**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**Washington, DC 20549**

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**FORM 10-Q**

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

**Forthe quarterly period ended March 31, 2006**

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

**CommissionFile Number 0-28308**

**CollaGenex Pharmaceuticals, Inc.**

(Exact Name of Registrantas 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**

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(Registrant’s Telephone Number,Including Area Code)

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

Yes: x  No: o

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

Large accelerated filer o  Acceleratedfiler x  Non-accelerated filer o

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

Yes: o  No: x

Indicate the number of shares outstanding of each ofthe issuer’s classes of common stock as of May 1, 2006:

| Class                        |   | Number of Shares |
|------------------------------|--------|------------------|
| Common Stock  $.01 par value |   | 17,478,909       |

 

 

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**COLLAGENEXPHARMACEUTICALS, INC.**

**TABLE OF CONTENTS**
|               | ** ** | ** **                                                                                                           | ** ** | **Page** | ** ** |
|---------------|------------|----------------------------------------------------------------------------------------------------------------------|------------|----------|------------|
| PART I.  |       | FINANCIAL  INFORMATION                                                                                               |       | 1        |       |
| Item 1.       |       | Financial Statements (unaudited)                                                                                     |       | 1        |       |
|          |       | Condensed Consolidated Balance Sheets as of  March 31, 2006 and December 31, 2005 (unaudited)         |       | 2        |       |
|          |       | Condensed Consolidated Statements of Operations for  the Three Months Ended March 31, 2006 and 2005 (unaudited) |       | 3        |       |
|          |       | Condensed Consolidated Statements of Cash Flows for  the Three Months Ended March 31, 2006 and 2005 (unaudited) |       | 4        |       |
|          |       | Notes  to Condensed Consolidated Financial Statements (unaudited)                                                    |       | 5        |       |
| Item 2.       |       | Management’s Discussion and Analysis of Financial  Condition and Results of Operations                          |       | 15       |       |
|          |       | Results of Operations                                                                                                |       | 17       |       |
|          |       | Liquidity and Capital Resources                                                                                      |       | 20       |       |
| Item 3.       |       | Quantitative and Qualitative Disclosures About Market  Risk                                                          |       | 24       |       |
| Item 4.       |       | Controls and Procedures                                                                                              |       | 25       |       |
| PART II. |       | OTHER  INFORMATION                                                                                                   |       | 26       |       |
| Item  1A.     |       | Risk Factors                                                                                                         |       | 26       |       |
| Item 6.       |       | Exhibits                                                                                                             |       | 37       |       |
| SIGNATURES    |       | 38                                                                                                                   |       |

 

**CollaGenex Pharmaceuticals, Inc. - UnitedStates trademarks:**Periostat®, Metastat®, Dermostat®, Nephrostat®, Osteostat®,Arthrostat®, Rheumastat®, Corneostat®, Gingistat®, IMPACSTM, PS20®, The WholeMouth Treatment®, Restoraderm®, Dentaplex®, LytraTM, Periostat-MRTM, SansRosaTM, UnorthodoxyTM,AprecinTM, ZedaraTM and OraceaTM.**CollaGenex Pharmaceuticals, Inc. - EuropeanCommunity trademarks:**Periostat®, Nephrostat®, Optistat®, Xerostat®, SansRosaTM,UnorthodoxyTM, AprecinTM, ZedaraTM and OraceaTM.**CollaGenex International, Ltd. (our wholly-ownedsubsidiary) - United Kingdom trademarks:**Periostat®, Nephrostat®, Optistat®, Xerostat®, IMPACS®, Dentaplex®,Restoraderm®, Periocycline®, Periostatus® and Periostat-MR®.**CollaGenex International, Ltd. - EuropeanCommunity and United Kingdom trademarks:**CollaGenex®, PS20®, Dermastat®, Periostan®, Periostat-SR®, “C” Logo® and “TheWhole Mouth Treatment” Logo®.**CollaGenex International, Ltd. - EuropeanCommunity Trademarks:**PeriocyclineTM, RestoradermTM, and Periostat-MRTM.

Marks listed herein may additionally be registered injurisdictions not specified in the above list. All other trade names,trademarks or service marks appearing in this Quarterly Report are the propertyof their respective owners and are not property of CollaGenexPharmaceuticals, Inc. or any of our subsidiaries.

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**PART I.  FINANCIAL INFORMATION**

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

 

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**COLLAGENEX PHARMACEUTICALS, INC.AND SUBSIDIARIES**

Condensed ConsolidatedBalance SheetsMarch 31, 2006 and December 31, 2005(dollars in thousands, except share data)(unaudited)
| **Assets**                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            | ** ** | **March 31,  2006** | ** ** | **December 31,  2005** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------------|------------|-----------------------------|------------|
| ** **                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            | ** ** | ** **               | ** ** | ** **                  | ** ** |
| Current assets:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  |       |                     |       |                        |       |
| Cash and cash  equivalents                                                                                                                                                                                                                                                                                                                                                                                                                                                                            |       | $                        | 22,883     |                        | $          | 26,219 |   |
| Short-term  investments                                                                                                                                                                                                                                                                                                                                                                                                                                                                               |       | 21,370                   |       | 18,206                      |       |
| Accounts  receivable, net of allowances of $115 and $104 at March 31, 2006 and  December 31, 2005, respectively                                                                                                                                                                                                                                                                                                                                                                             |       | 1,538                    |       | 1,428                       |       |
| Inventories                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           |       | 759                      |       | 630                         |       |
| Prepaid expenses  and other current assets                                                                                                                                                                                                                                                                                                                                                                                                                                                            |       | 1,924                    |       | 1,564                       |       |
| Total current  assets                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 |       | 48,474                   |       | 48,047                      |       |
| Equipment and leasehold  improvements, net                                                                                                                                                                                                                                                                                                                                                                                                                                                            |       | 633                      |       | 539                         |       |
| Acquired product  rights, net                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |       | 469                      |       | 536                         |       |
| Other assets                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          |       | 43                       |       | 43                          |       |
| Total assets                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          |       | $                        | 49,619     |                        | $          | 49,165 |   |
| **Liabilities and Stockholders’ Equity**                                                                                                                                                                                                                                                                                                                                                                                                                                                         | ** ** | ** **               | ** ** | ** **                  | ** ** |
| Current liabilities:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  |       |                     |       |                        |       |
| Accounts payable                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      |       | $                        | 3,715      |                        | $          | 5,411 |   |
| Accrued expenses                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      |       | 5,097                    |       | 6,024                       |       |
| Accrued  financing costs                                                                                                                                                                                                                                                                                                                                                                                                                                                                              |       | —                   |       | 1,069                       |       |
| Preferred  dividends payable                                                                                                                                                                                                                                                                                                                                                                                                                                                                          |       | —                   |       | 900                         |       |
| Total current  liabilities                                                                                                                                                                                                                                                                                                                                                                                                                                                                            |       | 8,812                    |       | 13,404                      |       |
| Deferred revenue                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      |       | 36                       |       | 93                          |       |
| Commitments and  Contingencies (Notes: 5 and 7)                                                                                                                                                                                                                                                                                                                                                                                                                                                       |       |                     |       |                        |       |
| Stockholders’  equity:                                                                                                                                                                                                                                                                                                                                                                                                                                                                           |       |                     |       |                        |       |
| Preferred stock,  $0.01 par value, 5,000,000 shares authorized, 200,000 shares of Series D-1  Cumulative Convertible Preferred Stock issued and outstanding at  March 31, 2006 and December 31, 2005 (liquidation value of $20,000  at March 31, 2006 and $20,900 at December 31, 2005); 150,000 shares  of Series A Participating Preferred Stock $0.01 par value, designated  and no shares issued and outstanding at March 31, 2006 and  December 31, 2005 |       | 2                        |       | 2                           |       |
| Common stock,  $0.01 par value; 25,000,000 shares authorized, 17,465,369 and 16,054,797  shares issued and outstanding at March 31, 2006 and December 31,  2005, respectively                                                                                                                                                                                                                                                                                                               |       | 175                      |       | 161                         |       |
| Additional  paid-in capital                                                                                                                                                                                                                                                                                                                                                                                                                                                                           |       | 138,614                  |       | 124,647                     |       |
| Accumulated  other comprehensive loss                                                                                                                                                                                                                                                                                                                                                                                                                                                                 |       | (30                      | )          | (4                          | )          |
| Accumulated  deficit                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  |       | (97,990                  | )          | (89,138                     | )          |
| Total  stockholders’ equity                                                                                                                                                                                                                                                                                                                                                                                                                                                                      |       | 40,771                   |       | 35,668                      |       |
| Total liabilities and  stockholders’ equity                                                                                                                                                                                                                                                                                                                                                                                                                                                      |       | $                        | 49,619     |                        | $          | 49,165 |   |

 

See accompanyingnotes to unaudited condensed consolidated financial statements.

