revenues were comprised of the following:

|                    | ** ** | **Three Months Ended** | ** ** |
|--------------------|------------|----------------------------------|------------|
| ** **         | ** ** | **March 31,**               | ** ** |
| ** **         | ** ** | **2007**                         | ** ** | **2006** | ** ** |
| Oracea             |       | 77                               | %          | — | % |
| Other  dermatology |       | 11                               | %          | 35 | % |
| Dental             |       | 11                               | %          | 62 | % |
| Grant revenue      |       | 1                                | %          | 3 | % |
| Total              |       | 100                              | %          | 100 | % |

 

**Note 3 — Share-BasedCompensation**

At March 31, 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).

During the three months ended March 31, 2007 theCompany recorded $631 of stock-based compensation cost.  The amount is composed of $116 related toresearch and development expenses and $515 related to selling, general andadministrative expenses. During the three months ended March 31, 2006 theCompany recorded $793 of stock-based compensation cost.  Such amount is composed of $99 related toresearch and development expenses and $694 related to selling, general andadministrative expenses. No amount of stock-based compensation cost has beencapitalized into inventory or other assets during the three months ended March31, 2007 and 2006.

Certain options granted in 2003 have been amortized ata rate that is accelerated versus the contractual vesting period of suchoptions as these options are performance-based and it is anticipated that theperformance criteria will be met prior to straight-line vesting. Such optionswere fully amortized at December 31, 2006.

The following table summarizes activity under allstock option plans. 

|                                                                                   | ** ** | **Three Months Ended** | ** ** |
|-----------------------------------------------------------------------------------|------------|----------------------------------|------------|
| ** **                                                                        | ** ** | **March 31,**               | ** ** |
| ***(dollars in thousands, except per share data)*** | ** ** | **2007**                         | ** ** | **2006** | ** ** |
| Weighted-average  fair value of options granted per share                         |       | $                                | 9.05       |   | $ | 7.78 |   |
| Intrinsic value of  options exercised                                             |       | $                                | 559        |   | $ | 349 |   |

 

9

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At March 31, 2007, the value of the unvested portionof all outstanding stock-related awards was $4,429 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 three monthsended March 31, 2007 and 2006 from the exercise of options was $739 and $525,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 fair values of the options granted during thethree months ended March 31, 2007 and 2006 were determined using theBlack-Scholes option pricing model, which incorporates various assumptions. Therisk-free rate of interest for the average contractual life of the option isbased on U.S. Government Securities Treasury Constant Maturities. Expectedvolatility is based on the historical daily volatility of the Company’s commonstock. The expected life is determined using the short-cut method permittedunder Staff Accounting Bulletin No. 107, *Share-BasedPayment*. The expected dividend rate yield is zero because theCompany currently does not pay or expect to pay dividends to commonstockholders.

The following are theweighted average assumptions used during the respective periods:

|                         | ** ** | **Three Months Ended  March 31,** | ** ** |
|-------------------------|------------|--------------------------------------------------|------------|
| ** **              | ** ** | **2007**                                         | ** ** | **2006** | ** ** |
| Expected life in years  |       | 6.50                                             |       | 6.50 |   |
| Risk-free interest rate |       | 4.62                                             | %          | 4.54 | % |
| Volatility              |       | 62.01                                            | %          | 69.70 | % |
| Expected dividend yield |       | —                                           |       | — |   |

 

Stock option activityduring the three months ended March 31, 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                   |       | 384,760            |       | 14.29                   |       |                  |       |          |       |
| Options  exercised                |       | (85,305            | )          | 8.66                    |       |                  |       |          |       |
| Options  forfeited or cancelled   |       | (10,025            | )          | 10.68                   |       |                  |       |          |       |
| Outstanding at March  31, 2007    |       | 3,768,020          |       | $                       | 10.18      |                  | 6.26       |          | $          | 12,543 |   |
| Unvested at March 31,  2007       |       | 1,491,161          |       | $                       | 10.54      |                  | 8.54       |          | $          | 4,429 |   |
| Exercisable at March 31, 2007     |       | 2,276,859          |       | $                       | 9.95       |                  | 4.80       |          | $          | 8,106 |   |

----

(1)             Theaggregate intrinsic value was calculated based on the positive difference betweenthe closing sales price of the Company’s common stock ($13.51 per share) onMarch 30, 2007 and the exercise prices of the underlying options.

10

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**Note4 — Inventories**

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

|                  | ** ** | **March 31,** | ** ** | **December 31,** | ** ** |
|------------------|------------|--------------------|------------|-----------------------|------------|
| ** **       | ** ** | **2007**           | ** ** | **2006**              | ** ** |
| Raw materials    |       | $                  | 946        |                  | $          | 978 |   |
| Work in processs |       | 451                |       | 339                   |       |
| Finished goods   |       | 956                |       | 642                   |       |
| Total            |       | $                  | 2,353      |                  | $          | 1,959 |   |

 

