**UNITED STATES**

**SECURITIES AND EXCHANGE COMMISSION**

**Washington, DC 20549**

 

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**FORM 10-Q**

 
| **ý** | **QUARTERLY REPORT PURSUANT TO  SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**  |
|------------|---------------------------------------------------------------------------------------------------------|
|       |                                                                                                    |
| ** ** | **For the quarterly period ended September 30, 2005**                                              |
|       |                                                                                                    |
| **o**      | **TRANSITION REPORT PURSUANT TO  SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934** |

 
| **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                            |   | (I.R.S. Employer |
| Incorporation or Organization)                             |   | 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:  ý | No:  o |
|------------------------|------------------|

 

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

 
| Yes:  ý | No:  o |
|------------------------|------------------|

 

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

 
| Yes:  o | No:  ý |
|-------------------|-----------------------|

 

Indicate the number of shares outstanding of each of the issuer’sclasses of common stock as of October 31, 2005:

 
| **Class**                   | ** ** | **Number of Shares** |
|-----------------------------|------------|----------------------|
| Common Stock $.01 par value |       | 14,488,547           |

 

 

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**COLLAGENEX PHARMACEUTICALS, INC.**

 

**TABLE OF CONTENTS**

 
| **PART I.**    FINANCIAL INFORMATION | ** ** | ** **                                                                                                                    |
|----------------------------------------------------------|------------|-------------------------------------------------------------------------------------------------------------------------------|
| ** **                                               | ** ** | ** **                                                                                                                    | ** ** | ** ** |
| **Item 1.**                                              | ** ** | **Financial Statements (unaudited)**                                                                                          | ** ** | ** ** |
| ** **                                               | ** ** | ** **                                                                                                                    | ** ** | ** ** |
| ** **                                               | ** ** | **Condensed Consolidated Balance Sheets as of  September 30, 2005 and December 31, 2004 (unaudited)**               | ** ** | ** ** |
| ** **                                               | ** ** | ** **                                                                                                                    | ** ** | ** ** |
| ** **                                               | ** ** | **Condensed Consolidated Statements of  Operations for the Three Months Ended September 30, 2005 and 2004  (unaudited)** | ** ** | ** ** |
| ** **                                               | ** ** | ** **                                                                                                                    | ** ** | ** ** |
| ** **                                               | ** ** | **Condensed Consolidated Statements of  Operations for the Nine Months Ended September 30, 2005 and 2004  (unaudited)**  | ** ** | ** ** |
| ** **                                               | ** ** | ** **                                                                                                                    | ** ** | ** ** |
| ** **                                               | ** ** | **Condensed Consolidated Statements of Cash  Flows for the Nine Months Ended September 30, 2005 and 2004 (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**                                                                                           | ** ** | ** ** |
| ** **                                               | ** ** | ** **                                                                                                                    | ** ** | ** ** |
| ** **                                               | ** ** | **Additional Risks That May Affect  Results**                                                                            | ** ** | ** ** |
| ** **                                               | ** ** | ** **                                                                                                                    | ** ** | ** ** |
| **Item 3.**                                              | ** ** | **Quantitative and Qualitative Disclosures  About Market Risk**                                                               | ** ** | ** ** |
| ** **                                               | ** ** | ** **                                                                                                                    | ** ** | ** ** |
| **Item 4.**                                              | ** ** | **Controls and Procedures**                                                                                                   | ** ** | ** ** |
| ** **                                               | ** ** | ** **                                                                                                                    | ** ** | ** ** |
| **PART II.**    OTHER INFORMATION    | ** ** | ** **                                                                                                                    |
| ** **                                               | ** ** | ** **                                                                                                                    | ** ** | ** ** |
| **Item 6.**                                              | ** ** | **Exhibits**                                                                                                                  | ** ** | ** ** |
| ** **                                               | ** ** | ** **                                                                                                                    | ** ** | ** ** |
| **SIGNATURES**                                           | ** ** | ** **                                                                                                                    | ** ** | ** ** |

 

**CollaGenex Pharmaceuticals, Inc. - United Statestrademarks:**

Periostat®,Metastat®, Dermostat®, Nephrostat®, Osteostat®, Arthrostat®, Rheumastat®,Corneostat®, Gingistat®, IMPACSTM, PS20®, The Whole Mouth Treatment®,Restoraderm®, Dentaplex®, LytraTM, Periostat-MRTM and OraceaTM.

 

**CollaGenex Pharmaceuticals, Inc. - European Communitytrademarks:**

Periostat®,Nephrostat®, Optistat®, Xerostat® and OraceaTM.

 

**CollaGenex International, Ltd. (our wholly-owned subsidiary) -United Kingdom trademarks:**

Periostat®,Nephrostat®, Optistat®, Xerostat®, IMPACS®, Dentaplex®, Restoraderm®,Periocycline®, Periostatus® andPeriostat-MR®.

 

**CollaGenex International, Ltd. - European Community andUnited Kingdom trademarks:**

CollaGenex®,PS20®, Dermastat®, Periostan®, Periostat-SR®, “C” Logo® and “The Whole MouthTreatment” Logo®.

 

**CollaGenex International, Ltd. - European CommunityTrademarks:**

PeriocyclineTM,RestoradermTM, and Periostat-MRTM.

 

**Marks listed herein mayadditionally be registered in jurisdictions not specified in the abovelist.  All other trade names, trademarksor service marks appearing in this Quarterly Report are the property of theirrespective owners and are not property of CollaGenex Pharmaceuticals, Inc.or any of our subsidiaries.**  

 

i

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**PART I.  FINANCIAL INFORMATION**

 

**Item 1.  Financial Statements (unaudited).**

 

1

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**COLLAGENEX PHARMACEUTICALS, INC.**

**AND SUBSIDIARIES**

 

Condensed Consolidated Balance Sheets

September 30, 2005 and December 31, 2004

(dollars in thousands, except share data)

 
| ** **                                                                                                                                                                                                                                                                                                                                                                                                                                                               | ** ** | **September 30,  2005** | ** ** | **December 31,  2004** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------------|------------|-----------------------------|------------|
| ** **                                                                                                                                                                                                                                                                                                                                                                                                                                                               | ** ** | **(unaudited)**              | ** ** | ** **                  | ** ** |
| **Assets**                                                                                                                                                                                                                                                                                                                                                                                                                                                               | ** ** | ** **                   | ** ** | ** **                  | ** ** |
| Current assets:                                                                                                                                                                                                                                                                                                                                                                                                                                                          | ** ** | ** **                   | ** ** | ** **                  | ** ** |
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                     | ** ** | ** **                   | ** ** | ** **                  | ** ** |
| Cash and cash equivalents                                                                                                                                                                                                                                                                                                                                                                                                                                                |       | $                            | 12,683     |                        | $          | 11,889 |   |
| Short-term investments                                                                                                                                                                                                                                                                                                                                                                                                                                                   |       | 21,975                       |       | 26,756                      |       |
| Accounts receivable, net of allowances of  $404 and $483 at September 30, 2005 and December 31, 2004, respectively                                                                                                                                                                                                                                                                                                                                             |       | 1,858                        |       | 6,983                       |       |
| Inventories                                                                                                                                                                                                                                                                                                                                                                                                                                                              |       | 660                          |       | 2,692                       |       |
| Prepaid expenses and other current assets                                                                                                                                                                                                                                                                                                                                                                                                                                |       | 1,794                        |       | 2,096                       |       |
| Total current assets                                                                                                                                                                                                                                                                                                                                                                                                                                                     |       | 38,970                       |       | 50,416                      |       |
| Equipment and leasehold improvements, net                                                                                                                                                                                                                                                                                                                                                                                                                                |       | 499                          |       | 498                         |       |
| Acquired product rights, net                                                                                                                                                                                                                                                                                                                                                                                                                                             |       | 725                          |       | 1,164                       |       |
| Other assets                                                                                                                                                                                                                                                                                                                                                                                                                                                             |       | 43                           |       | 43                          |       |
| Total assets                                                                                                                                                                                                                                                                                                                                                                                                                                                             |       | $                            | 40,237     |                        | $          | 52,121 |   |
| **Liabilities  and Stockholders’ Equity**                                                                                                                                                                                                                                                                                                                                                                                                                           |       |                         |       |                        |       |
| Current liabilities:                                                                                                                                                                                                                                                                                                                                                                                                                                                     |       |                         |       |                        |       |
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                     |       |                         |       |                        |       |
| Accounts payable                                                                                                                                                                                                                                                                                                                                                                                                                                                         |       | $                            | 4,402      |                        | $          | 4,317 |   |
| Accrued expenses                                                                                                                                                                                                                                                                                                                                                                                                                                                         |       | 7,339                        |       | 5,585                       |       |
| Preferred stock dividend                                                                                                                                                                                                                                                                                                                                                                                                                                                 |       | —                       |       | 800                         |       |
| Total current liabilities                                                                                                                                                                                                                                                                                                                                                                                                                                                |       | 11,741                       |       | 10,702                      |       |
| Other long-term liabilities                                                                                                                                                                                                                                                                                                                                                                                                                                              |       | 100                          |       | 204                         |       |
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                     |       |                         |       |                        |       |
| Commitments and Contingencies                                                                                                                                                                                                                                                                                                                                                                                                                                            |       |                         |       |                        |       |
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                     |       |                         |       |                        |       |
| Stockholders’ equity:                                                                                                                                                                                                                                                                                                                                                                                                                                               |       |                         |       |                        |       |
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                     |       |                         |       |                        |       |
| Preferred stock, $0.01 par value, 5,000,000  shares authorized; 200,000 shares of Series D cumulative convertible  preferred stock issued and outstanding at September 30, 2005 and  December 31, 2004 (liquidation value of $20,454 and $20,800,  respectively); 150,000 shares of Series A participating preferred stock,  $0.01 par value, designated and no shares issued and outstanding at  September 30, 2005 and December 31, 2004 |       | 2                            |       | 2                           |       |
| Common stock, $0.01 par value; 25,000,000  shares authorized, 14,475,047 and 14,385,877 shares issued and outstanding at  September 30, 2005 and December 31, 2004, respectively                                                                                                                                                                                                                                                                               |       | 145                          |       | 144                         |       |
| Additional paid-in capital                                                                                                                                                                                                                                                                                                                                                                                                                                               |       | 106,412                      |       | 106,016                     |       |
| Accumulated other comprehensive loss                                                                                                                                                                                                                                                                                                                                                                                                                                     |       | (11                          | )          | (21                         | )          |
| Accumulated deficit                                                                                                                                                                                                                                                                                                                                                                                                                                                      |       | (78,152                      | )          | (64,926                     | )          |
| Total stockholders’ equity                                                                                                                                                                                                                                                                                                                                                                                                                                          |       | 28,396                       |       | 41,215                      |       |
| Total liabilities and stockholders’ equity                                                                                                                                                                                                                                                                                                                                                                                                                          |       | $                            | 40,237     |                        | $          | 52,121 |   |

 

See accompanying notes to unaudited condensedconsolidated financial statements.

 

2

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**COLLAGENEX PHARMACEUTICALS, INC.**

**AND SUBSIDIARIES**

 

Condensed Consolidated Statements of Operations

For the Three Months Ended September 30, 2005 and 2004

(amounts in thousands, except share and per share data)(unaudited)

 
| ** **                                                                                                      | ** ** | **Three Months Ended September 30,** | ** ** |
|-----------------------------------------------------------------------------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                                                                                      | ** ** | **2005**                                  | ** ** | **2004** | ** ** |
|                                                                                                            |       |                                      |       |   |   |
| Revenues:                                                                                                       |       |                                      |       |   |   |
| Net product sales                                                                                               |       | $                                         | 4,298      |   | $ | 10,991 |   |
| Contract and license revenues                                                                                   |       | 202                                       |       | 84 |   |
| Total revenues                                                                                                  |       | 4,500                                     |       | 11,075 |   |
|                                                                                                            |       |                                      |       |   |   |
| Operating expenses:                                                                                             |       |                                      |       |   |   |
| Cost of product sales                                                                                           |       | 852                                       |       | 1,537 |   |
| Research and development                                                                                        |       | 3,942                                     |       | 2,178 |   |
| Selling, general and administrative                                                                             |       | 4,918                                     |       | 6,341 |   |
| Total operating expenses                                                                                        |       | 9,712                                     |       | 10,056 |   |
| Operating (loss) income                                                                                         |       | (5,212                                    | )          | 1,019 |   |
|                                                                                                            |       |                                      |       |   |   |
| Other income:                                                                                                   |       |                                      |       |   |   |
| Interest income                                                                                                 |       | 288                                       |       | 99 |   |
| Other income                                                                                                    |       | —                                    |       | 7 |   |
| Net (loss) income                                                                                               |       | (4,924                                    | )          | 1,125 |   |
| Preferred stock dividend                                                                                        |       | 454                                       |       | 400 |   |
| Net (loss) income allocable to common  stockholders                                                             |       | $                                         | (5,378     | ) | $ | 725 |   |
| Net (loss) income per basic share allocable  to common stockholders                                             |       | $                                         | (0.37      | ) | $ | 0.05 |   |
| Weighted average shares used in computing  net (loss) income per basic share allocable to common stockholders   |       | 14,455,223                                |       | 14,375,139 |   |
| Net (loss) income per diluted share  allocable to common stockholders                                           |       | $                                         | (0.37      | ) | $ | 0.05 |   |
| Weighted average shares used in computing  net (loss) income per diluted share allocable to common stockholders |       | 14,455,223                                |       | 14,516,779 |   |

 

See accompanying notes to unaudited condensedconsolidated financial statements.