 

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**COLLAGENEXPHARMACEUTICALS, INC.**AND SUBSIDIARIES

Condensed ConsolidatedStatements of OperationsFor the Three Months Ended March 31, 2006 and 2005(amounts in thousands, except share and per share data)(unaudited)
| ** **                                                                                                        | ** ** | **Three Months Ended March 31,** | ** ** |
|-------------------------------------------------------------------------------------------------------------------|------------|------------------------------------------------------|------------|
| ** **                                                                                                        | ** ** | **2006**                                             | ** ** | **2005** | ** ** |
| Revenues:                                                                                                         |       |                                                 |       |   |   |
| Net product sales                                                                                                 |       | $                                                    | 3,341      |   | $ | 11,836 |   |
| Contract revenues                                                                                                 |       | 252                                                  |       | 39 |   |
| License revenues                                                                                                  |       | 23                                                   |       | 160 |   |
| Grant revenues                                                                                                    |       | 105                                                  |       | — |   |
| Total revenues                                                                                                    |       | 3,721                                                |       | 12,035 |   |
| Operating  expenses:                                                                                              |       |                                                 |       |   |   |
| Cost of product sales                                                                                             |       | 895                                                  |       | 2,465 |   |
| Research and development                                                                                          |       | 3,713                                                |       | 4,094 |   |
| Selling, general and administrative                                                                               |       | 8,511                                                |       | 7,746 |   |
| Total operating expenses                                                                                          |       | 13,119                                               |       | 14,305 |   |
| Operating loss                                                                                                    |       | (9,398                                               | )          | (2,270 | ) |
| Other income:                                                                                                     |       |                                                 |       |   |   |
| Interest income                                                                                                   |       | 546                                                  |       | 212 |   |
| Net loss                                                                                                          |       | (8,852                                               | )          | (2,058 | ) |
| Preferred stock  dividend                                                                                         |       | 464                                                  |       | 400 |   |
| Net loss  allocable to common stockholders                                                                        |       | $                                                    | (9,316     | ) | $ | (2,458 | ) |
| Net loss per  basic and diluted share allocable to common stockholders                                            |       | $                                                    | (0.54      | ) | $ | (0.17 | ) |
| Weighted average shares  used in computing net loss per basic and diluted share allocable to common  stockholders |       | 17,348,984                                           |       | 14,404,677 |   |

 

See accompanyingnotes to unaudited condensed consolidated financial statements.

 

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**COLLAGENEX PHARMACEUTICALS, INC.AND SUBSIDIARIES**

Condensed ConsolidatedStatements of Cash FlowsFor the Three Months Ended March 31, 2006 and 2005(dollars in thousands)(unaudited)
| ** **                                                                   | ** ** | **Three Months Ended March 31,** | ** ** |
|------------------------------------------------------------------------------|------------|------------------------------------------------------|------------|
| ** **                                                                   | ** ** | **2006**                                             | ** ** | **2005** | ** ** |
| Cash flows from  operating activities:                                       |       |                                                 |       |   |   |
| Net loss                                                                     |       | $                                                    | (8,852     | ) | $ | (2,058 | ) |
| Adjustments to reconcile net loss to net cash used  in operating activities: |       |                                                 |       |   |   |
| Share-based compensation                                                     |       | 793                                                  |       | — |   |
| Write-down of inventory                                                      |       | —                                               |       | 844 |   |
| Depreciation and amortization expense                                        |       | 124                                                  |       | 212 |   |
| Accounts receivable provisions                                               |       | 11                                                   |       | (5 | ) |
| Charge for in-process research and development                               |       | 200                                                  |       | — |   |
| Changes in operating assets and liabilities:                                 |       |                                                 |       |   |   |
| Accounts receivable                                                          |       | (121                                                 | )          | (542 | ) |
| Inventories                                                                  |       | (129                                                 | )          | 273 |   |
| Prepaid expenses and other assets                                            |       | (360                                                 | )          | (306 | ) |
| Accounts payable                                                             |       | (1,696                                               | )          | 555 |   |
| Accrued expenses                                                             |       | (927                                                 | )          | (194 | ) |
| Deferred revenue                                                             |       | (57                                                  | )          | (91 | ) |
| Net cash used in operating activities                                        |       | (11,014                                              | )          | (1,312 | ) |
| Cash flows from  investing activities:                                       |       |                                                 |       |   |   |
| Capital expenditures                                                         |       | (151                                                 | )          | (157 | ) |
| Purchase of in-process research and development                              |       | (200                                                 | )          | (150 | ) |
| Purchase of short-term investments                                           |       | (12,240                                              | )          | (6,168 | ) |
| Maturities of short-term investments                                         |       | 9,050                                                |       | 12,623 |   |
| Net cash (used in) provided by investing activities                          |       | (3,541                                               | )          | 6,148 |   |
| Cash flows from  financing activities:                                       |       |                                                 |       |   |   |
| Net proceeds from issuance of common stock                                   |       | 11,594                                               |       | — |   |
| Net proceeds from common stock under share-based  compensation plans         |       | 525                                                  |       | 26 |   |
| Payment of preferred dividends                                               |       | (900                                                 | )          | (800 | ) |
| Net cash provided by (used in) financing activities                          |       | 11,219                                               |       | (774 | ) |
| Net (decrease) increase in cash and cash equivalents                         |       | (3,336                                               | )          | 4,062 |   |
| Cash and cash  equivalents at beginning of period                            |       | 26,219                                               |       | 11,889 |   |
| Cash and cash  equivalents at end of period                                  |       | $                                                    | 22,883     |   | $ | 15,951 |   |

 

See accompanyingnotes to unaudited condensed consolidated financial statements.

 

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**COLLAGENEX    PHARMACEUTICALS, INC.AND SUBSIDIARIES**

**NOTESTO CONDENSED CONSOLIDATED FINANCIAL STATEMENTSMarch 31, 2006 and 2005(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, or 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. Certain information and footnote disclosuresnormally included in the annual consolidated financial statements prepared inaccordance with accounting principles generally accepted in the United Statesof America have been condensed or omitted pursuant to such rules and theregulations of the Securities and Exchange Commission. These unauditedcondensed consolidated financial statements should be read in conjunction withthe Company’s 2005 audited consolidated financial statements and footnotesincluded in its Annual Report on Form 10-K for the year ended December 31,2005.

The accompanyingunaudited condensed consolidated financial statements include the results ofthe Company and its subsidiaries. All intercompany accounts and transactionshave been eliminated in consolidation.

Certain amounts inthe 2005 consolidated financial statements have been reclassified to conform tothe 2006 presentation.

In the opinion ofthe 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 31,2005 and contain adjustments, all of which are of a normal recurring nature,necessary to present fairly the Company’s consolidated financial position at March 31,2006, the results of operations for the three months ended March 31, 2006and 2005, and the cash flows for the three months ended March 31, 2006 and2005. Interim results are not necessarily indicative of results anticipated forthe full fiscal year.

The preparation ofconsolidated financial statements in conformity with accounting principlesgenerally accepted in the United States requires management to make estimatesand assumptions that affect the amounts reported in the consolidated financialstatements and accompanying notes. Actual results could differ from thoseestimates.

***Net Product Sales***

The Companyhistorically recognized 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 genericcompetitor to Periostat in May 2005 and commencing with the second quarterof

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2005, the Company began recognizing Periostat® sales revenue based on sales to end-users,which are estimated using prescription dispensing data generated by a leadingindependent prescription tracking service, as well as on-hand inventoryestimates in the distribution channel. Since the launch of generic competitionto Periostat may result in increased product returns existing in the wholesaleand retail channel, the Company has accrued an estimated liability of $969 forpotential Periostat and other product returns in accrued expenses on theconsolidated balance sheet at March 31, 2006.