**Note5 — Intangible Assets, Net**

Intangible assets, net at March 31, 2007 and December31, 2006 consist of the following:

|                                     | ** ** | **March 31,** | ** ** | **December 31,** | ** ** |
|-------------------------------------|------------|--------------------|------------|-----------------------|------------|
| ** **                          | ** ** | **2007**           | ** ** | **2006**              | ** ** |
| Oracea milestone fees               |       | $                  | 1,670      |                  | $          | 1,670 |   |
| Accumulated  amortization           |       | (84                | )          | (56                   | )          |
| Oracea milestone  fees, net         |       | $                  | 1,586      |                  | $          | 1,614 |   |
| Atrix acquired product  rights      |       | $                  | 1,876      |                  | $          | 1,876 |   |
| Accumulated  amortization           |       | (1,674             | )          | (1,608                | )          |
| Atrix acquired  product rights, net |       | $                  | 202        |                  | $          | 268 |   |
| Total intangible  assets, net       |       | $                  | 1,788      |                  | $          | 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. The Atrix acquired product rights are being amortized throughDecember 2007.

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 of productsales, was $94 for the three months ended March 31, 2007 and $67 for the threemonths ended March 31, 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 

11

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amended credit facility in amounts totaling up to$2,000. As the Company pays down amounts under any letter of credit, the amountavailable to it under the credit facility increases. The Company is notobligated to draw down any amounts under the amended credit facility and anyborrowings shall bear interest, payable monthly, at Silicon Valley Bank’s primerate, or 8.25%, at March 31, 2007. Under the Sixth Loan Modification Agreement,the Company is charged an unused line credit fee of 0.25% per annum. Inaddition, under the amended credit facility, the Company is subject tofinancial covenants that require the Company to maintain certain minimumliquidity and tangible net worth levels on a quarterly basis. During the threemonths ended March 31, 2007 and 2006, the Company’s unused line of credit feewas $11 and $6 respectively. As of March 31, 2007 the Company had no borrowingsoutstanding.

**Note7 — Contract and License Revenues**

The Company recorded contract and license revenues of$230 and $275 for the three months ended March 31, 2007 and 2006. In June 2005,the Company entered into the Promotion Agreement with Primus, under which theCompany will promote Alcortin, a prescription topical antifungal steroidcombination, and Novacort, a prescription topical steroid and anesthetic. Underthe Promotion Agreement, the Company receives a percentage of the gross profitarising from prescriptions written by dermatology professionals (or offices)that result in sales of the products in the United States. Through June 30,2006, the majority of marketing expenses, excluding sales force compensationand sample product costs, related to the promotion of the Primus products werefunded by Primus and the majority of product sample costs and all sales forcecompensation were funded by the Company. Effective July 1, 2006, the Companyand Primus amended the Promotion Agreement. As a result of the amendment,sample expenses and marketing costs, excluding sales force compensation, arefunded 60% by the Company and 40% by Primus.

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 three monthsended March 31, 2007, the Company classified the up front non-refundable fee of$5,000 as non-current deferred licensing revenue. Additionally, the Company maybe entitled to an additional $7,500 in milestone payments upon the achievementof certain annual sales thresholds achieved by MediGene. In addition, theCompany will receive an agreed upon transfer price and a royalty of 12% ofannual net sales up to $10,000 and 15% of annual net sales in excess of $10,000in the specified territories. At March 31, 2007, $1,055 of the up front fee wasunpaid and recorded, in the accompanying Condensed Consolidated Balance Sheetas licensing fee receivable from MediGene. This amount was paid in April 2007.

In October 2002, the Company announced the executionof a license agreement with Medtronic, Inc., or Medtronic, involving theCompany’s IMPACSTM 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 three months ended March 31, 2007the Company received the $250 

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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. Medtronicmust also pay royalties based on a percentage of net sales of such a product. Neitherthe Company nor Medtronic have developed a timetable for clinical developmentor 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 March 31, 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’s licenseagreement with The State University of New York at Stony Brook, or SUNY,covering Periostat and Oracea, the Company is entitled to deduct costs incurredto defend its patents from current and future royalties due to SUNY on netsales of Oracea, Periostat and sales to United Research Laboratories,Inc./Mutual Pharmaceutical Company, Inc. of its branded version of Periostat. Thecumulative legal patent defense, litigation and settlement costs incurredduring the litigation period through March 31, 2007 currently exceeds theamount of the royalties earned by SUNY, by $3,333. This excess amount, whichhas been previously expensed, will be available to offset future royaltiesearned by SUNY, if any, on sales of products based on the SUNY technology. 

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**Note10 — Accrued Expenses**

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

|                                           | ** ** | **March 31,** | ** ** | **December 31,** | ** ** |
|-------------------------------------------|------------|--------------------|------------|-----------------------|------------|
| ** **                                | ** ** | **2007**           | ** ** | **2006**              | ** ** |
| Research and  development costs           |       | $                  | 1,512      |                  | $          | 1,257 |   |
| Product returns                           |       | 1,114              |       | 996                   |       |
| Payroll and related  costs                |       | 1,041              |       | 3,041                 |       |
| Sales and marketing  costs                |       | 892                |       | 786                   |       |
| Patient rebates                           |       | 230                |       | 78                    |       |
| Professional and  consulting fees         |       | 154                |       | 132                   |       |
| State and franchise  taxes                |       | 104                |       | 161                   |       |
| Government rebates and  distribution fees |       | 98                 |       | 80                    |       |
| Foreign taxes(1)                          |       | —             |       | 945                   |       |
| Other                                     |       | 196                |       | 98                    |       |
| Total                                     |       | $                  | 5,341      |                  | $          | 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 changes wereneeded to the Company’s previously filed tax return. Accordingly, no additionalincome 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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** **