 

3

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**COLLAGENEX PHARMACEUTICALS, INC.**

**AND SUBSIDIARIES**

 

Condensed Consolidated Statements of Operations

For the Nine Months Ended September 30, 2005 and 2004

(amounts in thousands, except share and per share data)(unaudited)

 
| ** **                                                                                                      | ** ** | **Nine Months Ended September 30,** | ** ** |
|-----------------------------------------------------------------------------------------------------------------|------------|------------------------------------------|------------|
| ** **                                                                                                      | ** ** | **2005**                                 | ** ** | **2004** | ** ** |
|                                                                                                            |       |                                     |       |   |   |
| Revenues:                                                                                                       |       |                                     |       |   |   |
| Net product sales                                                                                               |       | $                                        | 23,006     |   | $ | 38,691 |   |
| Contract and license revenues                                                                                   |       | 446                                      |       | 235 |   |
| Total revenues                                                                                                  |       | 23,452                                   |       | 38,926 |   |
| Operating expenses:                                                                                             |       |                                     |       |   |   |
| Cost of product sales                                                                                           |       | 5,017                                    |       | 5,590 |   |
| Research and development                                                                                        |       | 11,237                                   |       | 6,023 |   |
| Selling, general and administrative – other                                                                |       | 19,175                                   |       | 22,122 |   |
| Selling, general and administrative – legal  settlement                                                    |       | —                                   |       | 2,000 |   |
| Selling, general and administrative –  restructuring                                                       |       | 1,184                                    |       | 348 |   |
| Total operating expenses                                                                                        |       | 36,613                                   |       | 36,083 |   |
| Operating (loss) income                                                                                         |       | (13,161                                  | )          | 2,843 |   |
|                                                                                                            |       |                                     |       |   |   |
| Other income:                                                                                                   |       |                                     |       |   |   |
| Interest income                                                                                                 |       | 763                                      |       | 239 |   |
| Other income                                                                                                    |       | —                                   |       | 5 |   |
| Net (loss) income                                                                                               |       | (12,398                                  | )          | 3,087 |   |
| Preferred stock dividend                                                                                        |       | 1,282                                    |       | 1,200 |   |
| Net (loss) income allocable to common  stockholders                                                             |       | $                                        | (13,680    | ) | $ | 1,887 |   |
| Net (loss) income per basic share allocable  to common stockholders                                             |       | $                                        | (0.95      | ) | $ | 0.13 |   |
| Weighted average shares used in computing  net (loss) income per basic share allocable to common stockholders   |       | 14,425,038                               |       | 14,224,619 |   |
| Net (loss) income per diluted share  allocable to common stockholders                                           |       | $                                        | (0.95      | ) | $ | 0.13 |   |
| Weighted average shares used in computing  net (loss) income per diluted share allocable to common stockholders |       | 14,425,038                               |       | 14,535,183 |   |

 

See accompanying notes to unaudited condensedconsolidated financial statements.

 

4

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**COLLAGENEX PHARMACEUTICALS, INC.**

**AND SUBSIDIARIES**

 

Condensed Consolidated Statements of Cash Flows

For the Nine Months Ended September 30, 2005 and 2004

(dollars in thousands)

(unaudited)

 
| ** **                                                                                          | ** ** | **Nine Months Ended September 30,** | ** ** |
|-----------------------------------------------------------------------------------------------------|------------|------------------------------------------|------------|
| ** **                                                                                          | ** ** | **2005**                                 | ** ** | **2004** | ** ** |
| Cash flows from operating activities:                                                               |       |                                     |       |   |   |
| Net (loss) income                                                                                   |       | $                                        | (12,398    | ) | $ | 3,087 |   |
| Adjustments to reconcile net (loss) income  to net cash (used in) provided by operating activities: |       |                                     |       |   |   |
| Write-down of inventory                                                                             |       | 979                                      |       | — |   |
| Write-down of fixed assets                                                                          |       | 96                                       |       | — |   |
| Depreciation and amortization expense                                                               |       | 661                                      |       | 679 |   |
| Accounts receivable provisions                                                                      |       | (79                                      | )          | (44 | ) |
| Changes in operating assets and  liabilities:                                                       |       |                                     |       |   |   |
| Accounts receivable                                                                                 |       | 5,204                                    |       | 1,245 |   |
| Inventories                                                                                         |       | 1,053                                    |       | (657 | ) |
| Prepaid expenses and other assets                                                                   |       | 302                                      |       | (841 | ) |
| Accounts payable                                                                                    |       | 85                                       |       | (944 | ) |
| Accrued expenses                                                                                    |       | 1,904                                    |       | (841 | ) |
| Other non-current liabilities                                                                       |       | (104                                     | )          | (16 | ) |
| Net cash (used in) provided by operating  activities                                                |       | (2,297                                   | )          | 1,668 |   |
| Cash flows from investing activities:                                                               |       |                                     |       |   |   |
| Capital expenditures                                                                                |       | (319                                     | )          | (281 | ) |
| Purchase of in-process research and  development                                                    |       | (150                                     | )          | (150 | ) |
| Purchase of short-term investments                                                                  |       | (25,768                                  | )          | — |   |
| Sale of short-term investments                                                                      |       | 30,559                                   |       | — |   |
| Net cash provided by (used in) investing  activities                                                |       | 4,322                                    |       | (431 | ) |
| Cash flows from financing activities:                                                               | ** ** | ** **                               | ** ** | ** ** | ** ** |
| Net proceeds from issuance of common stock                                                          |       | 397                                      |       | 2,342 |   |
| Payment of preferred dividends                                                                      |       | (1,628                                   | )          | (1,600 | ) |
| Net cash (used in) provided by financing  activities                                                |       | (1,231                                   | )          | 742 |   |
| Net increase in cash and cash equivalents                                                           |       | 794                                      |       | 1,979 |   |
| Cash and cash equivalents at beginning of  period                                                   |       | 11,889                                   |       | 32,670 |   |
| Cash and cash equivalents at end of period                                                          |       | $                                        | 12,683     |   | $ | 34,649 |   |

 

See accompanying notes to unaudited condensedconsolidated financial statements.

 

5

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**COLLAGENEX PHARMACEUTICALS, INC.AND SUBSIDIARIES**

 

**NOTES TO CONDENSED CONSOLIDATED FINANCIALSTATEMENTSSeptember 30, 2005 and 2004(dollars in thousands, except per share data)(Unaudited)**

 

**Note 1 — Basis of Presentation**

 

The unauditedcondensed consolidated financial statements included herein have been preparedby CollaGenex Pharmaceuticals, Inc. and subsidiaries (the “Company”),pursuant to the rules and regulations of the Securities and ExchangeCommission and in accordance with accounting principles generally accepted inthe United States of America.  Certaininformation and footnote disclosures normally included in the annualconsolidated financial statements prepared in accordance with accounting principlesgenerally accepted in the United States of America have been condensed oromitted pursuant to such rules and the regulations of the Securities andExchange Commission.  These unauditedcondensed consolidated financial statements should be read in conjunction withthe Company’s 2004 audited consolidated financial statements and footnotesincluded in its Annual Report on Form 10-K for the year ended December 31,2004.

 

Theaccompanying unaudited condensed consolidated financial statements include theresults of the Company and its wholly-owned subsidiaries.  All intercompany accounts and transactionshave been eliminated in consolidation.

 

Certainamounts in the 2004 consolidated financial statements have been reclassified toconform to the 2005 presentation.

 

In the opinionof the Company’s management, the accompanying unaudited condensed consolidatedfinancial statements have been prepared on a basis substantially consistentwith the audited consolidated financial statements for the year ended December 31,2004 and contain adjustments, all of which are of a normal recurring nature,necessary to present fairly the Company’s consolidated financial position at September 30,2005, the results of operations for the three and nine months ended September 30,2005 and 2004, and the cash flows for the nine months ended September 30,2005 and 2004.  Interim results are notnecessarily indicative of results anticipated for the full fiscal year.

 

Thepreparation of consolidated financial statements in conformity with accountingprinciples generally accepted in the United States requires management to makeestimates and assumptions that affect the amounts reported in the consolidatedfinancial statements and accompanying notes. Actual results could differ from those estimates.

 

Historically,the Company has recognized all product sales revenue upon shipment to wholesalecustomers, net of estimated future returns and estimates for chargebacks,applicable wholesale distribution fees, rebates and current inventory levels inthe distribution channel, provided that collection was probable and nosignificant obligations remained. Following the launch of a third party generic competitor to Periostat®in May 2005 and commencing with the

 

6

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second quarter of 2005, the Companyrecognizes Periostat sales revenue primarily based on sales to end-users, whichare estimated using prescription dispensing data generated by a leadingindependent prescription tracking service. Since it is possible that the launch of generic competition to Periostatin May 2005 could increase the rate of product returns from thedistribution channel, the Company has accrued $1,158 for potential Periostatreturns in Accrued Expenses on the Condensed Consolidated Balance Sheet at September 30,2005.  (See note 9)

 

Upon the May 2005launch of a third party generic equivalent to Periostat, the Company’sagreement with United Research Laboratories/Mutual Pharmaceutical Company, Inc.(“Mutual”) provided for rebates to be paid to Mutual to compensate Mutual andits customers for price erosion on the value of certain of its inventories ofMutual’s branded version of Periostat. Accordingly, the Company has deferred revenues associated with suchshipments of these products until such future time as the selling price becomesfixed and determinable.  At September 30,2005, the Company’s Condensed Consolidated Balance Sheet included $70 indeferred revenue associated with sales of Mutual’s branded version ofPeriostat.  (See note 9)

 

The Companyrecognizes all other product sales revenue (excluding Periostat and Mutual’sbranded version of Periostat) upon shipment, net of estimated returns, rebates,chargebacks and wholesale distribution fees, if applicable, provided thatcollection is determined to be probable and no significant obligations remain.

 

Pursuant tothe Company’s Promotion and Cooperation Agreement (the “Promotion Agreement”)with Primus Pharmaceuticals, Inc. (“Primus”), contract revenues forAlcortinTM, a prescription topical antifungal steroid combination,and NovacortTM, a prescription topical steroid and anesthetic, arefee-based arrangements where contract revenue is earned as prescriptions arefilled and recognized as a percentage of the gross profit earned byPrimus.  The Company does not take titleto the inventory sold by Primus under the Promotion Agreement.

 

***Recently IssuedAccounting Standards***

 

In December 2004,the Financial Accounting Standards Board (the “FASB”) issued SFAS No. 123(revised 2004), “Share-Based Payment” (“SFAS 123R”), which replaces SFAS No. 123,(“SFAS No. 123”) “*Accounting for StockBased Compensation”*and supercedes APB Opinion No. 25 (“OpinionNo. 25”) *“Accounting for Stock Issuedto Employees.”*  SFAS 123Rrequires all share-based payments to employees to be recognized in thefinancial statements based on their fair values.  Share-based payments include grants ofemployee stock options and liabilities that are based on the fair value of theCompany’s equity instruments or that may be settled by the issuance of suchequity instruments.  The pro formadisclosures previously permitted under SFAS 123 may no longer be provided inlieu of recording these payments in the Company’s financial statements.

 

The Company isrequired to adopt SFAS 123R no later than January 1, 2006, and the Companyexpects this adoption to have a material effect on its results of operationsand earnings per share.  The Company hasnot yet determined its method of adopting SFAS 123R and whether it will resultin amounts that are similar to the current pro forma disclosures under SFAS No. 123in Note 1 to these Condensed Consolidated Financial Statements.