Pursuant to theCompany’s Promotion and Cooperation Agreement, or the Promotion Agreement, withPrimus Pharmaceuticals, Inc., or Primus, contract revenues for AlcortinTM, a prescription topicalantifungal steroid combination, and NovacortTM, a prescription topical steroid andanesthetic, are fee-based arrangements where contract revenue is earned asprescriptions are filled and recognized as a percentage of the gross profitearned by Primus. The Company does not take title to the inventory sold byPrimus under the Promotion Agreement.

During the fourthquarter of 2005, the Company received notice that a grant had been approved bythe National Institutes of Health, or NIH, to fund additional research by theCompany and its collaborators of the potent anti-inflammatory effects ofincyclinide. The Company expenses such research expenditures as they areincurred and recognizes grant revenue for the portion of the expenditures thatare reimbursed by the NIH. These revenues are recorded at the time they aresubmitted for reimbursement. The Company recognized $105 in grant revenuesduring three months ended March 31, 2006.

***Pre-LaunchManufacturing Costs***

TheCompany classifies direct manufacturing costs relating to the manufacture ofproduct inventory and samples in advance of a new product launch as researchand development expense until it receives an approval letter from the Food andDrug Administration, or FDA, for a new product. Following FDA approval of aproduct, the Company capitalizes the inventory costs relating to that product.

***Stock-Based Compensation***

As part of the Company’s adoption of Statement ofFinancial Accounting Standards (SFAS) No. 123 (revised 2004), *Share-Based Payment,*orSFAS No. 123R, as of January 1, 2006, the Company recognizedthe fair value of share-based compensation awards in the Company’s consolidatedfinancial statements using the modified prospective method. The Company appliesthe Black-Scholes option pricing model in order to determine the fair value ofstock options on the date of grant, and it applies judgment in estimating keyassumptions that are important elements in the model, such as the expectedstock-price volatility and expected stock option life. The Company’s estimatesof these important assumptions and expected forfeiture rates are based onhistorical data and judgment regarding market trends and factors.

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

The Company considers all highly liquid investmentswith an original maturity of three months or less at the date of acquisition tobe cash equivalents. Cash equivalent investments are held at amortized cost,which approximates fair value. All short-term investments have originalmaturity dates of between three months and one year. The Company’s short-terminvestments are primarily composed of commercial paper and government notes. AtMarch 31, 2006, all of the Company’s short-term investments, carried atfair value, were classified as available-for-sale with unrealized gains andlosses included as a separate component of equity. The accumulated netunrealized loss on short-term investments was $30 and $4 at March 31, 2006and December 31, 2005, respectively.

***Recently Issued Accounting Pronouncements***

In November 2005, the FASB issued FASBStaff Position SFAS 123(R)-3, Transition Election Related to Accounting for theTax Effects of Share-based Payment Awards, that provides an electivealternative transition method of calculating the pool of excess tax benefitsavailable to absorb tax deficiencies recognized subsequent to the adoption ofSFAS No. 123R to the method otherwise required by paragraph 81 of SFAS No.123R.  We may take up to one year fromthe effective date of the FSP to evaluate our available alternatives and makeour one-time election.  We are currentlyevaluating the alternative methods in connection with our adoption of SFAS No.123R.

**Note 2 —Concentration of Credit and Other Risks**

The Company invests its excess cash in money marketfunds with major U.S. financial institutions, commercial paper and governmentnotes. The Company has established investment guidelines focused on protectingthe safety and liquidity of this invested cash.

The Company currently contracts with a single sourcefor the domestic manufacturing of Periostat tablets and has an agreement with asingle company to supply the active ingredient in Periostat. A single companyalso provides all warehousing and distribution services to the Company.

A majority of theCompany’s revenue has historically been derived from a small number ofwholesale drug distributors and United Research Laboratories, Inc./MutualPharmaceutical Company, Inc., or Mutual. For the three months ended March 31,2006, sales to Cardinal Health, Inc., McKesson Corporation, andAmerisource Bergen, represented approximately 53%, 26% and 14%, respectively,of the Company’s aggregate net product sales. Such customers also represented58%, 29% and 8% of the Company’s total accounts receivable balance at March 31,2006. For the three months ended March 31, 2005, sales to Cardinal Health, Inc.,McKesson Corporation, Amerisource Bergen Corporation and Mutual representedapproximately 30%, 29%, 12% and 25%, respectively, of the Company’s aggregatenet product sales. Such customers also represented 19%, 14%, 8% and 55%,respectively, of the Company’s total accounts receivable balance at March 31,2005.

During the threemonths ended March 31, 2006, Periostat accounted for approximately 42% ofthe Company’s total net revenues. During the three months ended March 31,2005, Periostat and Mutual’s branded version of Periostat accounted forapproximately 87% of the Company’s total net revenues.

**Note 3 — Share-Based Compensation**

At March 31, 2006,the Company had one active share-based employee compensation plan. Stock optionawards granted from this plan and historical plans are granted with an exerciseprice per share equal to the fair market value of a share of the Company’scommon stock on the date of grant. The option awards vest over a perioddetermined at the time the options are granted, ranging from two to five years,and generally have a maximum term of ten years. Certain options provide foraccelerated vesting if there is a change in control (as defined in the plans).Prior to January 1, 2006, the Company accounted for share-based employeecompensation, including stock options, using the method prescribed in 

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Accounting Principles Board (APB) Opinion No. 25,“Accounting for Stock Issued to Employees” and related Interpretations. UnderAPB Opinion No. 25, for stock options granted with an exercise price pershare equal to the fair market value of a share of the Company’s common stock,no compensation cost was recognized, and a disclosure was made regarding thepro forma effect on net earnings assuming compensation cost had been recognizedin accordance with SFAS No. 123, “Accounting for Stock-Based Compensation”.On December 16, 2004, the Financial Accounting Standards Board issuedSFAS No. 123R, *Share-Based Payment*,which requires companies to measure and recognize compensation expense for allshare-based payments at fair value. SFAS No. 123R eliminates theability to account for share-based compensation transactions using APB Opinion No. 25,and generally requires that such transactions be accounted for using prescribedfair-value-based methods. SFAS No. 123R permits public companies toadopt its requirements using one of two methods: (a) a “modifiedprospective” method in which compensation costs are recognized beginning withthe effective date based on the requirements of SFAS No. 123R for allshare-based payments granted or modified after the effective date, and based onthe requirements of SFAS No. 123 for all awards granted to employeesprior to the effective date of SFAS No. 123R that remain unvested onthe effective date, or (b) a “modified retrospective” method whichincludes the requirements of the modified prospective method described above,but also permits companies to restate based on the amounts previouslyrecognized under SFAS No. 123 for purposes of pro forma disclosureseither for all periods presented, or prior interim periods of the year ofadoption.

EffectiveJanuary 1, 2006, the Company adopted SFAS No. 123R using themodified prospective method. Nocompensation expense related to stock option grants has been recorded in theconsolidated statement of operations for the three months ended March 31, 2005,as all of the options granted had an exercise price per share equal to themarket value of a share of the Company’s common stock on the date of grant.Results for prior periods have not been restated. The Company isusing the straight-line method to recognize stock-based compensation expense. Theamount of stock-based compensation recognized during a period is based on thevalue of the portion of the awards that are ultimately expected to vest. SFAS No. 123Rrequires forfeitures to be estimated at the time of grant and revised, ifnecessary, in subsequent periods if actual forfeitures differ from thoseestimates. The term “forfeitures” is distinct from “cancellations” or “expirations”and represents only the unvested portion of the surrendered option. The Companyhas applied an annual forfeiture rate of 2.8% to all unvested options as of thedate of adoption and during the quarter ended March 31, 2006. Thisanalysis will be re-evaluated quarterly and the forfeiture rate will beadjusted as necessary. Ultimately, the actual expense recognized over thevesting period will only be for those shares that vest. During the three monthsended March 31, 2006, the Company recorded $793 of stock compensationexpense. This amount is composed of $99 related to research and developmentexpenses and $694 related to selling, general and administrative expenses. Noamounts of share-based compensation cost have been capitalized into inventoryor other assets during the quarter ended March 31, 2006.