**Item 2.**                                   Management’sDiscussion and Analysis of 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 for which we are developing for the treatment oferythema (skin redness) associated with dermatological conditions and for whichwe recently completed the clinical portion of a Phase I clinical trial andinitiated a Phase II clinical trial; and Restoraderm®, a foam-based, topicaldermal drug delivery system, which is currently under 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 PrimusPharmaceuticals Inc., or Primus, to market Alcortin and Novacort todermatologists.

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.

15

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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, SansRosaTMand Restoraderm.

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. OurSansRosa technology, which we acquired in connection with the acquisition ofSansRosa Pharmaceutical Development Inc., or SansRosa, in December 2005,****is a class of compounds that have shownpromise in reducing the redness associated with rosacea, and we intend toformulate and develop a topical treatment for rosacea based on one or more ofthese compounds. Our Restoraderm technology is a proprietary, foam-based,topical drug delivery technology that originated from a Swedish collaborator. Wehave acquired all rights, title and interest to the Restoraderm technology. Wehave formulated various prescription and over the counter products based on theRestoraderm technology. We do not currently have a timetable for either theinitiation of clinical development or the launch of any Restoraderm products.

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 $128.0million at March 31, 2007. We do not expect to generate a profit for the yearending December 31, 2007.

**Significant RecentDevelopments**

On February 1, 2007 we received written notice oftermination from Altana, Inc., or Altana, which provides for the termination ofthe Sublicense Agreement relating to Pandel effective November 1, 2007. Underthe terms of the agreement, we are entitled to receive a payment of $1.7million from Altana, which represents initial license fees paid to Altana. Suchpayment is due from Altana upon termination of the agreement.

On March 29, 2007, we announced that we had beganenrollment 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 will enroll 100 patients withmoderate-to-severe acne at thirteen investigational centers across the UnitedStates and that the double-blinded, placebo-controlled study will evaluate adaily 40 mg dose of incyclinide over a 12 week period with a 4-week follow up.On May 2, 2007, we learned that one patient had experienced apparentsignificant photo-toxicity, a known side effect of tetracyclines, whileparticipating in the 40 mg cohort. We are currently investigating thisadverse event and have suspended enrollment of all new patients in this study.

On April 23, 2007 we announced that the U.S. Patentand Trademark Office, or USPTO, posted on its website a final rejection of ourpatent application No. 10/757,656 covering a 

16

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method of treating acne using chemically modifiedtetracyclines, including incyclinide. We will request continued examination ofthis application.

On May 1, 2007, our patent application No. 10/117,709issued as U.S. Patent No. 7,211,267, or the 267 Patent. This patent covers theuse of sub-antimicrobial doses of tetracyclines, including Oracea, for thetreatment of acne and acne rosacea. The USPTO published a notice of allowanceof the 267 Patent in November 2006.

**Resultsof Operations**

*Comparisonof the Three Months Ended March 31, 2007 and March 31, 2006*

**Revenues**
| ***Revenues***                         | ** ** | ** ** | ** ** | ** ** | ** ** | **Change** | ** ** |
|----------------------------------------|------------|------------|------------|------------|------------|------------|------------|
| ***(dollars in thousands)*** | ** ** | **2007**   | ** ** | **2006**   | ** ** | **$**      | ** ** | **%** | ** ** |
| Net Oracea  Product Sales              |       | $          | 11,108     |       | $          | —     |       | $ | 11,108 |   | N/A |   |
| Other Net  Product Sales               |       | 2,846      |       | 3,341      |       | (495       | )          | (14.8 | )% |
| Total Net Product Sales                |       | 13,954     |       | 3,341      |       | 10,613     |       | 317.7 | % |
| Contract  Revenues                     |       | 210        |       | 252        |       | (42        | )          | (16.7 | )% |
| Grant Revenue                          |       | 90         |       | 105        |       | (15        | )          | (14.3 | )% |
| License Revenues                       |       | 20         |       | 23         |       | (3         | )          | (13.0 | )% |
| Total Revenues                         |       | $          | 14,274     |       | $          | 3,721      |       | $ | 10,553 |   | 283.6 | % |

 

Total net product sales, during the three months endedMarch 31, 2007 which included sales of Oracea,Pandel, Periostat and the AtrixProducts, increased $10.6 million, or 317.7%, due primarily to sales fromOracea, which was launched in July 2006. Net revenues from dermatologicalproducts were 88.0% of total net revenues in the three months ended March 31,2007 compared to 35.0% for the three months ended March 31, 2006. Totaldeductions from gross sales for estimated product returns, trade cashdiscounts, government and patient rebates and wholesale distribution fees forOracea were approximately 12% of gross sales during the three months endedMarch 31, 2007.