 

7

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In November 2004,the FASB issued SFAS No. 151, “*InventoryCosts - An amendment of ARB No. 43, Chapter 4*” (“SFAS No. 151”).  SFAS No. 151 amends the guidance in ARB No. 43,Chapter 4, “Inventory Pricing,” to clarify the accounting for abnormal amountsof idle facility expense, freight, handling costs and wasted material(spoilage).  Among other provisions, thenew rule requires that items such as idle facility expense, extensivespoilage, double freight and rehandling costs be recognized as current periodcharges regardless of whether they meet the criterion of “abnormal” under ARB No. 43.  Additionally, SFAS No. 151 requires thatfixed production overheads be allocated to the costs of conversion based on thenormal capacity of the production facilities. SFAS No. 151 is effective for fiscal years beginning after June 15,2005 and is required to be adopted by the Company in the first quarter of2006.  The Company is currentlyevaluating the impact, if any, that SFAS No. 151 will have on the resultsof operations and financial position of the Company

 

***Cash, CashEquivalents and Short-term Investments***

 

The Companyconsiders all highly liquid investments with a maturity of three months or lessat the date of acquisition to be cash equivalents.  Cash equivalent investments are held atamortized cost, which approximates fair value. The Company’s short-term investments are primarily composed ofcommercial paper and government notes. At September 30, 2005, all of the Company’s short-term investments,carried at fair value, were classified as available-for-sale with unrealizedgains and losses included as a separate component of equity.  The gross unrealized loss on short-terminvestments was $11 at September 30, 2005.

 

***Stock–BasedCompensation***

 

SFAS No. 123encourages but does not require companies to record compensation cost forstock-based employee and director compensation plans at fair value.  Rather than adopt the recommended fair valuemethod, the Company has elected to account for stock-based compensation underOpinion No. 25, and related interpretations.  Under Opinion No. 25, compensation costfor stock options issued to employees and directors is measured as the excess,if any, of the market price of the Company’s common stock over the exerciseprice at the date both the number of shares and exercise price per share areknown (measurement date).  Such amountsare amortized on a straight-line basis over the respective vesting periods ofthe option grants.  Transactions withnon-employees (if any) in which goods or services are the considerationreceived for the issuance of equity instruments are accounted for on afair-value-basis in accordance with SFAS No. 123 and relatedinterpretations.

 

Had theCompany adopted the fair value method and recognized the grant-date fair valueof the equity instruments issued (using one of the various valuation modelspermitted), the compensation cost relating to the Company’s share-based paymenttransactions would have been recognized in the Company’s financialstatements.  The pro forma net (loss)income allocable to common stockholders and net (loss) income per shareallocable to common stockholders if the Company had adopted the fair valuebased method of accounting in accordance with SFAS No. 123, as amended bySFAS No. 148, are set out below:

 

8

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| ** **                                                                                                      | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|-----------------------------------------------------------------------------------------------------------------|------------|--------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                                                                                      | ** ** | **2005**                                   | ** ** | **2004**                                  | ** ** | **2005** | ** ** | **2004** | ** ** |
| Net (loss) income allocable to common  stockholders:                                                            |       |                                       |       |                                      |       |   |   |   |   |
|                                                                                                            |       |                                       |       |                                      |       |   |   |   |   |
| As reported                                                                                                     |       | $                                          | (5,378     | )                                         | $          | 725 |   | $ | (13,680 | ) | $ | 1,887 |   |
|                                                                                                            |       |                                       |       |                                      |       |   |   |   |   |
| Add: Stock-based employee compensation  expenses included in net (loss) income allocable to common stockholders |       | —                                     |       | —                                    |       | — |   | — |   |
|                                                                                                            |       |                                       |       |                                      |       |   |   |   |   |
| Less: Stock-based employee compensation  under fair value based method                                          |       | (848                                       | )          | (892                                      | )          | (2,578 | ) | (2,815 | ) |
| Pro forma net loss allocable to common  stockholders                                                            |       | $                                          | (6,226     | )                                         | $          | (167 | ) | $ | (16,258 | ) | $ | (928 | ) |
|                                                                                                            |       |                                       |       |                                      |       |   |   |   |   |
| Basic and diluted net (loss) income per  share allocable to common stockholders:                                |       |                                       |       |                                      |       |   |   |   |   |
|                                                                                                            |       |                                       |       |                                      |       |   |   |   |   |
| As reported                                                                                                     |       | $                                          | (0.37      | )                                         | $          | 0.05 |   | $ | (0.95 | ) | $ | 0.13 |   |
| Pro forma net loss per share allocable to  common stockholders                                                  |       | $                                          | (0.43      | )                                         | $          | (0.01 | ) | $ | (1.13 | ) | $ | (0.07 | ) |

 

**Note 2 — Customer andProduct Concentrations**

 

A majority ofthe Company’s revenue has historically been derived from a small number ofwholesale drug distributors and Mutual. For the nine months ended September 30, 2005, sales to CardinalHealth, Inc., McKesson Corporation, Amerisource Bergen Corporation andMutual, represented approximately 35%, 24%, 12% and 24%, respectively, of theCompany’s aggregate net product sales. For the nine months ended September 30, 2004, sales to CardinalHealth, Inc., McKesson Corporation, Amerisource Bergen Corporation andMutual represented approximately 34%, 29%, 18% and 12%, respectively, of theCompany’s aggregate net product sales.

 

During thenine months ended September 30, 2005, Periostat and Mutual’s brandedversion of Periostat accounted for approximately 78% of the Company’s total netrevenues.  During the nine months ended September 30,2004, Periostat and Mutual’s branded version of Periostat accounted forapproximately 88% of the Company’s total net revenues.

 

9

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**Note 3 — Inventories**

 

Inventories atSeptember 30, 2005 and December 31, 2004 consist of the following:

 
| ** **      | ** ** | **2005** | ** ** | **2004** | ** ** |
|-----------------|------------|----------|------------|----------|------------|
| Raw  materials  |       | $        | 138        |     | $          | 395 |   |
| Work-in-process |       | —   |       | 394      |       |
| Finished  goods |       | 522      |       | 1,903    |       |
|            |       | $        | 660        |     | $          | 2,692 |   |

 

During thenine month period ended September 30, 2005, the Company recorded a chargeto cost of product sales of $979 for excess inventory of Periostat and Mutual’sbranded version of Periostat.  The chargeresulted from decreased demand for Periostat and the termination of the Company’sLicense and Supply Agreement with Mutual both of which resulted from theintroduction of a third party generic version of Periostat in May 2005.

 

**Note 4 — Line ofCredit**

 

On June 7,2004, the Company entered into a Loan Modification Agreement with SiliconValley Bank to renew and amend its revolving credit facility.  The amended credit facility expires on May 31,2006.  Under the amended credit facility,the Company may borrow up to the lesser of $5,000 or 80% of eligible accountsreceivable, as defined under the amended credit facility.  The amount available to the Company isreduced by any outstanding letters of credit which may be issued under theamended credit facility in amounts totaling up to $2,000.  As the Company pays down amounts under anyletter of credit, the amount available to it under the credit facilityincreases.  The Company is not obligatedto draw down any amounts under the amended credit facility and any borrowingsshall bear interest, payable monthly, at the current prime rate.  As of September 30, 2005, the Companyhad no borrowings or letters of credit outstanding.

 

**Note 5 — Contract andLicense Revenues**

 

The Companyrecorded $446****and $235 in contractand licensing revenues for the nine months ended September 30, 2005 and September 30,2004, respectively.  During the ninemonths ended September 30, 2005, $160 of license revenue was recorded toreflect the unamortized portion of upfront license revenue from the License andSupply Agreement with Showa Yakuhin Kako Co., Ltd., which was terminated in March 2005.

 

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.  Under the Promotion Agreement, the Companywill receive a percentage of the gross profit arising from prescriptionswritten by dermatology professionals (or offices) that result in sales of theproducts in the United States.  Themajority of marketing expenses, excluding sales force compensation and sampleproduct costs, related to the promotion of the Primus products will be fundedby Primus.  The majority of productsample costs and all sales force

 

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compensation will be funded by theCompany.  During the three and ninemonths ended September 30, 2005, the Company recognized $144 and $152,respectively, in contract revenues associated with the promotion of the Primusproducts.

 

**Note 6 — LegalSettlements and Proceedings**

 

On April 8,2004, the Company announced that it had settled all pending litigation betweenthe Company and Mutual.  In thesettlement, the Company paid to Mutual $2,000, which was recorded during thethree month period ended March 31, 2004.

 

In connectionwith the settlement, the Company and Mutual entered into a License and SupplyAgreement pursuant to which Mutual received a license to sell a branded versionof Periostat and would purchase this product exclusively from the Company atprices below the Company’s average manufacturer’s price.  The Agreement also provided for the Companyto make price adjustments to Mutual after a generic version of Periostat hadbecome available on the market at a price lower than the selling price ofMutual’s branded version of Periostat. These adjustments were to take the form of rebates or credits to Mutualto reduce the acquisition cost of the branded version of Periostat in Mutual’sinventory or to offset rebates and similar retroactive price adjustmentsrequested by, and actually provided by, Mutual to its customers.

 

On May 13,2005, the FDA approved a third party generic version of Periostat that waslaunched in late May 2005.  Uponthis generic launch, Mutual was no longer obligated to purchase its brandedversion of Periostat from the Company. Net product sales for the nine months ended September 30, 2005 arenet of a $984 reduction in revenue for price protection payments paid toMutual.  As of September 30, 2005,the Company has recorded deferred revenue of $70 for sales to Mutual since theprice protection rebate and final selling price had not yet beendetermined.  (See note 9)

 

In June 2003,the Company commenced an action and filed a motion for a preliminary injunctionin the United States District Court for the District of Columbia challengingthe FDA’s decision to treat Periostat as an antibiotic drug, thus denyingPeriostat certain protections afforded non-antibiotic drugs under the Food,Drug, and Cosmetic Act and against FDA approval of generic copies of Periostat(the “FDA Litigation”).  On July 23,2003, the United States District Court for the District of Columbia issued aninjunction in favor of the Company.  On January 20,2005, the United States District Court for the District of Columbia reached itsdecision on the merits of the FDA Litigation, and dissolved the injunction thathad prohibited the FDA from approving any Abbreviated New Drug Applications, orANDAs, submitted for any generic version of Periostat.  The Company lodged, but has now withdrawn, anappeal against this decision in the Court of Appeals for the District ofColumbia Circuit.

 

On October 1,2004, the Company filed a complaint for patent infringement against IVAXPharmaceuticals Inc. (“IVAX”) and CorePharma LLC (“CorePharma”) in the UnitedStates District Court for the Eastern District of New York.  In its complaint, the Company alleged thatthe submission of ANDAs by each of IVAX and CorePharma for 20 mg tablets ofdoxycycline hyclate infringed United States Patent RE 34,656, for which theCompany is the exclusive licensee.  TheCompany also alleged that any manufacture, importation, marketing and sale ofgeneric 20 mg tablets of doxycycline hyclate by IVAX and CorePharma wouldinfringe

 

11

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the RE 34,656 patent.  The Company sought an injunction preventing IVAXand CorePharma from introducing 20 mg tablets of doxycycline hyclate in theUnited States.  The injunction was deniedby the Court on June 16, 2005.  Thelitigation on the merits of the Company’s patent infringement claims is stillpending before the Court in the Eastern District of New York.

 

**Note 7 — LegalExpenses to Defend Periostat Patents**

 

Under theCompany’s license agreement with the Research Foundation of the StateUniversity of New York (“SUNY”) covering Periostat, the Company is entitled to deductcosts incurred to defend its patents, including the $2,000 settlement paymentto Mutual in April 2004, from current and future royalties due to SUNY onnet sales of Periostat and sales to Mutual of its branded version ofPeriostat.  The Company anticipates thatits future legal costs in these matters relating to patent infringement anddefense will be reimbursed by SUNY pursuant to its Technology License Agreementwith SUNY to the extent that these legal expenses do not exceed royaltiesearned by SUNY during that period. During the nine months ended September 30, 2005 and September 30,2004, the Company incurred $1,073 and $3,203 respectively, in legal defense,litigation and settlement costs, of which $844 and $1,496, respectively, werededucted from royalties payable to SUNY. In the event such cumulative legal costs exceed the amount of theroyalties payable to SUNY, the Company will not be able to recover such legalcosts from SUNY.  The cumulative legalpatent defense, litigation and settlement costs incurred as of September 30,2005 exceed the amount of the royalties earned and payable to SUNY by$4,168.  These amounts, which have beenexpensed, will be available to offset future royalties earned by SUNY, if any,on net sales of products based on the SUNY technology.