Thefollowing table illustrates the effect on net loss and net loss per commonshare if the Company had applied the fair value recognition provisions of SFAS No. 123to stock-based employee compensation during the first quarter of 2005 (optionforfeitures are accounted for as they occurred and no amounts of compensationexpense have been capitalized into inventory or other assets, but instead areconsidered period expenses in the pro forma amounts):

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| ** **                                                                                                                     | ** ** | **Three Months  Ended  March 31, 2005** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------|------------|--------------------------------------------------------|------------|
| Net loss  allocable to common stockholders - as reported                                                                       |       | $                                                      | (2,458     | ) |
| Add: Stock based  compensation included in the determination of net income as reported                                    |       | —                                                 |       |
| Deduct: Total  stock based compensation expense determined under the fair value method for  all grants     |       | (811                                                   | )(1)       |
| Net loss  allocable to common stockholders - pro forma                                                                         |       | $                                                      | (3,269     | ) |
| Basic and  diluted net loss per share                                                                                          |       |                                                   |       |
| As reported                                                                                                                    |       | $                                                      | (0.17      | ) |
| Pro forma                                                                                                                      |       | $                                                      | (0.23      | ) |

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(1)             Amountshave not been tax-effected as a result of the Company’s significant netoperating loss carry-forwards.

As a result of adoptingSFAS No. 123R, the Company’s loss allocable to common stockholders for thethree months ended March 31, 2006 was $800 larger than if it had continued toaccount for share-based compensation under APB No. 25. Basic and diluted lossper share allocable to common stockholders for the three months ended March 31,2006 would have been $0.58 per share if the Company had not adopted SFAS No. 123R,compared to reported basic and diluted loss per share allocable to commonstockholders of $0.54 per share.

Sinceinception, the Company has had four stock-based compensation plans. The Companyissues new shares of common stock upon the exercise of stock options. The onlyactive plan at March 31, 2006 is the 2005 Equity Incentive Plan, or the2005 Plan.

The1992 Stock Option Plan, as amended, or the 1992 Plan, provided for the grantingof incentive and nonqualified options to directors, employees and consultantsto purchase up to 291,000 shares of the Company’s common stock at a price, forthe incentive options, not less than the fair value on the grant date. Suchoptions are exercisable for a period of ten years from the grant date andgenerally vest over a four-year period. All 291,000 options available under the1992 Plan were granted by 1996.

The1996 Non-Employee Director Stock Option Plan, or the Non-Employee DirectorPlan, provides for the issuance of stock options to new non-employee directorsto purchase up to 300,000 shares of common stock at an exercise price equal tothe fair value on the date of grant. Such options are exercisable for a periodof ten years from the date of grant and vest 20% per year commencing one yearfrom the grant date. The Non-Employee Director Plan expired in March 2006.No outstanding shares under the Non-Employee Director Plan were eligible to betransferred into other active Company stock-based compensation plans.

The1996 Stock Option Plan, as amended, or the 1996 Plan, provides for the issuanceof incentive and nonqualified options to employees and consultants to purchaseup to 3,000,000 shares of the Company’s common stock at a price, for theincentive options, no less than the fair value of the common stock on the dateof grant. Such options are exercisable for a period of ten years from the grantdate and generally vest over a two-to-five-year period, although vesting foroptions granted to certain Company officers is subject to acceleration undercertain circumstances. The 1996 Plan expired in March 2006, at which timeall unissued options were rolled over to the 2005 Plan.

9

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The2005 Plan provides for the issuance of incentive and nonqualified options,restricted stock awards, restricted stock units and other stock-based awards,including the grant of stock appreciation rights to employees, officers,directors, consultants, advisors, and other service providers to purchaseshares of the Company’s common stock at a price per share, for the incentiveoptions, not less than the fair value of a share of the Company’s common stock onthe grant date. The number of shares of common stock that may be issuedpursuant to the 2005 Plan is 1,000,000 shares plus the roll over of 476,555remaining shares of common stock reserved for issuance under the 1996 Plan uponits expiration in March 2006. At March 31, 2006, there were onlystock options available for issuance under the 2005 Plan. Such options areexercisable for a period of ten years from the grant date and generally vestover a five-year period, although vesting for options granted to certainCompany officers is subject to acceleration under certain circumstances. At March 31,2006, 1,010,555 shares of common stock were available for issuance pursuant toawards under the 2005 Plan.

Certain options grantedin 2003 are being amortized at a rate that is accelerated versus thecontractual vesting period of such options as these options are performance-basedand it is anticipated that the performance criteria will be met prior to straight-linevesting.

The following table summarizes activity under allstock option plans for the respective periods:

|                                                                    | ** ** | **Three Months Ended** | ** ** |
|--------------------------------------------------------------------|------------|----------------------------------|------------|
| **(In thousands, except per share data)** | ** ** | **March 31,  2006**         | ** ** | **March 31,  2005** | ** ** |
| Weighted-average  fair value of options granted per share          |       | $                                | 7.78       |   | $ | 3.91 |   |
| Intrinsic value of  options exercised                              |       | $                                | 349        |   | $ | 125 |   |

 

At March 31, 2006,the value of the unvested portion of all outstanding stock-related awards was$8,386, which the Company expects to amortize and recognize as compensationexpense over the weighted average service period of approximately 3.3 years.

Theamount of cash received during the three months ended March 31, 2006 fromexercise of options was approximately $525. No related tax benefit from theexercise of such options was realized as a result of the Company’s significantnet operating loss carryforwards and full valuation allowance.

The fair values of theoptions granted during the three months ended March 31, 2006 and 2005 weredetermined using the Black-Scholes option pricing model, which incorporatesvarious assumptions. The risk-free rate of interest for the average contractuallife of the option is based on U.S. Government Securities Treasury ConstantMaturities. Expected volatility is based on the historical daily volatility ofthe Company’s stock. The expected life is determined using the short-cut methodpermitted under SAB 107. The expected dividend rate yield is zero because theCompany currently does not pay or expect to pay dividends to common stockholders.The following are the weighted average assumptions used during the respectiveperiods:

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|                          | ** ** | **Three Months  Ended  March 31,** | ** ** |
|--------------------------|------------|----------------------------------------------|------------|
| ** **               | ** ** | **2006**                                     | ** ** | **2005** | ** ** |
| Expected life in  years  |       | 6.50                                         |       | 6.46 |   |
| Risk-free  interest rate |       | 4.54                                         | %          | 4.09 | % |
| Volatility               |       | 69.7                                         | %          | 72.8 | % |
| Expected dividend yield  |       | 0                                            | %          | 0 | % |

 

Stock optionactivity under all plans during the three months ended March 31, 2006 isas follows:
| ** **                         | ** ** | **Number of  Shares** | ** ** | **Weighted  Average  Exercise  Price per  Share** | ** ** | **Weighted  Average  Remaining  Contractual  Term (years)** | ** ** | **Aggregate  Intrinsic  Value (1)** | ** ** |
|------------------------------------|------------|----------------------------|------------|--------------------------------------------------------|------------|------------------------------------------------------------------|------------|------------------------------------------|------------|
| Balance at  December 31, 2005 |       | 3,305,267                  |       | $                                                      | 9.35       |                                                             |       |                                     |       |   |
| Options granted                    |       | 387,600                    |       | $                                                      | 11.45      |                                                             |       |                                     |       |   |
| Options exercised                  |       | (60,562                    | )          | $                                                      | 8.67       |                                                             |       |                                     |       |   |
| Options forfeited or cancelled     |       | (19,550                    | )          | $                                                      | 8.69       |                                                             |       |                                     |       |   |
| Balance at March 31,  2006    |       | 3,612,755                  |       | $                                                      | 9.58       |                                                             | 6.40       |                                     | $          | 18,859 |   |
| Exercisable,  March 31, 2006  |       | 2,133,582                  |       | $                                                      | 9.99       |                                                             | 4.77       |                                     | $          | 10,263 |   |

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(1)             Theaggregate intrinsic value on this table was calculated based on the positivedifference between the closing sales price of the Company’s common stock on March 31,2006 and the exercise price of the underlying options.