**Cost ofProduct Sales**

Cost of product sales forthe three months ended March 31, consist of the following:
| ***Cost of Product Sales***     | ** ** | ** ** | ** ** | ** ** | ** ** | **Change** | ** ** |
|---------------------------------|------------|------------|------------|------------|------------|------------|------------|
| ***(dollars in thousands)***    | ** ** | **2007**   | ** ** | **2006**   | ** ** | **$**      | ** ** | **%** | ** ** |
| Product  Royalties              |       | $          | 1,134      |       | $          | 390        |       | $ | 744 |   | 190.8 | % |
| Manufacturing  Costs(1)         |       | 1,008      |       | 438        |       | 570        |       | 130.1 | % |
| Amortization of  Licensing Fees |       | 94         |       | 67         |       | 27         |       | 40.3 | % |
| Cost of Product Sales           |       | $          | 2,236      |       | $          | 895        |       | $ | 1,341 |   | 149.8 | % |
| Percent of Net Product  Sales   |       | 16.0       | %          | 26.8       | %          |       |       |   |   |

----

(1)             Includescontract manufacturing costs (Periostat and Oracea), transfer price (Pandel andthe Atrix Products), overhead costs and internal costs

17

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Four product lines, Oracea, Pandel, Periostat and theAtrix Products are included in cost of product sales for the three months endedMarch 31, 2007 compared to three product lines, Pandel, Periostat and the AtrixProducts for the three months ended March 31, 2006.

Cost of product sales increased $1.3 million duringthe three months ended March 31, 2007 compared to the three months ended March31, 2006 due to the addition of Oracea sales. Cost of product sales was 16.0 %of net sales for the three months ended March 31, 2007 and 26.8% for the threemonths ended March 31, 2006. The decrease as a percent of net product sales duringthe three months ended March 31, 2007 is due to the addition of Oraceasales, which have higher gross margins than our other products.

**Researchand Development**

**Research and development for the three months ended March31, consist of the following:**
| ***Research and Development***  | ** ** | ** ** | ** ** | ** ** | ** ** | **Change** | ** ** |
|---------------------------------|------------|------------|------------|------------|------------|------------|------------|
| ***(dollars in thousands)***    | ** ** | **2007**   | ** ** | **2006**   | ** ** | **$**      | ** ** | **%** | ** ** |
| incyclinide                     |       | $1,520     |       | $1,043     |       | $477       |       | 45.7 | % |
| COL-118                         |       | 1,157      |       | 227        |       | 930        |       | 409.7 | % |
| Oracea                          |       | 688        |       | 1,288      |       | (600       | )          | (46.6 | %) |
| Internal and Other Costs(1)     |       | 1,482      |       | 1,155      |       | 327        |       | 28.3 | % |
| Total Research and  Development |       | $4,847     |       | $3,713     |       | $1,134     |       | 30.5 | % |

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(1)             Includespersonnel costs, SFAS 123(R) costs, 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 $1.1million or 30.5 %, during the three months ended March 31, 2007, due primarilyto costs associated with Phase I studies of COL-118 for the treatment oferythema, Phase II dose-finding studies of incyclinide for the treatment ofrosacea and higher internal 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 commercialization would be between $15.0million and $20.0 million. We are currently conducting formulation andstability work on products incorporating our Restoraderm technology, and we arereviewing product options and the timetable associated with clinicaldevelopment or commercial launch.****Itis premature to estimate future development and clinical costs associated withCOL-118. We anticipate that our personnel and direct internal expenses willincrease during 2007 as we add additional clinical personnel.

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**Selling,General and Administrative**

**Selling, general and administrative for the three monthsended March 31, consist of the following:**
| ***Selling, General and Administrative*** | ** ** | ** ** | ** ** | ** ** | ** ** | **Change** | ** ** |
|----------------------------------------------------------|------------|------------|------------|------------|------------|------------|------------|
| ***(dollars in thousands)***                   | ** ** | **2007**   | ** ** | **2006**   | ** ** | **$**      | ** ** | **%** | ** ** |
| Marketing  Expense                                       |       | $          | 5,503      |       | $          | 2,517      |       | $ | 2,986 |   | 118.6 | % |
| Selling Expense                                          |       | 4,121      |       | 3,245      |       | $          | 876        |   | 27.0 | % |
| Corporate &  Administrative Expense                  |       | 2,330      |       | 2,092      |       | $          | 238        |   | 11.4 | % |
| SFAS 123(R) Expense                                      |       | 515        |       | 657        |       | $          | (142       | ) | (21.6 | )% |
| Total Selling, General  and Administrative               |       | $          | 12,469     |       | $          | 8,511      |       | $ | 3,958 |   | 46.5 | % |

 

Marketing expenses include personnel salaries andbenefits and market research, advertising and promotional expenses related toOracea, the Primus products and Pandel.

Selling expenses include personnel salaries and benefits,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 and accountingexpenses.

Selling, general and administrative expenses increasedapproximately $4.0 million, or 46.5%, during the three months ended March 31,2007, mainly due to higher promotion costs for Oracea, which was launched inJuly 2006. During the three months ended March 31, 2007 personnel costs relatedto selling, general and administrative increased by approximately $800,000 as comparedto the three months ended March 31, 2006.