 

**Note 8 — Sales ForceRestructuring**

 

On May 16,2005, the Company announced the restructuring of its sales force following theFDA’s approval of a third party generic version of Periostat.  As a result of the restructuring, the Companyceased all dental promotional activities. The Company incurred a $1,184 restructuring charge during the ninemonths ended September 30, 2005.  Ofthis charge, $813 related to employee severance costs while the remainingportion was primarily related to the write-off of tangible assets and paymentsdue under an operating lease associated with the Company’s dental sales andmarketing activities that could no longer be utilized by the Company.  As of September 30, 2005, $116 of therestructuring charge had not yet been paid and is a component of accruedexpenses on the Company’s Condensed Consolidated Balance Sheet.  (See note 9) The accrued expense of $116 is expected to be paid over the next twelvemonths.

 

On April 22,2004, the Company announced the restructuring of its pharmaceutical salesorganization into dedicated dental and dermatology sales forces.  The Company incurred a $348 restructuringcharge during the year ended December 31, 2004.  As of September 30, 2005, all of thesecosts have been paid by the Company.

 

**Note 9 — Accrued Expenses**

 

Accruedexpenses at September 30, 2005 and December 31, 2004 consist of thefollowing:

 

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| ** **                                      | ** ** | **2005** | ** ** | **2004** | ** ** |
|-------------------------------------------------|------------|----------|------------|----------|------------|
| Contracted  development and manufacturing costs |       | $        | 2,618      |     | $          | 1,648 |   |
| Sales and  marketing costs                      |       | 253      |       | 212      |       |
| Payroll and  related costs                      |       | 1,483    |       | 1,731    |       |
| Professional  and consulting fees               |       | 324      |       | 159      |       |
| Deferred  revenue (notes 1 and 6)               |       | 107      |       | 54       |       |
| Foreign  taxes                                  |       | 937      |       | 945      |       |
| Product  returns (note 1)                       |       | 1,296    |       | 592      |       |
| Miscellaneous  taxes                            |       | 75       |       | 99       |       |
| Restructuring  expenses (note 8)                |       | 116      |       | 25       |       |
| Other                                           |       | 130      |       | 120      |       |
|                                            |       | $        | 7,339      |     | $          | 5,585 |   |

 

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**Item 2.****                                                           Management’sDiscussion and Analysis of Financial Condition and Results of Operations.**

 

Our management’sdiscussion and analysis of our financial condition and results of operationsinclude the identification of certain trends and other statements that maypredict or anticipate future business or financial results.  There are important factors that could causeour actual results to differ materially from those indicated.  See “Additional Risks That May AffectResults.”

 

**Overview**

 

CollaGenexPharmaceuticals, Inc. and subsidiaries is a specialty pharmaceuticalcompany currently focused on developing and marketing innovative proprietarymedical therapies to the dermatology market. We currently market three prescription pharmaceutical products to thedermatology market through our professional dermatology sales force.  Our marketed dermatology products are Pandel®,a prescription corticosteroid we licensed from Altana, Inc. in May 2002,AlcortinTM, a prescription topical antifungal steroid combination, andNovacortTM, a prescription topical steroid and anesthetic.  We are promoting Alcortin and Novacort todermatology offices pursuant to a Promotion and Cooperation Agreement executedin June 2005 with Primus Pharmaceuticals, Inc. (“Primus”).

 

Prior to the May 2005introduction of a third party generic version of Periostat®, ourdental sales force detailed four prescription pharmaceutical products to thedental market.  On May 20, 2005, weceased all sales promotion activities for these products.  We currently still generate sales from thesedental products, which all treat periodontal disease and include our ownproduct Periostat, as well as Atridox®, Atrisorb FreeFlow®and Atrisorb-D® (the “Atrix Products”) which are licensed from AtrixLaboratories, Inc. (now known as QLT USA, Inc.).  We had also sold a separately branded versionof Periostat to United Research Laboratories, Inc./Mutual PharmaceuticalCompany, Inc. (“Mutual”) pursuant to a License and Supply Agreementexecuted in April 2004 as part of a settlement of our outstanding patentlitigation with Mutual.  As a result ofthe launch of a third party generic version of Periostat in May 2005,Mutual ceased purchasing product from us during June 2005.  Based on data provided by a leadingindependent prescription tracking service, we estimate that Periostat’s shareof the 20 mg doxycycline market was approximately 19% during the month of September 2005.  We anticipate Periostat’s share of the marketwill continue to decrease as a result of the third party introduction of ageneric version of Periostat.

 

In addition toour marketed products, we have a pipeline of products in clinical andpre-clinical development.  These productsare based on our two proprietary platform technologies, IMPACSTM and 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 is ourfirst FDA-approved IMPACS product. Periostat-MRTM is a once-a-day, controlled release formulation ofPeriostat currently in a Phase III clinical trial for the treatment of adultperiodontitis.  We do not intend to seekregulatory approval or market Periostat-MR in the United States.  Alliance Pharma PLC, a U.K. specialtypharmaceutical company that acquired our U.K. and European dental assets in

 

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2004, has an option to acquire the rights toseek regulatory approval and market Periostat-MR in the U.K. and Europe.

 

We recentlycompleted two Phase III clinical trials for OraceaTM for the treatment ofrosacea, a dermatological condition. Oracea contains the same active ingredient and controlled delivery asPeriostat-MR.  We submitted our New DrugApplication for Oracea to the FDA on August 1, 2005.  In April 2005, we announced thecompletion of a Phase II proof-of-concept clinical trial for incyclinide(formerly known as COL-3), our second generation IMPACS compound, for thetreatment of rosacea.  In September 2005,we initiated a 300-patient, double-blinded, placebo-controlled, Phase IIdose-finding clinical trial to evaluate the safety and efficacy of incyclinidefor the treatment of acne.

 

OurRestoraderm technology is a proprietary, foam-based, topical drug delivery technologythat originated from a Swedish collaborator. We have acquired all rights, title and interest to the Restoradermtechnology and have initiated the development of five products based on thistechnology.  We are currently developingRestoraderm products for the treatment of acne and psoriasis.

 

Our strategyis to become a leading developer and marketer of innovative prescriptionpharmaceutical products to the dermatology market.  We intend to continue to market our currentproducts and develop and launch new products based on our two proprietaryplatform technologies.  Our core focus ison the dermatology market, although we intend to seek additional partnershipswith third parties to develop potential uses of our technology outside of thatfocus.

 

We werefounded in 1992 and completed an initial public offering of our common stock in1996.  We recorded our first profit inthe third quarter of 2002.  Although weearned net income of $6.5 million and $6.4 million for the years ended December 31,2004 and 2003, respectively, we incurred a net loss allocable to commonstockholders of $13.7 million during the nine months ended September 30,2005 and we have an accumulated deficit of $78.2 million as of September 30,2005.  We do not expect to generate profitsfor the year ending December 31, 2005 or 2006.

 

**Significant Recent Developments**

 

On June 6,2005, we announced the results of our two double-blind, placebo-controlledPhase III clinical studies for Oracea, the first orally administered,systemically delivered drug to treat rosacea. The two Phase III clinical trials were identical in design and conductedconcurrently.  Both studies achievedtheir primary endpoint by demonstrating a greater reduction in inflammatorylesion count from baseline for the Oracea-treated patients compared to thepatients receiving placebo.  In the twotrials, patients receiving Oracea experienced a 61% and 46% mean reduction ininflammatory lesions compared to 29% and 20% mean reduction in patientsreceiving placebo.

 

On August 1,2005, we announced the filing of a New Drug Application with the FDA forOracea.

 

15

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On October 3,2005, we announced that the New Drug Application for Oracea had been acceptedfor review by the FDA.  The PrescriptionDrug User Fee Act (PDUFA) target date for reviewing the submission is May 30,2006.

 

On August 2,2005, the results from a Phase II clinical trial evaluating incyclinide as atreatment for rosacea were presented. The Phase II trial was designed to establish proof of principle forincyclinide as a potential treatment for a dermatologic condition.  In this double-blind, placebo-controlledclinical trial, patients were administered either incyclinide or placebo once aday for 28 days.  The study achieved itsprimary endpoint, demonstrating a statistically significant, greater reductionin inflammatory lesion count from baseline for the incyclinide treated patientscompared to patients on placebo.

 

On August 3,2005, we announced that the United States Patent and Trademark Office hadpublished on its website that U.S. Patent Application, serial no. 10/117,709,had been allowed.  This patent covers theuse of sub-antimicrobial tetracyclines, including Oracea, and non-antimicrobialtetracyclines, including incyclinide, for the treatment of acne and acnerosacea.  This patent application has apriority date of April 5, 2002 and an expiration date 20 years from thatdate.

 

On September 26,2005, we announced the initiation of a Phase II, double-blind,placebo-controlled, dose-finding clinical trial to evaluate the safety andefficacy of incyclinide.  This trial willenroll approximately 300 patients with moderate to severe acne at 20investigational centers throughout the United States.  The trial will evaluate three dosagestrengths of incyclinide and a placebo over a 12-week period with the objectiveof determining an optimal dose for Phase III testing.  We anticipate that the results of the trialwill be available in the fourth quarter of 2006.

 

## **Results ofOperations**

 

*Three Months Ended September 30, 2005Compared to Three Months Ended September 30, 2004*

 

**Revenues**

 
| **Revenues  (dollars in thousands)** | ** ** | **2005** | ** ** | **Change** | ** ** | **2004** | ** ** |
|--------------------------------------|------------|----------|------------|------------|------------|----------|------------|
| Net Product  Sales                   |       | $        | 4,298      |       | (60.9      | )%       | $          | 10,991 |   |
| Contract and  License Revenues       |       | 202      |       | 140.5      | %          | 84       |       |
| Total                                |       | $        | 4,500      |       | (59.4      | )%       | $          | 11,075 |   |

 

The decreasein net product sales during the three months ended September 30, 2005 wasprimarily due to the launch of a third party generic competitor to Periostat inMay 2005.  During the third quarterof 2005, Periostat accounted for 22% of the total dispensed prescriptions forthe 20 mg doxycycline market compared to the 100% market share held byPeriostat and Mutual’s branded version of Periostat supplied by us in the thirdquarter of 2004.  Contract and licenserevenues**during the thirdquarter of 2005** were derived from residual contract revenuesfrom our expired agreement with Merck & Co., Inc. for Vioxx®,contract revenues from our Promotion

 

16

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and Cooperation Agreement with Primus andinternational licensing revenues for Periostat. **During the thirdquarter of 2004, contract and license revenues were derived from residualrevenues from our expired agreement with Merck and international licensing feesfor Periostat.  The increase in contractand license revenues in the third quarter of 2005 compared to the third quarterof 2004 was due primarily to our** Promotion and CooperationAgreement with Primus, initiated in June 2005.

 

## **Cost of Product Sales**

 
| **Cost of Product Sales   (dollars in thousands)** | ** ** | **2005** | ** ** | **Change** | ** ** | **2004** | ** ** |
|----------------------------------------------------|------------|----------|------------|------------|------------|----------|------------|
| Cost of  Product Sales                             |       | $        | 852        |       | (44.6      | )%       | $          | 1,537 |   |
| Percent of  Net Product Sales                      |       | 19.8     | %          | N/A        |       | 14.0     | %          |
|                                                    |            |          |            |            |            |          |            |  |  |

 

Cost ofproduct sales includes product packaging, third party royalties, amortization ofproduct licensing fees, and the costs associated with the manufacturing,storage and stability of Periostat, Mutual’s branded version of Periostat,Pandel and the Atrix Products, as well as charges taken to reflect a decreasein inventory carrying value, if any.

 

The decreasein cost of products sales was primarily the result of lower net productsales.  The increase in cost of productsales as a percent of net product sales was due to a higher absorption of fixedoverhead costs over a smaller net product sales base as well as a change inproduct mix.

 

## **Research and Development**

 
| **Research and Development  (dollars in thousands)** | ** ** | **2005** | ** ** | **Change** | ** ** | **2004** | ** ** |
|------------------------------------------------------|------------|----------|------------|------------|------------|----------|------------|
| Research and  development                            |       | $        | 3,942      |       | 81         | %        | $          | 2,178 |   |
|                                                      |            |          |            |            |            |          |            |  |  |

 

Research anddevelopment expenses consist primarily of funds paid to third parties for theprovision of services and materials for drug development, including milestonefees, manufacturing and formulation enhancements, clinical trials, statisticalanalysis and report writing and regulatory compliance costs.