**Note 4 — Inventories**

Inventories at March 31, 2006 and December 31,2005 consist of the following:

|                | ** ** | **2006** | ** ** | **2005** | ** ** |
|----------------|------------|----------|------------|----------|------------|
| Raw materials  |       | $        | 77         |     | $          | 77 |   |
| Finished goods |       | 682      |       | 553      |       |
|           |       | $        | 759        |     | $          | 630 |   |

**Note5 — Line of Credit**

On June 7,2004, the Company entered into a Loan Modification Agreement with SiliconValley Bank to renew and amend its revolving credit facility, which expired on March 15,2004. The amended credit facility expires on May 31, 2006. Under theamended credit facility, the Company may borrow up to the lesser of $5,000 or80% of eligible accounts receivable, as defined under the amended creditfacility. The amount available to the Company is reduced by any outstandingletters of credit which may be issued under the amended credit facility in

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amounts totaling up to $2,000. As the Company paysdown amounts under any letter of credit, the amount available to it under thecredit facility increases. No letter of credit was outstanding at March 31,2006 and December 31, 2005. The Company is not obligated to draw down anyamounts under the amended credit facility and any borrowings shall bearinterest, payable monthly, at the current prime rate, or 7.75% at March 31,2006. The Company is charged an unused line credit fee of 0.375% of the unusedline per annum. As of March 31, 2006 and December 31, 2005, theCompany had no borrowings outstanding.

The Company iscurrently in discussions with Silicon Valley Bank regarding the renewal of theline of credit, however, the Company cannot offer assurance that suchdiscussions will result in a renewal.

**Note 6 —Contract and License Revenues**

The Companyrecorded $275****in contract andlicensing revenues for the three months ended March 31, 2006. In June 2005,the Company entered into the Promotion Agreement with Primus, under which theCompany will promote Alcortin, a prescription topical antifungal steroidcombination, and Novacort, a prescription topical steroid and anesthetic. Underthe Promotion Agreement, the Company will receive a percentage of the grossprofit arising from prescriptions written by dermatology professionals (oroffices) that result in sales of the products in the United States. The majorityof marketing expenses, excluding sales force compensation and sample productcosts, related to the promotion of the Primus products will be funded by Primus.The majority of product sample costs and all sales force compensation will befunded by the Company. During the three months ended March 31, 2005, $132of license revenue was recorded to reflect the unamortized portion of upfrontlicense revenue from the License and Supply Agreement with Showa Yakuhin KakoCo., Ltd., which was terminated in March 2005.

***Note 7 — LegalSettlements and Proceedings***

***Mutual***

On April 8,2004, the Company settled all pending litigation with Mutual. As part of thesettlement, the Company paid to Mutual $2,000, which represented a portion ofthe anticipated fees and expenses that the Company would save as a result ofthe settlement of the pending actions with Mutual.

In connection withthe 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 License and SupplyAgreement also provided for the Company to make price adjustments to Mutualafter a generic version of Periostat had become available on the market at aprice lower than the selling price of Mutual’s branded version of Periostat. Theseadjustments were to take the form of rebates or credits to Mutual to reduce theacquisition cost of the branded version of Periostat in Mutual’s inventory orto offset rebates and similar retroactive price adjustments requested by, andactually provided by, Mutual to its customers.

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On May 13,2005, the FDA approved a third party generic version of Periostat that waslaunched in late May 2005. Upon this generic launch, the License andSupply Agreement terminated and Mutual was no longer obligated to purchase itsbranded version of Periostat from the Company and ceased purchasing from theCompany in June 2005.

***FDA***

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,or the FDA Litigation. On July 23, 2003, the United States District Courtfor the District of Columbia issued a preliminary injunction prohibiting theFDA from approving any Abbreviated New Drug Applications, or ANDAs, submittedfor any generic version of Periostat. On January 20, 2005, the UnitedStates District Court for the District of Columbia reached its decision on themerits of the FDA Litigation, and dissolved the injunction that had prohibitedthe FDA from approving any ANDAs submitted for any generic version of Periostat.The Company lodged, but has now withdrawn, an appeal against this decision inthe Court of Appeals for the District of Columbia Circuit.

***IVAX and CorePharma***

On October 1,2004, the Company filed a complaint for patent infringement against IVAXPharmaceuticals Inc., or IVAX, and CorePharma LLC, or CorePharma, in the UnitedStates District Court for the Eastern District of New York. In its complaint,the Company alleged that the submission of ANDAs by each of IVAX and CorePharmafor 20 mg tablets of doxycycline hyclate infringed United States Patent RE34,656, for which the Company is the exclusive licensee. The Company alsoalleged that any manufacture, importation, marketing and sale of generic 20 mgtablets of doxycycline hyclate by IVAX and CorePharma would infringe the RE34,656 patent. The Company sought an injunction preventing IVAX and CorePharmafrom introducing 20 mg tablets of doxycycline hyclate in the United States. Theinjunction was denied by the Court on June 16, 2005. The litigation on themerits of the Company’s patent infringement claims is still pending before theCourt in the Eastern District of New York.

**Note 8 —Legal Expenses to Defend Periostat Patents**

Under the Company’slicense agreement with the Research Foundation of the State University of NewYork, or SUNY, covering Periostat, the Company is entitled to deduct costsincurred to defend its patents, including the $2,000 settlement payment toMutual in April 2004, from current and future royalties due to SUNY on netsales of Periostat and sales to Mutual of its branded version of Periostat. Thecumulative legal patent defense, litigation and settlement costs incurred as ofMarch 31, 2006 exceed the amount of the royalties earned and payable toSUNY by $4,049. These amounts, which have been expensed, will be available tooffset future royalties earned by SUNY, if any, on net sales of products basedon the SUNY technology.

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**Note 9 — Accrued Expenses**

Accrued expenses at March 31, 2006 and December 31,2005 consist of the following:

|                                                 | ** ** | **2006** | ** ** | **2005** | ** ** |
|-------------------------------------------------|------------|----------|------------|----------|------------|
| Contracted  development and manufacturing costs |       | $        | 1,083      |     | $          | 739 |   |
| Sales and  marketing costs                      |       | 190      |       | 239      |       |
| Payroll and  related costs                      |       | 785      |       | 2,097    |       |
| Professional and  consulting fees               |       | 477      |       | 232      |       |
| Current portion  of deferred revenue            |       | 110      |       | 58       |       |
| Foreign taxes                                   |       | 945      |       | 945      |       |
| Product returns                                 |       | 969      |       | 1,267    |       |
| State and franchise  taxes                      |       | 75       |       | 110      |       |
| Restructuring                                   |       | 75       |       | 96       |       |
| Distribution  fees and rebates                  |       | 250      |       | 237      |       |
| Other                                           |       | 138      |       | 4        |       |
|                                            |       | $        | 5,097      |     | $          | 6,024 |   |

 

**Note 10 — Common Stock Offering**

On December 21,2005, the Company entered into definitive agreements with institutional andother investors to sell 2,900,000 shares of the Company’s common stock for anaggregate purchase price of $29,000. On December 23, 2005, the Companyclosed on the first tranche of the offering and issued 1,550,000 shares ofcommon stock in exchange for proceeds of $14,388, net of approximately $1,069in placement agency fees and other estimated offering expenses that wereaccrued by the Company at December 31, 2005. All placement agency fees andrelated expenses accrued at December 31, 2005 were paid in the firstquarter of 2006. On January 6, 2006, the Company closed on the secondtranche of the offering and issued 1,350,000 shares of common stock in exchangefor $12,663 of net proceeds.

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**Item 2.   Management’s Discussion and Analysis ofFinancial 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 importantfactors that could cause our actual results to differ materially from thoseindicated. See “Risk Factors.”

**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 threeprescription pharmaceutical products to the dermatology market through ourprofessional dermatology sales force and generate revenues from fourprescription pharmaceutical products that we continue to sell to the dentalmarket.