**InterestIncome**
| ***Other Income (Expense)*** | ** ** | ** ** | ** ** | ** ** | ** ** | **Change** | ** ** |
|----------------------------------------|------------|------------|------------|------------|------------|------------|------------|
| ***(dollars in thousands)*** | ** ** | **2007**   | ** ** | **2006**   | ** ** | **$**      | ** ** | **%** | ** ** |
| Interest Income                        |       | $          | 844        |       | $          | 546        |       | $ | 298 |   | 54.6 | % |
| Interest Expense                       |       | $          | (8         | )          | $          | —     |       | $ | (8 | ) | N/A |   |
| Total Other Income (Expense)           |       | $          | 836        |       | $          | 546        |       | $ | 290 |   | 53.1 | % |

 

Interest income increased $298,000, or 54.6%,primarily due to higher average investment balances and yields for the threemonths ended March 31, 2007 compared to the comparable period in 2006.

Interest expense of $8,000 for the three months endedMarch 31, 2007 is due to the capital lease for computer equipment entered intoJuly 2006.

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**Preferred Stock Dividend**

Preferred stock dividends included in net lossallocable to common stockholders were $514,000 during the three months endedMarch 31, 2007 and $464,000 during the three months ended March 31, 2006.

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 10.0% per annum, which are declared and paid every six months.  The annual dividend rate increases by 1.0%per annum on May 19, 2007 and each subsequent anniversary thereof until theearlier of the date that all of the shares of Series D-1 Stock are (i)converted into shares of common stock, or (ii) redeemed.

**Liquidityand Capital 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;

**·**                 The successfulcommercialization of Oracea and its acceptance by managed care organizationsand 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;

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

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·                  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 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;

·                  Successfullyobtaining European Union approval of Oracea and in turn the success of MediGeneAG, our foreign marketing partner for Oracea, in commercializing Oracea in theEuropean 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.

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. We received an upfront non-refundable fee of $5.0 million, lessapplicable withholding taxes of approximately $1.0 million, for which we werepaid in April 2007. Additionally, we may be entitled to an additional $7.5million in milestone 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 

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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 March 31,2007. 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 three months ended March 31, 2007and 2006, our unused line of credit fee was $11,000 and $6,000 respectively. Asof March 31, 2007, we had no borrowings outstanding.

At March 31, 2007,we had cash, cash equivalents and short-term investments of approximately $59.1million compared to the approximately $65.8 million balance at December 31,2006.  This decrease is primarily aresult of cash used in operations of approximately $5.6 million during thethree months ended march 31, 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 March 31,2007 was $61.4 million compared to $59.6 million at December 31, 2006.  During the three months ended March 31, 2007,we invested $594,000 in capital expenditures and $250,000 for in-processresearch and development, paid $1.0 million in cash dividends to the holders ofour Series D-1 Stock and received proceeds of $739,000 from the exercise of commonstock options. During the three months ended March 31, 2007 we also investedapproximately $8.7 million in short-term investments (net of maturities).

We anticipate that our (i) current cash, cashequivalents and short-term investments at March 31, 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 equivalents and short-term investments atMarch 31, 2007 were $59.1 million representing 77% of total assets compared to$65.8 million, representing 83% of total assets at December 31, 2006.

The change in cash and cash equivalents for the threemonths ended March 31, are as follows:

| *(dollars in millions)*                    | ** ** | **2007** | ** ** | **2006** | ** ** |
|------------------------------------------------------|------------|----------|------------|----------|------------|
| Net cash used in  operating activities               |       | $        | (5.6)      |     | $          | (11.0 | ) |
| Net cash used in  investing activities               |       | (9.6     | )          | (3.5     | )          |
| Net cash (used  in) provided by financing activities |       | (0.3     | )          | 11.2     |       |
| Net decrease in cash  and cash equivalents           |       | $        | (15.5      | )        | $          | (3.3 | ) |

 

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Working capital at March 31, 2007 was $61.4 millioncompared to $59.6 million at December 31, 2006. The increase in working capital is due primarily to the up-frontmilestone fee received from MediGene.

***Net Cash Used in OperatingActivities***

Net cash used in operating activities was $5.6million, including a $4.4 million net loss, for the three months ended March31, 2007 compared to net cash used of $11.0 million, including an $8.9 millionnet loss, for the three months ended March 31, 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.

***Net Cash Used in InvestingActivities***

Net cash used in investing activities was $9.6 millionfor the three months ended March 31, 2007, compared to $3.5 million for thethree months ended March 31, 2006.  Thechange is due primarily to $5.8 million in additional purchases of short-terminvestments in the three months ended March 31, 2007.

***Net Cash (Used in) Provided ByFinancing Activities***

Net cash used in financing activities was approximately$282,000 for the three months ended March 31, 2007, compared to net cashprovided by financing activities of $11.2 million for the three months endedMarch 31, 2006. The change is due primarily to proceeds from issuance of stockthat 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 force and a capital lease for computerequipment.  The disclosures relating toour contractual obligations in our Annual Report on Form 10-K for the yearended December 31, 2006 have not materially changed since we filed that report.