 

Significantdevelopment projects conducted during the three months ended September 30,2005 included:

 

•                                          ourcontinuing clinical and manufacturing development work for Oracea, our oncedaily, controlled release formulation of doxycycline, 40 mg, for the treatmentof rosacea, which accounted for total costs of approximately $2.0 million;

 

•                                          ourclinical and manufacturing development work for incyclinide, a secondgeneration IMPACS compound, totaling $820,000;

 

•                                          stabilitytesting and formulation costs for two potential products utilizing our

 

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Restoradermtechnology, which accounted for total costs of approximately $236,000; and

 

•                                          ourcontinuing clinical and manufacturing development and formulation work for Periostat-MR,our once daily, controlled release formulation of doxycycline, 40 mg, for thetreatment of adult periodontitis, which accounted for total costs ofapproximately $313,000.

 

We estimatethat if Oracea, incyclinide and our Restoraderm acne and psoriasis products aredeveloped to the point of commercialization, the additional formulation andclinical development expenses and milestones fees expected to be incurred overthe next five years would be approximately $30.0 to $35.0 million.

 

Significant developmentprojects conducted during the three months ended September 30, 2004included:

 

•                                          ourcontinuing clinical and manufacturing development work for Oracea, our oncedaily, controlled release formulation of doxycycline, 40 mg, for the treatmentof rosacea, which accounted for total costs of approximately $443,000; and

 

•                                          ourcontinuing clinical and manufacturing development and formulation work forPeriostat-MR, our once daily, controlled release formulation of doxycycline, 40mg, for the treatment of adult periodontitis, which accounted for total costsof approximately $601,000; and

 

•                                          in-processresearch and development charges resulting from the purchase of Restoraderm,milestone, formulation and stability testing costs for two potential productsutilizing our Restoraderm technology, which accounted for total costs ofapproximately $530,000.

 

## **Selling, General and Administrative**

 
| **Selling, General and  Administrative  (dollars in thousands)** | ** ** | **2005** | ** ** | **Change** | ** ** | **2004** | ** ** |
|------------------------------------------------------------------|------------|----------|------------|------------|------------|----------|------------|
| Selling,  General and Administrative                             |       | $        | 4,918      |       | (22.4      | )%       | $          | 6,341 |   |
|                                                                  |            |          |            |            |            |          |            |  |  |

 

Selling,general and administrative expenses consist primarily of personnel salaries andbenefits, direct marketing costs, professional, legal and consulting fees,insurance and general office expenses.

 

Significantcomponents of selling, general and administrative expenses incurred during thethree months ended September 30, 2005 included approximately$2.1 million in direct selling and sales training expenses, approximately$1.4 million in marketing expenses (including advertising and promotionexpenditures for the Primus products and Pandel) and approximately $1.5 millionin general and administrative expenses, which include business development,finance, legal and corporate activities. Significant components of selling, general and administrative expensesincurred during the three months ended September 30, 2004 included

 

18

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approximately $3.2 million in directselling and sales training expenses, approximately $1.8 million in marketingexpenses (including advertising and promotion expenditures for Periostat, theAtrix Products, and Pandel) and approximately $1.5 million in general andadministrative expenses, which include business development, finance, legal andcorporate activities.  The decrease inselling, general and administrative expenses during the three months ended September 30,2005 compared to the three months ended September 30, 2004 is primarilyattributable to decreased personnel costs as a result of the May 2005 terminationof our dental sales and marketing activities and the corresponding reduction of63 employees, including our dental sales force.

 

## **Interest Income**

 
| **Interest Income  (dollars in thousands)** | ** ** | **2005** | ** ** | **Change** | ** ** | **2004** | ** ** |
|---------------------------------------------|------------|----------|------------|------------|------------|----------|------------|
| Interest  income                            |       | $        | 288        |       | 191        | %        | $          | 99 |   |
|                                             |            |          |            |            |            |          |            |  |  |

 

The increasein interest income was due to higher average investment yields.

 

## **Preferred Stock Dividend**

 

Preferredstock dividends included in net income allocable to common stockholders were$454,000 during the three months ended September 30, 2005 and $400,000during the three months ended September 30, 2004.  Such preferred stock dividends were paid incash and are the result of our obligations in connection with the issuance ofour Series D preferred stock in May 1999.

 

*Nine Months Ended September 30, 2005Compared to Nine Months Ended September 30, 2004*

 

**Revenues**

 
| **Revenues  (dollars in thousands)** | ** ** | **2005** | ** ** | **Change** | ** ** | **2004** | ** ** |
|--------------------------------------|------------|----------|------------|------------|------------|----------|------------|
| Net Product  Sales                   |       | $        | 23,006     |       | (40.5      | )%       | $          | 38,691 |   |
| Contract and  License Revenues       |       | 446      |       | 89.8       | %          | 235      |       |
| Total                                |       | $        | 23,452     |       | (39.8      | )%       | $          | 38,926 |   |

 

Revenuesduring the nine month period ending September 30, 2005 includedapproximately $23.0 million in net product sales of Periostat, Mutual’sbranded version of Periostat, Pandel and the Atrix Products.  The decrease in 2005 net product sales wasprimarily due to lower Periostat net sales as a result of the launch of a thirdparty generic competitor in May 2005. During the nine month period ended September 30, 2005, Periostatand Mutual’s branded version of Periostat supplied by us accounted for approximately34% of the total dispensed prescriptions for the 20 mg doxycycline marketcompared to the 100% market share held by Periostat and Mutual’s brandedversion of Periostat supplied by us in the nine month period ended September 30,2004. ** Contract** and licenserevenues during the nine months ended September 30, 2005 were derived fromresidual contract revenues from our expired agreement

 

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with Merck & Co., Inc. forVioxx, contract revenues from our Promotion and Cooperation Agreement withPrimus and international licensing revenues for Periostat.  During the nine months ended September 30,2005, $160,000 of contract and license revenue was recorded to include theunamortized portion of upfront license revenue received in 2000 from theLicense and Supply Agreement with Showa Yakuhin Kako Co., Ltd., which wasterminated in March 2005.  Duringthe nine months ended September 30, 2004, contract and license revenueswere derived from residual contract revenues from our expired agreement withMerck and international license fees, including the amortization of the ShowaYakuhin Kako Co., Ltd. license.

 

## **Cost of Product Sales**

 
| **Cost of Product Sales   (dollars in thousands)** | ** ** | **2005** | ** ** | **Change** | ** ** | **2004** | ** ** |
|----------------------------------------------------|------------|----------|------------|------------|------------|----------|------------|
| Cost of  Product Sales                             |       | $        | 5,017      |       | (10.3      | )%       | $          | 5,590 |   |
| Percent of  Net Product Sales                      |       | 21.8     | %          | N/A        |       | 14.4     | %          |
|                                                    |            |          |            |            |            |          |            |  |  |

 

Cost ofproduct sales includes product packaging, third party royalties, amortizationof product licensing fees, and the costs associated with the manufacturing,storage and stability of Periostat, Mutual’s branded version of Periostat,Pandel and the Atrix Products, as well as charges taken to reflect a decreasein inventory carrying value, if any.

 

Cost ofproduct sales for the nine months ended September 30, 2005 includes acharge of approximately $979,000 associated with the estimated excessinventories of Periostat and Mutual’s branded version of Periostat supplied byus as a result of the launch by a third party generic competitor.  Cost of product sales also increased as apercentage of net product sales as a result of lower average selling prices toMutual, a greater absorption of fixed overhead expense over a smaller net salesbase and a change in product mix during the nine month period ended September 30,2005 as compared to the nine month period ended September 30, 2004.

 

## **Research and Development**

 
| **Research and Development  (dollars in thousands)** | ** ** | **2005** | ** ** | **Change** | ** ** | **2004** | ** ** |
|------------------------------------------------------|------------|----------|------------|------------|------------|----------|------------|
| Research and  development                            |       | $        | 11,237     |       | 86.6       | %        | $          | 6,023 |   |
|                                                      |            |          |            |            |            |          |            |  |  |

 

Research anddevelopment expenses consist primarily of funds paid to third parties for theprovision of services and materials for drug development, including milestonefees, manufacturing and formulation enhancements, clinical trials, statisticalanalysis and report writing and regulatory compliance costs.

 

Significantdevelopment projects conducted during the nine months ended September 30,2005 included:

 

•                                          ourcontinuing clinical and manufacturing development work for Oracea, our oncedaily, controlled release formulation of doxycycline, 40 mg, for the

 

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treatment ofrosacea, which accounted for total costs of approximately $5.2 million;

 

•                                          ourclinical and manufacturing development work for incyclinide, a secondgeneration IMPACS compound, totaling $2.0 million;

 

•                                          stabilitytesting and formulation costs for two potential products utilizing ourRestoraderm technology, which accounted for total costs of approximately$740,000; and

 

•                                          ourcontinuing clinical and manufacturing development and formulation work forPeriostat-MR, our once daily, controlled release formulation of doxycycline, 40mg, for the treatment of adult periodontitis, which accounted for total costsof approximately $1.3 million.

 

We estimatethat if Oracea, incyclinide and our Restoraderm acne and psoriasis products aredeveloped to the point of commercialization, the additional formulation andclinical development expenses and milestones fees expected to be incurred overthe next five years would be approximately $30.0 to $35.0 million.

 

Significantdevelopment projects conducted during the nine months ended September 30,2004 included:

 

•                                          ourcontinuing clinical and manufacturing development work for Oracea, our oncedaily, controlled release formulation of doxycycline, 40 mg, for the treatmentof rosacea, which accounted for total costs of approximately $1.6 million;

 

•                                          ourcontinuing clinical and manufacturing development and formulation work forPeriostat-MR, our once daily, controlled release formulation of doxycycline, 40mg, for the treatment of adult periodontitis, which accounted for total costsof approximately $1.3 million;

 

•                                          in-processresearch and development charges resulting from the purchase of Restoraderm,milestone, formulation and stability testing for two potential productsutilizing our Restoraderm technology, which accounted for total costs ofapproximately $853,000; and

 

•                                          aPhase III clinical trial to evaluate Periostat for the treatment of rosacea,which accounted for total costs of approximately $417,000.

 

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## **Selling, General and Administrative**

 
| **Selling, General and  Administrative  (dollars in thousands)** | ** ** | **2005** | ** ** | **Change** | ** ** | **2004** | ** ** |
|------------------------------------------------------------------|------------|----------|------------|------------|------------|----------|------------|
| Selling, General and Administrative – other                 |       | $        | 19,175     |       | (13.3      | )%       | $          | 22,122 |   |
| Selling, General and Administrative – legal  settlement     |       | —   |       | N/A        |       | 2,000    |       |
| Selling, General and Administrative –  restructuring        |       | $        | 1,184      |       | 240.2      | %        | 348        |   |
| Total                                                            |       | $        | 20,359     |       | (16.8      | )%       | $          | 24,470 |   |

 

Selling,general and administrative – other expenses consist primarily of personnelsalaries and benefits, direct marketing costs, professional, legal andconsulting fees, insurance and general office expenses.

 

Significantcomponents of selling, general and administrative – other expenses incurredduring the nine months ended September 30, 2005 included approximately$8.8 million in direct selling and sales training expenses, approximately$5.0 million in marketing expenses (including advertising and promotionexpenditures for Periostat, the Atrix Products, the Primus products and Pandel)and approximately $5.4 million in general and administrative expenses,which include business development, finance, legal and corporateactivities.  Significant components ofselling, general and administrative – other expenses incurred during the nine monthsended September 30, 2004 included approximately $11.4 million in directselling and sales training expenses, approximately $5.9 million inmarketing expenses (including advertising and promotion expenditures forPeriostat, the Atrix Products and Pandel), and approximately $4.8 millionin general and administrative expenses, which include business development,finance, legal and corporate activities. The decrease in selling, general and administrative – other expensesduring the nine months ended September 30, 2005 compared to the nine monthsended September 30, 2004 was primarily attributable to decreased personnelcosts as a result of the April 2004 sales force restructuring and the May 2005termination of our dental sales and marketing activities and the correspondingreduction of 63 employees, including our dental sales force, offset partiallyby increased legal costs.

 

Selling,general and administrative – legal settlement consisted of$2.0 million during the three months ended September 30, 2004 thatresulted from the accrual for a one-time payment to Mutual in connection withthe settlement of all outstanding litigation between us and Mutual.