Our strategy is tobecome a leading developer and marketer of innovative prescriptionpharmaceutical products to the dermatology market. We intend to continue tomarket our current products and develop and launch new products based on ourproprietary platform technologies as well as other technologies. Our leaddevelopment candidates are: OraceaTM, for which a New Drug Application, or NDA,is currently under review by the United States Food and Drug Administration, orFDA, for the treatment of rosacea; incyclinide (formerly known as COL-3),which is currently in Phase II dose-finding clinical trials for the treatmentof acne; COL-118, a pre-clinical topical compound based upon theSansRosaTM technology that we are developing for the treatment of erythema (skinredness) associated with dermatological conditions; and our Restoraderm® dermal drug delivery system, which iscurrently under development.

Our marketeddermatology 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. In June 2005, weexecuted a Promotion and Cooperation Agreement with Primus PharmaceuticalsInc., or Primus, to market Alcortin and Novacort to dermatologists.

Our originaldental product, Periostat®, is anorally administered, prescription pharmaceutical product that was approved bythe FDA in September 1998 for the treatment of adult periodontitis. Welaunched Periostat in January 1999, and by 2005 Periostat was the largestbranded prescription pharmaceutical product in the dental market. Between April 2004and June 2005, we also sold a separately branded version of Periostat toUnited Research Laboratories, Inc./Mutual Pharmaceutical Company, Inc.,or Mutual, pursuant to a License and Supply Agreement executed in April 2004as part of a settlement of our outstanding patent litigation with Mutual. On May 20,2005, we terminated our dental sales force and promotional activities forPeriostat following the introduction of a third party generic version of theproduct and, as a result of this generic launch, Mutual ceased purchasingproduct from us during June 2005. We also discontinued the promotion ofour other dental products on May 20, 2005. We continue to generate salesfrom Periostat and the other dental products, which include Atridox®, Atrisorb FreeFlow® and Atrisorb-D®,also referred to as the Atrix Products, and are licensed from AtrixLaboratories, Inc. (now known as QLT USA, Inc.). Based on dataprovided by a leading independent prescription tracking service, we estimatethat Periostat’s share of the 20 mg doxycycline market was approximately 9.0%at March 31, 2006.

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In addition to ourmarketed products, we have a pipeline of product candidates in clinical andpreclinical development. These products are based on our proprietary platformtechnologies, IMPACSTM, SansRosa****andRestoraderm. IMPACS (Inhibitors of Multiple Proteases And CytokineS) are agroup of compounds that demonstrate a range of anti-inflammatory activities aswell as the ability to inhibit the breakdown of connective tissue. Periostat isour first FDA-approved IMPACS product. Oracea and incyclinide are IMPACScompounds currently in clinical development for the treatment of rosacea andacne, respectively. Our IMPACS technology is licensed on a perpetual basis fromthe Research Foundation of the State University of New York at Stony Brook, orSUNY. Our SansRosa technology was acquired in connection with our acquisitionof SansRosa Pharmaceutical Development Inc., or SansRosa, and is an early stageproject to develop a topical treatment (COL-118) for the rednessassociated with rosacea. Our Restoraderm technology is a proprietary,foam-based, topical drug delivery technology that originated from a Swedishcollaborator. We have acquired all rights, title and interest to theRestoraderm technology. We have formulated several potential productsincorporating the Restoraderm technology with active ingredients commonly usedto treat dermatological conditions, although we have not yet developedtimetables for the initiation of clinical development or the commercial launchof any of these products.

We were founded in1992 and completed an initial public offering of our common stock in 1996. Werecorded our first profit in the third quarter of 2002. We incurred net lossesallocable to common stockholders of $9.3 million for the three months ended March 31,2006 and $18.8 million for the year ended December 31, 2005, respectively.Although we achieved net income of $6.5 million and $6.4 million for the yearsended December 31, 2004 and 2003, respectively, we have incurred losses inevery other year since inception and have an accumulated deficit of $98.0million at March 31, 2006. We do not expect to generate profits for theyear ending December 31, 2006.

**SignificantRecent Developments**

In 2005, wecompleted two Phase III clinical trials for our leading IMPACS productcandidate, Oracea, for the treatment of rosacea, a dermatological condition. Oraceais a modified release form of a sub-anti-microbial dose of doxycycline, thesame active ingredient as Periostat. We submitted our NDA for Oracea to the FDAon August 1, 2005. On October 3, 2005, we announced that the NDA forOracea had been accepted for review by the FDA. The Prescription Drug User FeeAct (PDUFA) target date for reviewing the submission is May 31, 2006. In April 2005,we announced the completion of a Phase II proof-of-concept clinical trial forour second generation IMPACS compound, incyclinide for the treatment of rosacea.In September 2005, we initiated a 300-patient, double-blinded,placebo-controlled, Phase II dose-finding clinical trial to evaluate the safetyand efficacy of incyclinide for the treatment of acne. On November 9,2005, we announced that the National Institutes of Health, or NIH, had awardeda grant of approximately $962,000 for additional research into the potentanti-inflammatory effects of incyclinide.

In February 2006,we announced that a Marketing Authorization Application, or MAA, for Oracea wasfiled with the United Kingdom’s Medicines & Healthcare ProductsRegulatory Agency, or MHRA. The U.K. will act as reference member state in thisdecentralized procedure. The MAA for Oracea was submitted to the MHRA on February 24,2006.

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In March 2006,we announced that the European Patent Office had published on their websitethat our patent application covering the use of sub anti-microbial doxycycline,including Oracea, for the treatment of acne and rosacea, will be allowed.

**Results of Operations**

*ThreeMonths Ended March 31, 2006 Compared to Three Months Ended March 31,2005*

***Revenues***
| **Revenues  (dollars in thousands)** | ** ** | **2006** | ** ** | **Change** | ** ** | **2005** | ** ** |
|------------------------------------------------|------------|----------|------------|------------|------------|----------|------------|
| Net Product  Sales                             |       | $        | 3,341      |       | (71.8      | )%       | $          | 11,836 |   |
| Contract  Revenues                             |       | 252      |       | 546.2      | %          | 39       |       |
| License Revenues                               |       | 23       |       | (85.6      | )%         | 160      |       |
| Grant Revenues                                 |       | 105      |       | 100        | %          | —   |       |
| Total                                          |       | $        | 3,721      |       | (69.1      | )%       | $          | 12,035 |   |

Net product salesduring the three months ended March 31, 2006 included approximately $3.3million in net product sales of Periostat, Pandel and the Atrix Products. Thedecrease in net product sales was primarily due to lower Periostat net salesand the elimination of sales of the branded version of Periostat to Mutual as aresult of the launch of a third party generic competitor in May 2005. Basedon data provided by a leading independent prescription tracking service, weestimate that Periostat’s share of the 20 mg doxycycline market was 9.0% at March 31,2006. Contract revenues during the three months ended March 31, 2006 werederived primarily from our Promotion and Cooperation Agreement with Primus forthe Alcortin and Novacort products. During the three months ended March 31,2005, contract revenues were primarily derived from residual contract revenuefrom our expired agreement with Merck & Co., Inc. for Vioxx®. Licensingrevenues of $23,000 during the three months ended March 31, 2006 consistedof international licensing revenues for Periostat. Licensing revenues duringthe three months ended March 31, 2005 consisted primarily of internationallicensing revenues for Periostat and $132,000 in license revenue representingthe unamortized portion of upfront license revenue received in 2000 from theLicense and Supply Agreement with Showa Yakuhin Kako Co., Ltd., which wasterminated in March 2005. Grant revenues, of $105,000 recognized duringthe three month period ended March 31, 2006, represent reimbursementreceived during the quarter from the NIH related to the November 2005grant associated with our on-going incyclinide development program.

***Cost of Product Sales***
| **Cost of Product Sales   (dollars in thousands)** | ** ** | **2006** | ** ** | **Change** | ** ** | **2005** | ** ** |
|----------------------------------------------------------------------------------|------------|----------|------------|------------|------------|----------|------------|
| Cost of Product  Sales                                                           |       | $        | 895        |       | (63.7      | )%       | $          | 2,465 |   |
| Percent of Net Product  Sales                                                    |       | 26.8     | %          | N/A        |       | 20.8     | %          |
|                                                                                  |            |          |            |            |            |          |            |  |  |

Cost of productsales 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 decreases ininventory carrying value, if any.