**Critical AccountingPolicies 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.

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*** ***

***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 March 31, 2007, we have a liability of$545,000 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 an analysisof the historical returns of the product and similar products and we considercurrent end user demand and wholesale and retail inventory levels. If productreturns 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 chart details the activity in thereserves discussed above during the three months ended March 31, 2007 and 2006:

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| **Three Months Ended**         | ** ** | ** **            | ** ** | **Current Provision**             | ** ** | **Actual Returns or** | ** ** | ** **         | ** ** |
|------------------------------------------|------------|-----------------------|------------|----------------------------------------|------------|---------------------------------|------------|--------------------|------------|
| **March 31, 2006**             | ** ** | **December 31,** | ** ** | **Related to Sales in** | ** ** | **Credits in First**  | ** ** | **March 31,** | ** ** |
| ***(in thousands)***                | ** ** | **2005**              | ** ** | **First Quarter**                 | ** ** | **Quarter**                     | ** ** | **2006**           | ** ** |
| Accounts  receivable allowances:         |       |                  |       |                                   |       |                            |       |               |       |
| Chargebacks                              |       | $                     | 78         |                                   | $          | 421                             |       | $                  | (413       | ) | $ | 86 |   |
| Cash discounts                           |       | 26                    |       | 80                                     |       | (77                             | )          | 29                 |       |
| Total                                    |       | $                     | 104        |                                   | $          | 501                             |       | $                  | (490       | ) | $ | 115 |   |
|                                     |       |                  |       |                                   |       |                            |       |               |       |
| Accounts  payable/Accrued expenses:      |       |                  |       |                                   |       |                            |       |               |       |
| Patient rebates                          |       | $                     | —     |                                   | $          | —                          |       | $                  | —     |   | $ | — |   |
| Product returns (excluding Periostat)(1) |       | 98                    |       | 40                                     |       | (35                             | )          | 103                |       |
| Government rebates                       |       | 158                   |       | 75                                     |       | (42                             | )          | 191                |       |
| Wholesale distribution fees              |       | 80                    |       | 27                                     |       | (47                             | )          | 60                 |       |
| Total                                    |       | $                     | 336        |                                   | $          | 142                             |       | $                  | (124       | ) | $ | 354 |   |

 
| **Three Months Ended**         | ** ** | ** **            | ** ** | **Current Provision**             | ** ** | **Actual Returns or** | ** ** | ** **         | ** ** |
|------------------------------------------|------------|-----------------------|------------|----------------------------------------|------------|---------------------------------|------------|--------------------|------------|
| **March 31, 2007**             | ** ** | **December 31,** | ** ** | **Related to Sales in** | ** ** | **Credits in First**  | ** ** | **March 31,** | ** ** |
| ***(in thousands)***                | ** ** | **2006**              | ** ** | **First Quarter**                 | ** ** | **Quarter**                     | ** ** | **2007**           | ** ** |
| Accounts  receivable allowances:         |       |                  |       |                                   |       |                            |       |               |       |
| Chargebacks                              |       | $                     | 73         |                                   | $          | 351                             |       | $                  | (346       | ) | $ | 78 |   |
| Cash discounts                           |       | 114                   |       | 317                                    |       | (268                            | )          | 163                |       |
| Total                                    |       | $                     | 187        |                                   | $          | 668                             |       | $                  | (614       | ) | $ | 241 |   |
|                                     |       |                  |       |                                   |       |                            |       |               |       |
| Accounts  payable/Accrued expenses:      |       |                  |       |                                   |       |                            |       |               |       |
| Patient rebates                          |       | $                     | 78         |                                   | $          | 446                             |       | $                  | (294       | ) | $ | 230 |   |
| Product returns (excluding Periostat)(1) |       | 384                   |       | 262                                    |       | (77                             | )          | 569                |       |
| Government rebates                       |       | 80                    |       | 65                                     |       | (57                             | )          | 88                 |       |
| Wholesale distribution fees              |       | 296                   |       | 534                                    |       | (345                            | )          | 485                |       |
| Total                                    |       | $                     | 838        |                                   | $          | 1,307                           |       | $                  | (773       | ) | $ | 1,372 |   |

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(1)             Thereturns provision for Periostat was $545,000 at March 31, 2007 and $866,000 atMarch 31, 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

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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.  We do not take title to the inventory sold byPrimus under the Promotion Agreement.

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 thethree months ended March 31, 2007, we classified the up front non-refundablefee of $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 $90,000 in grant revenues during the three months endedMarch 31, 2007.

***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,deferred tax planning strategies, if any, and projected future taxable incomeover the periods in which the deferred tax asset items are deductible. The TaxReform Act of 1986 contains provisions that may limit the net operating lossand research and experimentation credit carryforwards available to be used inany given year upon the occurrence of certain events, including significantchanges in ownership interest. We have incurred a net loss for the years endedDecember 31, 2006 and 2005, and uncertainty regarding our future profitabilityhas prevented us from reaching the “more likely than not” conclusion requiredunder the applicable literature to recognize deferred tax assets on ourConsolidated Balance Sheet. Accordingly, the net deferred tax assets are fullyoffset by a valuation allowance at March 31, 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 be recoverable.We apply Statement of Financial Accounting Standards, or SFAS No. 144, 

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“*Accounting for theImpairment or Disposal of Long-Lived Assets*,” in order to determinewhether or not an asset is impaired. This standard requires an impairmentanalysis when indicators of impairment are present. When such indicators arepresent, the standard indicates that if the sum of the future expected cashflows from the asset, undiscounted and without interest charges, are less thanthe carrying value, an asset impairment must be recognized in the financialstatements.  The amount of the impairmentis the difference between the fair value of the asset and the carrying value ofthe asset.