 

Selling,general and administrative – restructuring during the nine monthsended September 30, 2005 consisted of a $1.2 million charge related to areorganization following the approval of a third party generic version ofPeriostat in May of 2005.  As aresult of the restructuring, we ceased all sales activities of our dentalfranchise.  Selling, general andadministrative – restructuring during the nine months ended September 30,2004 consisted of $348,000 that resulted from a charge related to the April 2004reorganization of our sales organization into dedicated dental and dermatologysales forces.

 

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## **Interest Income**

 
| **Interest Income  (dollars in thousands)** | ** ** | **2005** | ** ** | **Change** | ** ** | **2004** | ** ** |
|---------------------------------------------|------------|----------|------------|------------|------------|----------|------------|
| Interest  income                            |       | $        | 763        |       | 219.2      | %        | $          | 239 |   |
|                                             |            |          |            |            |            |          |            |  |  |

 

The increasein interest income was due to higher average investment balances in 2005, aswell as higher average investment yields.

 

## **Preferred Stock Dividend**

 

Preferredstock dividends included in net income allocable to common stockholders were$1.3 million during the nine months ended September 30, 2005 and $1.2million during the nine months ended September 30, 2004.  Such preferred stock dividends were paid incash and are the result of our obligations in connection with the issuance ofour Series D preferred stock in May 1999.

 

## **Liquidity and Capital Resources**

## ** **

***Cash Requirements/Sources and Uses of Cash***

 

We requirecash to fund our operating expenses, capital expenditures and dividend paymentson our outstanding Series D preferred stock.  We have historically funded our cashrequirements primarily through the following:

 

•              Public offerings and privateplacements of our preferred and common stock;

 

•              Cash from operations; and

 

•              Exercise of stock options andwarrants.

 

We believethat other key factors that could affect our ability to maintain and draw oninternal and external sources of cash are:

 

•                                          Thesuccess of our dermatology franchise;

 

•                                          Thesuccess of our pre-clinical, clinical and development programs;

 

•                                          Marketpenetration by third party generic manufacturers of a generic version ofPeriostat;

 

•                                          Revenuesand profits from sales of Periostat and our other product candidates, as wellas the products we co-promote;

 

•                                          Theterms and conditions of our outstanding Series D preferred stock;

 

•                                          Ourability to continue to meet the covenant requirements under our revolvingcredit facility with Silicon Valley Bank; and

 

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•                                          Thestate of the capital markets generally and, in particular, the receptivity ofthe capital markets to our future financings.

 

On June 7,2004, we entered into a Loan Modification Agreement with Silicon Valley Bank torenew and amend our revolving credit facility, which had expired on March 15,2004.  The amended credit facilityexpires on May 31, 2006.  Under theamended credit facility, we may borrow up to the lesser of $5.0 million or 80%of eligible accounts receivable, as defined under the amended creditfacility.  The amount available to us isreduced by any outstanding letters of credit which may be issued under theamended credit facility in amounts totaling up to $2.0 million.  As we pay down amounts under any letter ofcredit, the amount available to us under the credit facility increases.  We are not obligated to draw amounts underthe amended credit facility and any borrowings shall bear interest, payablemonthly, at the current prime rate.  Asof September 30, 2005, we had no outstanding borrowings or letters ofcredit.

 

At September 30,2005, we had cash, cash equivalents and short-term investments of approximately$34.7 million, a decrease of approximately $3.9 million compared to theapproximately $38.6 million balance at December 31, 2004.  This decrease is primarily attributable toour operating loss during the nine months ended September 30, 2005, offsetin part by cash receipts from revenues which were deferred, collection of ourtrade receivables and a reduction in our inventory levels.  In accordance with investment guidelinesapproved by our Board of Directors, cash balances in excess of those requiredto fund operations have been invested in government notes, commercial paper andmoney market funds.  Our working capitalat September 30, 2005 was $27.2 million compared to $39.7 million at December 31,2004.  During the nine months ended September 30,2005, we invested approximately $319,000 in capital expenditures, paid $1.6million in cash dividends to the holders of our Series D preferred stockand liquidated approximately $4.8 million (net of purchases) of short-terminvestments.

 

As of September 30,2005, we had approximately $416,000 in outstanding accounts receivable due fromMutual all of which was paid in October 2005.

 

***Cash Flows/Cash Management***

*** ***

The principaluse of cash in operating activities in the nine months ended September 30,2005 was the payment of operating expenses and related working capitalliabilities.  Cash flows from operationscan vary significantly due to various factors including the timing of paymentsmade to our vendors, vendor payment terms, customer mix and customer paymentterms.

 

Investingactivities during the nine months ended September 30, 2005 consistedprimarily of purchases and sales of short-term investments.  Financing activities during the nine monthsended September 30, 2005 consisted primarily of the payment of preferreddividends to our Series D preferred stockholders, partially offset by theexercise of common stock options.

 

***Contractual Obligations***

*** ***

Our majoroutstanding contractual obligations relate to cash dividends on our outstandingSeries D preferred stock, operating leases for our office space andcontractual commitments with our marketing partners for certain selling andpromotional expenses associated with the products

 

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we are currently detailing.  The disclosures relating to our contractualobligations in our Annual Report on Form 10-K for the year ended December 31,2004 have not materially changed since we filed that report.

 

**Certain provisions of our certificate ofincorporation require the written approval of a majority of the Series Dpreferred stockholders before we can make research and development expenses inexcess of $7,000,000 in any continuous twelve month period, unless we havereported positive net income for four consecutive quarters immediately prior tosuch twelve month period.  We may be deemedto have exceeded this $7,000,000 threshold in 2005 and anticipate that ourresearch and development expenditures will exceed this threshold in 2006.  Our management is currently in discussionswith the majority holder of the Series D preferred stock seeking to obtainits approval to exceed this threshold. If the Series D preferred stockholders do not approve ourcontemplated research and development expenditures, we may have to revise ourresearch and development spending in order to remain below the $7,000,000threshold, which could affect our competitive position, business prospects andfinancial condition.**

 

**Critical Accounting Policies and Estimates**

 

Management’sdiscussion and analysis of its financial position and results of operations arebased upon our consolidated financial statements, which have been prepared inaccordance with accounting principles generally accepted in the United Statesof America.  The preparation of thesefinancial 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 compensation and the valuation of deferred taxes,acquired product rights and inventory.

 

***Revenue Recognition***

 

Historically,we have recognized all product sales revenue upon shipment to wholesalecustomers, net of estimated future returns, estimates for chargebacks,wholesale distribution fees, if applicable, rebates, generic introductions andcurrent inventory levels in the distribution channel provided that collectionwas probable and no significant obligations remained.  Following the launch of generic competitionto Periostat in May 2005, and commencing with the second quarter of 2005,we now recognize Periostat sales revenue primarily based on sales to end-users,which we estimate using prescription demand data generated by a leadingindependent prescription tracking service. Accordingly, since it is possible that the launch of generic competitionto Periostat in May 2005 may increase the rate of product returns from thedistribution channel, we have accrued $1.2 million for potential Periostatreturns in Accrued Expenses on the Condensed Consolidated Balance Sheet at September 30,2005.

 

Upon thelaunch of the third party generic equivalent to Periostat, our agreement with Mutualprovides for rebates to be paid to Mutual to compensate Mutual and itscustomers for price erosion on the value of certain of its inventories ofMutual’s branded version of Periostat. Accordingly, we have deferred revenues associated with our shipments ofthese products until

 

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such future time as the selling price becomesfixed and determinable.  At September 30,2005, our Condensed Consolidated Balance Sheet included $70,000 in deferredrevenue associated with sales of Mutual’s branded version of Periostat.

 

We recognizeall other product sales revenue (excluding Periostat and Mutual’s brandedversion of Periostat) upon shipment, net of estimated returns, rebates,chargebacks and wholesale distribution fees, if applicable, provided thatcollection is determined to be probable and no significant obligations remain.

 

Pursuant toour Promotion and Cooperation Agreement with Primus contract revenues forAlcortin and Novacort are fee-based arrangements where revenue is earned asprescriptions are filled and recognized as a percentage of the gross profitearned by Primus.  We do not take titleto the inventory sold by Primus under the Promotion Agreement.

 

***Stock-BasedCompensation***

 

It is ourpolicy to apply Accounting Principles Board Opinion No. 25, “Accountingfor Stock Issued to Employees,” and related interpretations to account for ourstock option grants rather than Statement of Financial Accounting Standards No. 123,“Accounting for Stock-Based Compensation” and related interpretations.  As such, compensation expense is recorded onfixed stock option grants only if the market value of the underlying stockexceeds the exercise price of the option at the date of grant and is recognizedon a straight-line basis over the vesting period.  Had we applied SFAS No. 123, whichrequires recording stock option grants at their fair value, our net income(loss) would have varied from the reported net income (loss) as we would haverecorded additional expenses in each period. See Note 1 to our Condensed Consolidated Financial Statements for thepro forma effect of applying SFAS No. 123 to our results of operations andearnings per share allocable to common stockholders.

 

***Deferred Taxes***

 

In assessingthe realizability of deferred tax assets, we consider the likelihood that partor all of the deferred tax assets will not be realized.  This assessment requires significant judgmentand estimates.  The ultimate realizationof the deferred tax assets is dependent upon the generation of future taxableincome during the period in which those temporary differences becomedeductible.  We consider our history oflosses, scheduled reversal of deferred tax assets and liabilities and projectedfuture taxable income over the periods in which the deferred tax asset itemsare deductible.  The Tax Reform Act of1986 contains provisions that may limit the net operating loss and research andexperimentation credit carryforwards available to be used in any given yearupon the occurrence of certain events, including significant changes inownership interest.  While we have beenprofitable for the past two years, we have a loss for the nine months ended September 30,2005 and uncertainty regarding our future profitability has prevented us from reachingthe “more likely than not” conclusion required under the applicable literatureto recognize deferred tax assets on our consolidated balance sheet.

 

***Acquired Product Rights***

*** ***

We arerequired to test for asset impairment of acquired product rights wheneverevents or circumstances indicate that the carrying value of an asset may not berecoverable.  We apply

 

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SFAS No. 144, “Accounting for theImpairment or Disposal of Long-Lived Assets,” in order to determine whether ornot an asset was impaired.  This standardrequires an impairment analysis when indicators of impairment are present.  If such indicators are present, the standardindicates that if the sum of the future expected cash flows from the asset,undiscounted and without interest charges, is less than the carrying value, anasset impairment must be recognized in the financial statements.  The amount of the impairment is thedifference between the fair value of the asset and the carrying value of theasset.

 

In makingfuture cash flow analyses of our acquired product rights, we make assumptionsrelating to:  (i) the intended useof the product rights and the expected future cash flows resulting directlyfrom such use; (ii) generic competitor activities and regulatoryinitiatives that affect our products; and (iii) customer preferences andexpected managed care reimbursement.

 

***Excess Inventory***

*** ***

During thenine month period ended September 30, 2005, we recorded a charge of$979,000 for the estimated excess inventory of Periostat and Mutual’s brandedversion of Periostat due to decreased demand following the introduction of athird party generic version of Periostat.

 

Criticalaccounting estimates and the related assumptions are evaluated periodically asconditions warrant, and changes to such estimates are recorded as newinformation or changed conditions require revision.

 

## **Additional Risks That May Affect Results**

## ** **

Statementscontained or incorporated by reference in this Quarterly Report on Form 10-Qthat are not based on historical fact are “forward-looking statements” withinthe meaning of the Private Securities Litigation Reform Act of 1995, Section 27Aof the Securities Act of 1933, as amended, and Section 21E of theSecurities Exchange Act of 1934, as amended.  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 results ofoperations, selling, general and administrative expenses, research anddevelopment expenses, the sufficiency of our cash for future operation, thesuccess of our pre-clinical, clinical and development programs and our dermatologyfranchise and research and development expenditures in light of certainapproval rights related to such expenditures held by our Series D stockholders.  Forward-looking statements may be identifiedby the use of forward-looking terminology such as “believes,” “may,” “will,” “expect,”“estimate,” “anticipate,” “continue,” or similar terms, variations of suchterms or the negative of those terms.

 

We cannotassure investors that our assumptions and expectations will prove to have beencorrect.  Important factors could causeour actual results to differ materially from those indicated or implied byforward-looking statements.  Such factorsthat could cause 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 would likelysuffer.