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Cost of productsales for the three months ended March 31, 2005 includes a charge ofapproximately $844,000 associated with the estimated excess inventories ofPeriostat and Mutual’s branded version of Periostat as a result of theanticipated launch by a third party generic competitor which occurred in May 2005.The increase in cost of product sales as a percentage of net product sales is adirect result of decreased Periostat revenues in 2006, which is a higher marginproduct than our other existing products.

***Research and Development***
| **Research and Development  (dollars in thousands)** | ** ** | **2006** | ** ** | **Change** | ** ** | **2005** | ** ** |
|--------------------------------------------------------------------------|------------|----------|------------|------------|------------|----------|------------|
| Research and  development                                                |       | $        | 3,713      |       | (9.3       | )%       | $          | 4,094 |   |
|                                                                          |            |          |            |            |            |          |            |  |  |

Research anddevelopment expenses consist primarily of funds paid to third parties for theprovision of services and materials for drug development, pre-launchmanufacturing and production costs related to Oracea, including milestone fees,manufacturing and formulation enhancements, clinical trials, purchasedin-process research and development, statistical analysis and report writingand regulatory compliance costs (including a drug approval submission andfiling fees).

Significantdevelopment projects conducted during the three months ended March 31,2006 included:

·                  continuingclinical and manufacturing development work and regulatory compliance costs forOracea of approximately $1.2 million;

·                  clinical andmanufacturing development work for incyclinide was $ 1.5 million; and

·                  in-processresearch and development costs related to COL-118 of approximately$200,000.

Personnel anddirect internal overhead expenses, including consulting, regulatory andstock-based compensation costs incurred during the three months ended March 31,2006, were approximately $800,000.

We estimate thatif Oracea and incyclinide are developed to the point of commercialization, theadditional formulation and clinical development expenses and milestone feesexpected to be incurred over the next five years would be approximately $35.0million. We have discontinued all development work on Periostat-MRTM following the launch of generic competition toPeriostat in May 2005 and our decision to exit the dental business. We arecurrently conducting some formulation and stability work on various productsincorporating our Restoraderm technology, and we are reviewing product optionsand the timetable associated with clinical development or commercial launch. Accordingly,it is premature to estimate other future costs associated with the Restoradermtechnology. It is also premature to estimate future development and clinicalcosts associated with the SansRosa technology.

Significantdevelopment projects conducted during the three months ended March 31,2005 included:

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·                  continuingclinical and manufacturing development work for Oracea of approximately $1.8 million;

·                  clinical andmanufacturing development and formulation work for Periostat-MR, our oncedaily, modified release formulation of doxycycline, 40 mg, for the treatment ofadult periodontitis, which accounted for total costs of approximately $886,000;

·                  clinical andmanufacturing development work for incyclinide was $491,000; and

·                  stabilitytesting and formulation costs for two potential products utilizing ourRestoraderm technology, which accounted for total costs of approximately $250,000.

Personnel and directinternal overhead expenses, including consulting, regulatory fees and othermiscellaneous expenses, incurred during the three months ended March 31,2005 were approximately $666,000.

***Selling, General and Administrative***
| **Selling, General and Administrative  (dollars in thousands)** | ** ** | **2006** | ** ** | **Change** | ** ** | **2005** | ** ** |
|------------------------------------------------------------------------------------------|------------|----------|------------|------------|------------|----------|------------|
| Selling, General  and Administrative                                                     |       | $        | 8,511      |       | 9.9        | %        | $          | 7,746 |   |
|                                                                                          |            |          |            |            |            |          |            |  |  |

Selling, generaland administrative expenses consist primarily of personnel salaries andbenefits, including non-cash share-based compensation expense in 2006, directmarketing costs, professional, legal and consulting fees, insurance and generaloffice expenses.

Significantcomponents of selling, general and administrative expenses incurred during thethree months ended March 31, 2006 included approximately $3.6 million indirect selling and sales training expenses, approximately $2.4 million inmarketing expenses (including advertising and promotion expenditures the Primusproducts, Pandel and pre-launch costs associated with the anticipated Oraceatrade launch) and approximately $2.6 million in general and administrativeexpenses, which include business development, finance, legal and corporateactivities. Significant components of selling, general and administrativeexpenses incurred during the three months ended March 31, 2005 includedapproximately $3.8****million in direct selling and salestraining expenses, approximately $1.9million in marketing expenses (including advertising and promotion expendituresfor Periostat, the Atrix Products and Pandel) and approximately $2.0****millionin general and administrative expenses, which include business development,finance, legal and corporate activities. The increase in selling, general andadministrative expense of $765,000 during the three months ended March 31,2006 compared to the three months ended March 31, 2005, was primarily dueto non-cash share-based compensation expense of approximately $700,000. Thiswas offset in part by lower sales force compensation costs during the beginningportion of the three months ended March 31, 2006. Total salesrepresentatives and sales managers grew from 33 at January 1, 2006 to 75at March 31, 2006 in anticipation of a September 2006 Oracea tradelaunch date. This is compared to an average headcount of 80 professional salesrepresentatives and managers during the three months ended March 31, 2005.

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***OtherIncome/Expense***
| **Other Income/Expense  (dollars in thousands)** | ** ** | **2006** | ** ** | **Change** | ** ** | **2005** | ** ** |
|-----------------------------------------------------------------|------------|----------|------------|------------|------------|----------|------------|
| Interest income                                                 |       | $        | 546        |       | 157.5      | %        | $          | 212 |   |
|                                                                 |            |          |            |            |            |          |            |  |  |

The increase ininterest income was due to higher average investment balances and yields in2006.

***Preferred Stock Dividend***

Preferred stockdividends included in net loss allocable to common stockholders were $464,000during the three months ended March 31, 2006 and $400,000 during the threemonths ended March 31, 2005. Such preferred stock dividends are paid incash and are the result of our obligations in connection with the issuance ofour Series D Cumulative Convertible Preferred Stock, or the Series DStock, in May 1999. On December 15, 2005, we executed a Restructuringand Exchange Agreement with each of the holders of our outstanding Series DStock, pursuant to which, among other things, the Series D stockholdersagreed to effect an exchange, whereby we exchanged all 200,000 outstandingshares of our Series D Stock for 200,000 shares of our Series D-1Cumulative Convertible Preferred Stock, or the Series D-1 Stock.

Pursuant to theterms of our Series D-1 Stock, the holders of the Series D-1Stock are entitled to dividends payable in cash at a current rate of 9.0% perannum, which are declared and paid every six months. The annual dividend rateincreases by 1.0% per annum on May 19, 2006 and each subsequentanniversary thereof until the earlier of the date that all of the shares of Series D-1Stock are (i) converted into shares of common stock, or (ii) redeemed.

## **Liquidityand Capital Resources**

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

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

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

·                  Cash flows fromoperations; and

·                  Exercise ofstock options and warrants.

We believe thatother key factors that could affect our internal and external sources of cashare:

·                  The success ofour dermatology franchise;

·                  Receipt ofmarketing approvals from the FDA and similar foreign regulatory authorities forour product candidates;

·                  The success ofour preclinical, clinical and development programs (research and developmentexpenses are estimated to be approximately $17.0 million in 2006);

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·                  Revenues andprofits from sales of Periostat, Pandel and our other product candidates, aswell as the products we co-promote;

·                  The terms andconditions of our outstanding Series D-1 Stock;

·                  Our ability tocontinue to meet the covenant requirements under our revolving credit facilitywith Silicon Valley Bank and our ability to renew or replace our creditfacility; and

·                  The receptivityof the capital markets to our future financings.

In December 2005and January 2006, we raised $27.1 million in a public offering, net ofplacement agency fees and all offering expenses that were payable by us fromthe sale of 2.9 million shares of our common stock at a price of $10.00 pershare.

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 facility expires 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 credit facility. Theamount available to us is reduced by any outstanding letters of credit that maybe issued under the amended credit facility in amounts totaling up to $2.0million. As we pay down amounts under any letter of credit, the amountavailable to us under the credit facility increases. We are not obligated todraw amounts under the amended credit facility and any borrowings shall bearinterest, payable monthly, at the current prime rate. As of March 31,2006, we had no outstanding borrowingsor letters of credit. We are currently in discussions with Silicon Valley Bankregarding the renewal of the line of credit, however, we cannot offer assurancethat such discussions will result in a renewal.