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.

***Inventories***

Inventory carrying values are evaluated periodicallyand consider the saleable quantities of inventory versus quantities ofinventory 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 product developmentcosts are expensed as incurred.  Researchand development expenses consist primarily of personnel costs and funds paid tothird parties for the provision of services and materials for drug development,manufacturing and formulation enhancements, clinical trials (including postFDA-approval, clinical trials), statistical analysis and report writing andregulatory 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 expense relatingto 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.

***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 

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pricing model to determine the fair value of stockoptions on the date of grant, and we estimate key assumptions that areimportant elements in the model, such as the expected stock-price volatilityand expected stock option life. Our estimates of these important assumptionsand expected forfeiture rates are based on historical data and judgmentregarding market trends and factors. These estimates are not intended topredict actual future events or the value ultimately realized by individualswho 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 FASB issued FASB Interpretation No.48, *Accounting for Uncertainty in Income Taxes,*or FIN 48, which is applicable for fiscal years beginning after December 15,2006. FIN 48 clarifies the accounting for uncertainty in income taxesrecognized in an enterprise’s financial statements in accordance with SFAS No.109, *Accounting for Income Taxes*. FIN 48prescribes a recognition threshold and measurement for financial statementrecognition and measurement of a tax position reported or expected to bereported on a tax return. FIN 48 also provides guidance on derecognition,classification, interest and penalties, accounting in interim periods,disclosure, and transition. On January 1, 2007, we adopted FIN 48. Prior to theadoption of FIN 48, our policy was to recognize tax benefits of uncertain taxpositions only if it was “probable” that the position would be sustained. FIN48 requires application of a “more likely than not” threshold to therecognition and derecogntion of tax positions. As a result of the adoption ofFIN 48, retained earning increased in the amount of $945,000 and accruedexpenses decreased by the same amount as of January 1, 2007 (see Note 10).

***RecentlyIssued Accounting Pronouncements***

In September 2006, theFinancial Accounting Standards Board, or FASB, issued Statement of FinancialAccounting Standards, or SFAS No. 157, “*FairValue Measurements*”, or SFAS 157. SFAS 157 clarifies the definition of fair value, establishes a frameworkfor measuring fair value and expands the disclosures on fair valuemeasurements.  SFAS 157 is effective forus beginning January 1, 2008.  We arecurrently evaluating the impact of SFAS 157 adoption on our consolidatedfinancial 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 March 31, 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 March 31, 2007. Our short-term investments incommercial paper, certificates of deposit and government notes are carried atfair value.

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**Item 4.            Controls and 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 March 31, 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 submits underthe Exchange Act is accumulated and communicated to the company’s management,including its principal executive and principal financial officers asappropriate 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 March 31, 2007, ourchief executive officer and chief financial officer concluded that, as of suchdate, our disclosure controls and procedures were effective at the reasonableassurance 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 March 31, 2007 thathas materially affected, or is reasonably likely to materially affect, ourinternal control over financial reporting.

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**PART II.  OTHERINFORMATION**

**Item1A. 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 Exchange Act.  These forward-looking statements regardingfuture events and our future results are based on current expectations,estimates, forecasts, and projections and the beliefs and assumptions of ourmanagement including, without limitation, our expectations regarding revenues,results of operations, selling, general and administrative expenses, researchand development expenses, the sufficiency of our cash for future operations,and the success of our preclinical, clinical and development programs and ourdermatology franchise.  Forward-lookingstatements may be identified by the use of forward-looking terminology such as “believe,”“could increase the likelihood,” “hope,” “target,” “project,” “goals,” “potential,”“predict,” “might,” “expect,” “intend,” “is planned,” “should,” “will enable,” “wouldbe expected,” “look forward,” “may provide,” “would,” “may,” “could,” “will,” “expect,”“estimate,” “anticipate,” “continue,” or similar terms, variations of suchterms or the negative 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 discussedbelow.  We undertake no intention orobligation to update or revise any forward-looking statements, whether as aresult of new information, future events or otherwise.  If any of the following risks actually occur,our business, financial condition, results of operations or liquidity wouldlikely suffer.*

The following discussion includes two 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”and “We maybe unable to raise additional capital if needed, which would force us to delay,reduce or eliminate our product development programs and commercializationefforts”) that reflect developments subsequent to the discussion of riskfactors included in our most recent Annual Report on Form 10-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) 

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our revenue and profitability in the near future willdepend 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 Districtof Columbia upheld the FDA’s application of this principle to Periostat anddetermined that Periostat was not entitled to market exclusivity because itsactive ingredient, doxycycline, had previously been approved as an antibiotic.  Because Oracea also contains doxycycline asits active ingredient, it will also not be entitled 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 patent 

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applications. Similarly, because patent applications in the United States and manyforeign jurisdictions are typically not published until 18 months after filing,or in some cases not at all, we cannot be certain that we were the first tomake the inventions claimed or to file for protection of the inventions setforth in our patent applications.  As aresult, we may not be granted additional patents or our existing patents may befound to be invalid.  We may also berequired to obtain licenses under third-party patents to market our proposedproducts.  If licenses are not availableto us on acceptable terms, or at all, we will not be able to market theaffected products.