 

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***We are depending heavily on the success ofour most advanced product candidate, Oracea, for the treatment of rosacea,which is still under regulatory review. If we are unable to obtain approval for and commercialize Oracea, orexperience significant delays in doing so, our business will be materiallyharmed.***

*** ***

We haveinvested a significant portion of our recent efforts and financial resources onthe development of our most advanced product candidate, Oracea, for thetreatment of rosacea.  Our ability togenerate substantial product revenues from Oracea, which we do not expect willoccur for at least the next two years, if ever, will depend heavily on thesuccessful development and commercialization of Oracea.  The success of Oracea will depend on severalfactors, including the following:

 

•                                          receiptof marketing approvals from the FDA and similar foreign regulatory authorities;and

 

•                                          acceptanceof the product by patients, the medical community and third party payors.

 

If we areunable to obtain FDA approval for and successfully commercialize Oracea, we maynever realize revenue from this product candidate and we may have to curtailour other product development programs. As a result, our business would be materially harmed.

 

***If we are not able to obtain and enforcepatent protection for Oracea or our other discoveries, our ability tocommercialize our product candidates successfully will be harmed and we may notbe able to operate our business profitably.***

 

Our successdepends, in part, on our ability to protect proprietary methods andtechnologies that we develop under the patent and other intellectual propertylaws of the United States and other countries, so that we can prevent othersfrom using our inventions and proprietary information.  However, we may not hold proprietary rightsto some patents related to our current or future products andtechnologies.  Because patentapplications in the United States and many foreign jurisdictions are typicallynot published until 18 months after filing, or in some cases not at all, andbecause publications of discoveries in scientific literature lag behind actualdiscoveries, we cannot be certain that we were the first to make the inventionsclaimed in issued patents or pending patent applications, or that we were thefirst to file for protection of the inventions set forth in our patentapplications.  As a result, we may 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 strategydepends on our ability to identify our discoveries rapidly and to seek patentprotection for them.  This process isexpensive and time consuming, and we may not be able to file and prosecute allnecessary or desirable patent applications at a reasonable cost or in a timelymanner.  Despite our efforts to protectour proprietary 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

 

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could be used to prevent us from marketingour own patented product and practicing our own patented technology.

 

Our pendingpatent applications may not result in issued patents.  The patent position of pharmaceutical orbiotechnology companies, including ours, is generally uncertain and involvescomplex legal and factual considerations. The standards which the United States Patent and Trademark Office andits foreign counterparts use to grant patents are not always appliedpredictably or uniformly and can change. There is also no uniform, worldwide policy regarding the subject matterand scope of claims granted or allowable in pharmaceutical or biotechnologypatents.  The laws of some foreigncountries do not protect proprietary information to the same extent as the lawsof the United States, and many companies have encountered significant problemsand costs in protecting their proprietary information in these foreigncountries.  Accordingly, we do not knowthe degree of future protection for our proprietary rights or the breadth ofclaims allowed in any patents issued to us or to others.  The allowance of broader claims may increasethe incidence and cost of patent interference proceedings and/or oppositionproceedings, and the risk of infringement litigation.  On the other hand, the allowance of narrowerclaims may limit the value of our proprietary rights.

 

If issued, ourpatent for Oracea may not contain claims sufficiently broad to protect usagainst third parties with similar products, or provide us with any competitiveadvantage.  Moreover, once issued, any ofour patents may be challenged, narrowed, invalidated or circumvented.  In addition, the patent rights in ourproducts that derive from claims under method of use patents may be hard toassert or enforce if medical professionals prescribe similar (including generic),though non-approved, doxycycline products for indications covered by ourpatents.  If our patents are invalidatedor otherwise limited, other companies will be better able to develop productsand technologies that compete with ours, which could adversely affect ourcompetitive business position, business prospects and financial condition.

 

***If our preferred stockholders do not approveour research and development expenditures, our business will be adverselyaffected.***

*** ***

**Certain provisions of our certificate ofincorporation require the written approval of a majority of the Series Dpreferred stock holders before we can make research and development expenses inexcess of $7,000,000 in any continuous twelve month period, unless we havereported positive net income for four consecutive quarters immediately prior tosuch twelve month period.  We may bedeemed to have exceeded this $7,000,000 threshold in 2005 and anticipate thatour research and development expenditures will exceed this threshold in2006.  Our management is currently indiscussions with the majority holder of the Series D preferred stockseeking to obtain its approval to exceed this threshold.**

 

**If the Series D preferred stockholdersdo not approve our contemplated research and development expenditures, we mayhave to revise our research and development spending in order to remain belowthe $7,000,000 threshold.  If we arerequired to restrict our research and development expenditures, we may have todelay, reduce or abandon certain development programs and activities, whichwould impede our ability to implement our strategies and could affect ourcompetitive position, business prospects and financial condition.**

 

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***We cannot assure you that our pursuit ofbusiness in the dermatology market will be successful.***

*** ***

We continue toimplement our plans to expand into the dermatology market.  We recently filed a New Drug Application withthe FDA for Oracea to treat rosacea, and we continue to seek additional productlicensing opportunities to enhance our near-term offerings to the dermatologymarket.  We have also been allowed by theUnited States Patent and Trademark Office a patent for the use ofsub-antimicrobial tetracyclines for the treatment of acne and acne rosacea,including Oracea.

 

While we haveexperience in the sales and marketing of dental products, we have limitedexperience in the dermatology market. This market is very competitive and some of our competitors havesubstantially greater resources than we have. Our future success will depend on, among other things, our ability to: (i) achievemarket acceptance for any current or future dermatological offerings; (ii) hireand retain personnel with experience in the dermatology market; (iii) executeour business plan with respect to this market segment; and (iv) adapt totechnical or regulatory changes once operational.

 

At the sametime, new product development is a lengthy, complex and uncertain process thatwill require significant attention and resources from management.  A product candidate can fail at any stage ofthe development process due to, among other things, efficacy or safetyconcerns, the inability to obtain necessary regulatory approvals, the difficultyor excessive cost to manufacture and/or the infringement of patents orintellectual property rights of others. Furthermore, the sales of new products may prove to be disappointing andfail to reach anticipated levels.  Wetherefore cannot assure you that we will be successful in our pursuit ofbusiness in the dermatology market, or that we can sustain any business inwhich we achieve initial success.

 

The success ofour current technology platforms, and that of any other future technologyplatforms we may purchase or in-license, will depend on the quality andintegrity of the technologies licensed or sold to us.  Despite our due diligence and the safeguardswe have in place, we cannot guarantee the effectiveness or integrity of suchtechnologies, nor can we be certain that others do not have intervening rightsin such technologies.  If any of ourin-licensed technologies proved ineffective, or if a third party successfullyasserted any right to such technologies, our ability to develop new productsand implement our strategies would be materially adversely affected.

 

***If we are not able to obtain requiredregulatory approvals, we will not be able to commercialize our productcandidates, and our ability to generate revenue will be materially impaired.***

*** ***

Our productcandidates and the activities associated with their development andcommercialization, including their testing, manufacture, safety, efficacy,recordkeeping, labeling, storage, approval, advertising, promotion, sale anddistribution, are subject to comprehensive regulation by the FDA and otherregulatory agencies in the United States and by comparable authorities in othercountries.  Failure to obtain regulatoryapproval for a product candidate will prevent us from commercializing theproduct candidate.  Other than Periostat,we

 

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have not received regulatory approval tomarket any of our product candidates in any jurisdiction.  We have only limited experience in filing andprosecuting the applications necessary to gain regulatory approvals.  Securing FDA approval requires the submissionof extensive preclinical and clinical data, information about productmanufacturing processes and inspection of facilities and supporting informationto the FDA for each therapeutic indication to establish the product candidate’ssafety and efficacy.  Our future productsmay not be effective, may be only moderately effective or may prove to haveundesirable or unintended side effects, toxicities or other characteristicsthat may preclude our obtaining regulatory approval or prevent or limitcommercial use.

 

The process ofobtaining regulatory approvals is expensive, often takes many years, ifapproval is obtained at all, and can vary substantially based upon, among otherthings, the type, complexity and novelty of the product candidatesinvolved.  Changes in the regulatoryapproval policy during the development period, changes in or the enactment ofadditional statutes or regulations, or changes in regulatory review for eachsubmitted product application, may cause delays in the approval or rejection ofan application, or may affect the period for which the data filed in relationto the company’s products may not be accessed by those wishing to obtainapprovals to market similar products. The FDA, and comparable authorities in other countries, have substantialdiscretion in the approval process and may refuse to accept any application ormay decide that our data is insufficient for approval and require additionalpreclinical, clinical or other studies. In addition, varying interpretations of the data obtained frompreclinical and clinical testing could influence how a product candidate isclassified and delay, limit or prevent regulatory approval of a productcandidate.  Any regulatory approval weultimately obtain may be limited or subject to restrictions or post-approvalcommitments that render the product not commercially viable.

 

***Our products could be subject to restrictionsor withdrawal from the market and we may be subject to penalties if we fail tocomply with regulatory requirements or if we experience unanticipated problemswith our products, when and if any of them are approved.***

*** ***

Any productfor which we obtain marketing approval, along with the manufacturing processes,post-approval clinical data, labeling, advertising and promotional activitiesfor such product, will be subject to continual requirements of and review bythe FDA and comparable regulatory bodies. These requirements include submissions of safety and otherpost-marketing information and reports, registration requirements, current GoodManufacturing Practice, or cGMP, requirements relating to quality control,quality assurance and corresponding maintenance of records and documents,requirements regarding the distribution of samples to physicians andrecordkeeping.  Even if regulatoryapproval of a product is granted, the approval may be subject to limitations onthe indicated uses for which the product may be marketed or to the conditionsof approval, or contain requirements for costly post-marketing testing andsurveillance to monitor the safety or efficacy of the product.  Later discovery of previously unknownproblems with our products, manufacturers or manufacturing processes, orfailure to comply with regulatory requirements, may result in:

 

•                                          restrictionson such products, manufacturers or manufacturing processes;

 

•                                          warningletters;

 

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•                                          withdrawalof the products from the market;

 

•                                          refusalto approve pending applications or supplements to approved applications that wesubmit;

 

•                                          recall;

 

•                                          fines;

 

•                                          suspensionor withdrawal of regulatory approvals;

 

•                                          refusalto permit the import or export of our products;

 

•                                          productseizure; and

 

•                                          injunctionsor the imposition of civil or criminal penalties.

 

***We cannot predict with certainty the effecton our business of the decline in revenues generated by the dental businessfollowing the commercial launch of generic versions of Periostat and thetermination of our dental sales force.***

*** ***

We havehistorically relied on sales of Periostat and Mutual’s branded version ofPeriostat, together with revenues generated by the other products that made upour dental business, for most of our revenue. During the nine months ended September 30, 2005 and each of theyears ended December 31, 2004, 2003 and 2002, Periostat and Mutual’sbranded version of Periostat supplied by us (with respect to the nine monthsended September 30, 2005 and the year ended December 31, 2004),accounted for approximately 78%, 88%, 82% and 82% of our total net revenues,respectively.

 

On May 13,2005, the FDA approved a third party generic version of Periostat and a genericproduct was launched soon thereafter in late May 2005.  Upon this generic launch, Mutual was nolonger obligated to purchase and is not expected to purchase their brandedproduct from us.  We do not anticipatefuture shipments of Mutual’s branded version of Periostat supplied by us.  In addition, we have had to disband ourdental sales force and delay or discontinue certain research and developmentactivities in the dental business. Consequently, while we continue to generate cash flow from the dentalbusiness, our revenues and margins from Periostat and the volume of our otherdental business, have decreased significantly and are anticipated to continueto decrease as a result of the third party introduction of a generic version ofPeriostat.  If this decrease is moresignificant than we expect, we may experience difficulty in managing our cash,which would have a material adverse effect on our ability execute ourstrategies and develop our dermatology business.

 

***We cannot assure you that our clinical trialswill be completed in a timely manner or will meet agreed upon end-points.***

*** ***

As part of ourplans to expand into the dermatology market, we will need to conduct extensivetesting of our products, pursuant to protocols that measure end points agreedwith the FDA or other regulatory agencies. We cannot guarantee that Phase I, Phase II, or Phase III

 

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testing for our products in development willbe completed 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 inpatient enrollment in clinical trials may result in increased costs and delays,which could have a harmful effect on our ability to develop products.

 

It may takeseveral years to complete the testing of a product, and failure can occur atany stage of testing.  For example:

 

•                                          interimresults of preclinical or clinical studies do not necessarily predict theirfinal results, and results in early studies might not be seen in later studies;

 

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

 

•                                          anypreclinical or clinical test may fail to produce results satisfactory to theFDA or foreign regulatory authorities;

 

•                                          preclinicaland clinical data can be interpreted in different ways, which could delay,limit or prevent regulatory approval;

 

•                                          wemay not be able to manufacture the investigational or commercial product insufficient quantity or quality or at acceptable cost;

 

•                                          negativeor inconclusive 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;

 

•                                          theFDA can place 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;

 

•                                          wemay encounter delays or rejections based on changes in regulatory agencypolicies during the period in which we develop a drug or the period requiredfor review of any application for regulatory agency approval; and

 

•                                          ourclinical trials may not demonstrate the safety and efficacy needed for ourproducts to receive regulatory approval.