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 claimsgranted or 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 patent interference proceedings and/oropposition proceedings.  On the otherhand, the allowance of narrower claims may limit the value of our proprietaryrights.

A number of our pending patent applications arerelated and include claims that are intended to cover Oracea and/orincyclinide.  However, our issued patentrelating to Oracea, and if issued, our other patents relating to incyclinide,may not contain claims sufficiently broad to protect us against third partieswith similar products, or provide us with any competitive advantage.  Moreover, once issued, any of our patents maybe 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 our competitivebusiness position, business prospects and financial condition.

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***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 otherthings, efficacy or safety concerns, the inability to obtain necessaryregulatory approvals, the difficulty or excessive cost to manufacture and/orthe infringement 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, informationabout product manufacturing processes and inspection of facilities andsupporting information to the FDA and other comparable authorities  for each therapeutic indication to establishthe product candidate’s safety and efficacy. Our 

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future products may not be effective, may be onlymoderately effective or may prove to have undesirable or unintended sideeffects, toxicities or other characteristics that may preclude our obtainingregulatory approval 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 aproduct candidate is classified and delay, limit or prevent regulatory approvalof a product candidate.  Any regulatoryapproval we ultimately obtain may be limited or subject to restrictions orpost-approval commitments that render the product not commercially viable.

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 

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competitive price, if Hovione fails to comply withGood Manufacturing Requirements or if we cannot find a replacement supplier ina timely manner or with favorable pricing terms, our costs may increasesignificantly and we may experience delays in the supply and sale of Oracea.

We entered into an agreement effective December 31,2005 with Cardinal Health PTS, (now known as The Blackstone Group) pursuant towhich 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 of operationswould be materially adversely affected.

***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;

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·                  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 March 31, 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 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;

·                  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;

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·                  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;

·                  successfullyobtaining European Union approval of Oracea and in turn the success of MediGeneAG, our foreign marketing partner for Oracea, in commercializing Oracea in theEuropean 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 our stockholders.If we raise additional funds through collaboration and licensing arrangementswith third parties, it may be necessary to relinquish valuable rights to ourtechnologies, research programs or products or grant licenses on terms that maynot be favorable to us.

***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.

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;

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·                  potential productsthat appear promising at early stages of development may ultimately fail for anumber of reasons, including the possibility that the products may beineffective, less effective than products of our competitors or cause harmfulside 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 be ableto manufacture the investigational or commercial product in sufficient quantityor 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 marketing approval or we may obtain approval for indications that arenot as broad as intended.  Our productdevelopment costs will also increase if we experience delays in testing orapprovals.  Significant clinical trialdelays could allow our competitors to bring products to market before we do andimpair our ability to commercialize our products or potential products.  If any of this occurs, our business will be materiallyharmed.

***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 they 

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could be forced to stop or delay research,development, manufacturing or sales of the product or product candidate that isthe 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 themarketplace.  Patent litigation and otherproceedings may also 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 our products.  We rely on independent clinicalinvestigators, contract research organizations and other third party serviceproviders for successful execution of our clinical trials, but do not controlmany aspects of their activities.  We areresponsible for ensuring that each of our clinical trials is conducted inaccordance with the general investigational plan, protocols for the trial andapplicable regulatory requirements. Moreover, the FDA requires us to comply with standards, commonlyreferred to as Good Clinical Practices, for conducting and recording andreporting the results of clinical trials to assure that data and reportedresults 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 regulatory authoritiesin order to obtain marketing authorizations. We cannot guarantee the authenticity or accuracy of such data, nor canwe be certain that such data has not been fraudulently generated.  The failure of these third parties to carryout their 

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obligations would materially adversely affect ourability to develop and market new products and implement our strategies.

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

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 

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or may not be based upon any business or operatingresults.  Our common stock may experiencesimilar or even more dramatic price and volume fluctuations that may continueindefinitely.

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 April 1, 2005 through March 31, 2007, as reported on theNASDAQ Global Market:

| Quarter Ended  | ** ** | **High** | ** ** | **Low** | ** ** |
|---------------------|------------|----------|------------|---------|------------|
| June 30, 2005       |       | $        | 7.61       |    | $          | 3.99 |   |
| 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 |   |

 

**Item 6.            Exhibits.**

| 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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**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: May 3, 2007 | By:                              | /s/ Colin W. Stewart |
|              |                             | Colin W. Stewart |
|              |                             | President and Chief Executive Officer |
|              |                             | (Principal Executive Officer) |
|              |                             |   |
|              |                             |   |
| Date: May 3, 2007 | By:                              | /s/ Nancy C. Broadbent |
|              |                             | Nancy C. Broadbent |
|              |                             | Chief Financial Officer (Principal |
|              |                             | Financial and Accounting Officer) |

 

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