 

If we arerequired to conduct additional clinical trials or other studies beyond thosethat we currently contemplate, if we are unable to successfully complete ourclinical trials or other

 

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studies or if the results of these trials orstudies are not positive or are only modestly positive, we may be delayed inobtaining marketing approval, we may not be able to obtain marketing approvalor we may obtain approval for indications that are not as broad asintended.  Our product development costswill also increase if we experience delays in testing or approvals.  Significant clinical trial delays could allowour competitors to bring products to market before we do and impair our abilityto commercialize our products or potential products.  If any of this occurs, our business will bematerially harmed.

 

***If we infringe or are alleged to infringeintellectual property rights of third parties, it will adversely affect ourbusiness.***

*** ***

Our research,development and commercialization activities, as well as any product candidatesor products resulting from these activities, may infringe or be claimed toinfringe patents or patent applications under which we do not hold licenses orother rights.  Third parties may own orcontrol these patents and patent applications in the United States andabroad.  These third parties could bringclaims against us or our collaborators that would cause us to incur substantialexpenses and, if successful against us, could cause us to pay substantialdamages.  Further, if a patentinfringement suit were brought against us or our collaborators, we or theycould be forced to stop or delay research, development, manufacturing or salesof the product or product candidate that is the subject of the suit.

 

As a result ofpatent infringement claims, or in order to avoid potential claims, we or ourcollaborators may choose or be required to seek a license from the third partyand be required to pay license fees or royalties or both.  These licenses may not be available onacceptable terms, or at all.  Even if weor our collaborators were able to obtain a license, the rights may benonexclusive, which could result in our competitors gaining access to the sameintellectual property.  Ultimately, wecould be prevented from commercializing a product, or be forced to cease someaspect of our business operations, if, as a result of actual or threatenedpatent infringement claims, we or our collaborators are unable to enter intolicenses on acceptable terms.  This couldharm our business significantly.

 

There has beensubstantial litigation and other proceedings regarding patent and otherintellectual property rights in the pharmaceutical and biotechnologyindustries.  In addition to infringementclaims against us, we may become a party to other patent litigation and otherproceedings, including interference proceedings declared by the United StatesPatent and Trademark Office and opposition proceedings in the European PatentOffice, regarding intellectual property rights with respect to our products andtechnology.  The cost to us of any patentlitigation or other proceeding, even if resolved in our favor, could besubstantial.  Some of our competitors maybe able to sustain the costs of such litigation or proceedings more effectivelythan we can because of their substantially greater financial resources.  Uncertainties resulting from the initiationand continuation of patent litigation or other proceedings could have amaterial adverse effect on our ability to compete in the marketplace.  Patent litigation and other proceedings mayalso absorb significant management time.

 

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***We depend upon third party researchers andproviders of clinical services to perform as contractually required if we areto be successful in bringing new products to market.***

*** ***

We do not havethe ability independently to conduct the clinical trials required to obtainregulatory approval for our products.  Werely on independent clinical investigators, contract research organizations andother third party service providers for successful execution of our clinicaltrials, but do not control many aspects of their activities.  We are responsible for ensuring that each ofour clinical trials is conducted in accordance with the general investigationalplan, protocols for the trial and applicable regulatory requirements.  Moreover, the FDA requires us to comply withstandards, commonly referred to as Good Clinical Practices, for conducting andrecording and reporting the results of clinical trials to assure that data andreported results are credible and accurate and that the rights, integrity andconfidentiality of trial participants are protected.  Our reliance on third parties that we do notcontrol does not relieve us of these responsibilities and requirements.  Third parties may not, however, completeactivities on schedule, or may not conduct our clinical trials in accordancewith regulatory requirements or our stated protocols.  Furthermore the data that they generate maynot be accurate or may, in extreme cases, be fraudulent.

 

Our ability tobring our future products to market depends on the quality and integrity of thedata we present to regulatory authorities in order to obtain marketingauthorizations.  We cannot guarantee theauthenticity or accuracy of such data, nor can we be certain that such data hasnot been fraudulently generated.  Thefailure of these third parties to carry out their obligations would materiallyadversely affect our ability to develop and market new products and implementour strategies.

 

***We depend upon certain key relationships togenerate much of the technology required to maintain our competitive positionin the marketplace.***

*** ***

Our IMPACStechnology is licensed from SUNY (the “SUNY License”), and other academic andresearch institutions collaborating with SUNY. Under the SUNY License, we have an exclusive worldwide license to SUNY’srights in certain patents and patent applications to make and sell productsemploying tetracyclines 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 incursignificant expense and liability.***

 

Our businessmay be adversely affected by potential product liability claims arising out ofthe testing, manufacturing and marketing of Periostat and other productsdeveloped by or for

 

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us or for which we have licensing orpromotion and cooperation rights.  Wehave an aggregate of $10.0 million in product liability insurance ($5.0million for pediatric claims) covering Periostat and Mutual’s branded versionof Periostat, our product candidates and products for which we have licensingor promotion and cooperation rights.

 

Our insurerhas also notified us that our general product liability policy will not coverclaims arising from our past sales of Vioxx, to the extent such claims are madeafter December 31, 2004.  This doesnot affect our rights under the Co-Promotion Agreement with Merck, whichprovides for indemnification of us by Merck against any claims arising frommanufacturing or design defects in the Vioxx product or for which we, as theseller of the product, may be strictly liable as a seller of an inherentlydangerous product.

 

Our insurancemay not adequately protect us against product liability claims.  Insufficient insurance coverage or thefailure to obtain indemnification from third parties for their respectiveliabilities may expose us to product liability claims and/or recalls and couldcause our business, financial condition and results of operations to decline.

 

***Changes in stock option accounting rules mayhave a significant adverse affect on our operating results.***

*** ***

We have ahistory of using broad based employee stock option programs to hire,incentivize and retain our workforce in a competitive marketplace.  Statement of Financial Accounting Standards No. 123,“Accounting for Stock-Based Compensation,” allows companies the choice ofeither using a fair value method of accounting for options that would result inexpense recognition for all options granted, or using an intrinsic valuemethod, as prescribed by Accounting Principles Board Opinion No. 25, “Accountingfor Stock Issued to Employees,” or APB 25, with a pro forma disclosure of theimpact on net income (loss) of using the fair value option expense recognitionmethod.  We have elected to apply APB 25and, accordingly, we generally have not recognized any expense with respect toemployee stock options as long as such options are granted at exercise pricesequal to the fair value of our common stock on the date of grant.

 

In December 2004,the Financial Accounting Standards Board issued “Share-Based Payment”(Statement 123(R)).  Statement 123(R)requires that the compensation cost relating to share-based paymenttransactions be recognized in financial statements.  That cost will be measured based on thegrant-date fair value of the equity instruments issued.  In determining the fair value of options andother equity-based awards, companies may use different valuation models thatmay involve extensive and complex analysis. Statement 123(R) will be effective for us no later than January 1,2006, which is the first day of our 2006 fiscal year.  We are in the process of reviewing Statement123(R) to determine which model is more appropriate for us.  While we continue to evaluate the effect thatthe adoption of Statement 123(R) will have on our financial position andresults of operations, we currently expect that our adoption of Statement123(R) will adversely affect our operating results to some extent in futureperiods.

 

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***Our stock price is highly volatile and,therefore, the value of your investment may fluctuate significantly.***

*** ***

The marketprice of our common stock has fluctuated and may continue to fluctuate as aresult of variations in our quarterly operating results.  These fluctuations may be exaggerated if thetrading volume of our common stock is low. In addition, the stock market in general has experienced dramatic priceand volume fluctuations from time to time. These fluctuations may or may not be based upon any business oroperating results.  Our common stock mayexperience similar or even more dramatic price and volume fluctuations that maycontinue indefinitely.

 

The followingtable sets forth the high and low closing market price per share for our commonstock for each of the quarters in the period beginning October 1, 2002through September 30, 2005, as reported on the Nasdaq National Market:

 
| **Quarter Ended**        | ** ** | **High** | ** ** | **Low** | ** ** |
|--------------------------|------------|----------|------------|---------|------------|
| December 31,  2002  |       | $        | 9.74       |    | $          | 4.61 |   |
|                     |       |     |       |    |       |
| March 31,  2003     |       | $        | 11.03      |    | $          | 6.66 |   |
| June 30,  2003      |       | $        | 13.27      |    | $          | 8.62 |   |
| September 30,  2003 |       | $        | 15.84      |    | $          | 10.50 |   |
| December 31,  2003  |       | $        | 11.82      |    | $          | 8.90 |   |
|                     |       |     |       |    |       |
| March 31,  2004     |       | $        | 14.16      |    | $          | 10.07 |   |
| June 30,  2004      |       | $        | 13.21      |    | $          | 8.70 |   |
| September 30,  2004 |       | $        | 9.49       |    | $          | 6.09 |   |
| December 31,  2004  |       | $        | 7.49       |    | $          | 5.37 |   |
|                     |       |     |       |    |       |
| March 31,  2005     |       | $        | 7.52       |    | $          | 4.50 |   |
| June 30,  2005      |       | $        | 7.61       |    | $          | 3.99 |   |
| September 30,  2005 |       | $        | 9.95       |    | $          | 7.15 |   |

 

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

 

We had cashand cash equivalents and short-term investments at September 30, 2005which are exposed to the impact of interest rate changes and our interestincome fluctuates as interest rates change. Due to the short-term nature of our investments in money market funds,the carrying values of our cash equivalents approximate their fair value at September 30,2005.  Our short-term investments incommercial paper and government notes are carried at fair value.

 

**Item 4.                    Controlsand Procedures.**

 

Ourmanagement, with the participation of our chief executive officer and chieffinancial officer, evaluated the effectiveness of the Company’s disclosurecontrols and procedures as of September 30, 2005.  The term “disclosure controls and procedures,”as defined in Rules 13a-15(e) and 15d-15(e) under the ExchangeAct, means controls and other procedures of a company that are designed toensure that information required to be disclosed by a company in the reportsthat it files or submits under the Exchange Act is recorded, processed, summarizedand reported,

 

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within the time periods specified in the SEC’srules and forms.  Disclosurecontrols and procedures include, without limitation, controls and proceduresdesigned to ensure that information required to be disclosed by a company inthe reports that it files or submits under the Exchange Act is accumulated andcommunicated to the company’s management, including its principal executive andprincipal financial officer as appropriate to allow timely decisions regardingrequired disclosure.  Our managementrecognizes that any controls and procedures, no matter how well designed andoperated, can provide only reasonable assurance of achieving their objectivesand management necessarily applies its judgment in evaluating the cost-benefitrelationship of possible controls and procedures.  Based on the evaluation of our disclosurecontrols and procedures as of September 30, 2005, our chief executiveofficer and chief financial officer concluded that, as of such date, ourdisclosure controls and procedures were effective at the reasonable assurancelevel.

 

No change inour internal control over financial reporting (as defined in Rules 13a-15(f) and15d-15(f) under the Exchange Act) occurred during the fiscal quarter endedSeptember 30, 2005 that has materially affected, or is reasonably likelyto materially affect, our internal control over financial reporting.

 

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**PART II. OTHER INFORMATION**

 

**Item6.                    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 tothe requirements of the Securities Exchange Act of 1934, the registrant hasduly caused this report to be signed on its behalf by the undersigned thereuntoduly authorized.

 
|   |                  | CollaGenex Pharmaceuticals, Inc. |
|--------|-----------------------|---------------------------------------|
|   |                  |                                  |   |
|   |                  |                                  |   |
| Date:  | November 3, 2005 | By:                                   | /s/ Colin W. Stewart |   |
|   |                  |                                  | Colin W. Stewart |
|   |                  |                                  | President and Chief Executive Officer |
|   |                  |                                  | (Principal Executive Officer) |
|   |                  |                                  |   |
|   |                  |                                  |   |
| Date:  | November 3, 2005 | By:                                   | /s/ Nancy C. Broadbent |   |
|   |                  |                                  | Nancy C. Broadbent |
|   |                  |                                  | Chief Financial Officer (Principal |
|   |                  |                                  | Financial and Accounting Officer) |

 

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