At March 31,2006, we had cash, cash equivalents and short-term investments of approximately$44.3 million compared to theapproximately $44.4 million balance at December 31, 2005.

In accordance withinvestment guidelines approved by our Board of Directors, cash balances inexcess of those required to fund operations have been invested in governmentnotes, commercial paper and money market funds. Our working capital at March 31,2006 was $39.7 million comparedto $34.6 million at December 31, 2005. During the three months ended March 31,2006, we invested approximately $151,000in capital expenditures and $200,000 for in-process research and development,paid $900,000 in cash dividendsto the holders of our Series D-1 Stock and purchased approximately$3.2 million (net of sales) of short-term investments.

We anticipate thatour current cash, cash equivalents and short-term investments at March 31,2006, will be sufficient to fund our operations through at least mid-2007.However, our forecast of the period of time through which our financialresources will be adequate to support our operations is a forward-lookingstatement that involves risks and uncertainties, and actual results could varymaterially.

***Cash Flows/Cash Management***

The principal useof cash in operating activities during the three months ended March 31,2006 was the payment of operating expenses and related working capitalliabilities. Cash flows from operations can vary significantly due to variousfactors including the timing of payments

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made to our vendors, including research anddevelopment vendors, vendor payment terms, customer mix and customer paymentterms.

Investingactivities during the three months ended March 31, 2006 consistedprimarily of purchases and sales of short-term investments, capital purchasesand acquired in-process research and development. Financing activities duringthe three months ended March 31, 2006 consisted primarily of the cashinflows from the completion of the second tranche of our common stock offering,stock option exercises and the payment of preferred dividends to the holders ofour Series D-1 Stock.

***Contractual Obligations***

Our majoroutstanding contractual obligations relate to cash dividends on our outstandingSeries D-1 preferred stock and operating leases for our office space.The disclosures relating to our contractual obligations in our Annual Report onForm 10-K for the year ended December 31, 2005 have notmaterially changed since we filed that report.

***Critical Accounting Policies andEstimates***

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 these financial statements requires managementto make judgments and estimates that affect the reported amounts of assets,liabilities, revenues and expenses and related disclosure of contingent assetsand liabilities. Management believes the critical accounting policies and areasthat require the most significant judgments and estimates to be used in thepreparation of the consolidated financial statements pertain to revenuerecognition, stock compensation and the valuation of deferred taxes, acquiredproduct rights and inventory.

***RevenueRecognition***

Except forPeriostat, we recognize 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 ofgeneric competition to Periostat, and commencing with the second quarter of2005, we began to recognize Periostat sales revenue primarily based on sales toend-users, which we estimate using prescription demand data generated by aleading independent prescription tracking service, as well as on-handinventory estimates in the distribution channel. Accordingly, since the launchof generic competition to Periostat may increase the rate of product returnsfrom the distribution channel, we have accrued $866,000 for estimated potentialPeriostat returns in the distribution channel in accrued expenses on theconsolidated balance sheet at March 31, 2006.

Pursuant to ourPromotion and Cooperation Agreement with Primus, contract revenues for Alcortinand 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 title to the inventory sold by Primus underthe Promotion Agreement.

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During the fourthquarter of 2005, we received notice of a grant from the NIH for additionalresearch into the anti-inflammatory effects of incyclinide. We expense such expendituresas research and development as they are incurred and recognize grant revenuefor the portion of the expenditures that are reimbursed by the NIH. Theserevenues are recorded at the time they are submitted for reimbursement.

***Deferred Taxes***

In assessing therealizability of deferred tax assets, we consider the likelihood that part orall of the deferred tax assets will not be realized. This assessment requiressignificant judgment and estimates. The ultimate realization of the deferredtax assets is dependent upon the generation of future taxable income during theperiod in which those temporary differences become deductible. We consider ourhistory of losses, scheduled reversal of deferred tax assets and liabilitiesand projected future taxable income over the periods in which the deferred taxasset items are deductible. The Tax Reform Act of 1986 contains provisions thatmay limit the net operating loss and research and experimentation creditcarryforwards available to be used in any given year upon the occurrence ofcertain events, including significant changes in ownership interest. We haveincurred a net loss for the three months ended March 31, 2006 and for theyear ended December 31, 2005, and uncertainty regarding our futureprofitability has prevented us from reaching the “more likely than not”conclusion required under the applicable literature to recognize deferred taxassets on our consolidated balance sheet.

***Acquired ProductRights***

***Product rights are stated at cost, amortized over the shorter of theestimated useful life of the products or the contract term which such rightshave been licensed, using the straight-line method. Amortization of productrights is charged to cost of product sales.***

We are required totest for asset impairment of acquired product rights whenever events orcircumstances indicate that the carrying value of an asset may not berecoverable. We apply SFAS No. 144, “Accounting for the Impairment orDisposal of Long-Lived Assets,” in order to determine whether or not an assetwas impaired. This standard requires an impairment analysis when indicators ofimpairment are present. If such indicators are present, the standard indicatesthat if the sum of the future expected cash flows from the asset, undiscountedand without interest charges, is less than the carrying value, an assetimpairment must be recognized in the financial statements. The amount of theimpairment is the difference between the fair value of the asset and thecarrying value of the asset.

In making future cashflow analyses of our acquired product rights, we make assumptions relatingto:  (i) the intended use of theproduct rights and the expected future cash flows resulting directly from suchuse; (ii) generic competitor activities and regulatory initiatives thataffect our products; and (iii) customer preferences and expected managedcare reimbursement.

As a result of achange in the contractual life of the Licensing and Marketing Agreement withQLT USA, Inc., we adjusted the current and future amortization of itsacquired product rights asset to reflect an estimated useful life through December 31,2007.

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***Inventories***

Criticalaccounting estimates and assumptions, related to inventory carrying values areevaluated periodically and consider the saleable quantities of inventory versusquantities of inventory on-hand.

During the threemonths ended March 31, 2005, we recorded a charge of $844,000 for theestimated excess inventory of Periostat and Mutual’s branded version ofPeriostat due to the anticipated decreased demand following the introduction ofa third party generic version of Periostat that occurred in May 2005.

***Pre-LaunchManufacturing Costs***

Weclassify direct manufacturing costs relating to inventory and samplesmanufactured in advance of a new product launch as research and developmentexpense until such time as we receive an approval letter from the FDA for a newproduct, and then we begin to capitalize the inventory costs relating to thatproduct. If we are successful in attaining regulatory approval, the directmanufacturing costs associated with future product sales of approved productsin subsequent periods will be recorded net of previously expensed directmanufacturing costs incurred in periods prior to regulatory approval.

***Stock-BasedCompensation***

As part of our adoption of SFAS No. 123R asof January 1, 2006, we recognized the fair value of share-basedcompensation awards in our consolidated financial statements using the modifiedprospective method. We apply the Black-Scholes option-pricing model in order todetermine the fair value of stock options on the date of grant, and we applyjudgment in estimating key assumptions that are important elements in themodel, such as the expected stock-price volatility and expected stock optionlife. Our estimates of these important assumptions and expected forfeiturerates are based on historical data and judgment regarding market trends andfactors.

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

***Recently Issued AccountingPronouncements***

In November 2005, the FASB issued FASB Staff PositionSFAS 123(R)-3, Transition Election Related to Accounting for the Tax Effects ofShare-based Payment Awards, that provides an elective alternative transitionmethod of calculating the pool of excess tax benefits available to absorb taxdeficiencies recognized subsequent to the adoption of SFAS No. 123R to themethod otherwise required by paragraph 81 of SFAS No. 123R.  We may take up to one year from the effectivedate of the FSP to evaluate our available alternatives and make our one-timeelection.  We are currently evaluatingthe alternative methods in connection with our adoption of SFAS No. 123R.

**Item 3.    Quantitative and Qualitative DisclosuresAbout Market Risk.**

We had cash andcash equivalents and short-term investments at March 31, 2006 which areexposed to the impact of interest rate changes and our interest incomefluctuates as interest rates change. Due to the short-term nature of ourinvestments in money market funds, the carrying values of our cash equivalentsapproximate their fair value at March 31, 2006. Our short-term investmentsin commercial paper certificates of deposit and government notes are carried atfair value.

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**Item 4.    Controls and Procedures.**

Our management,with the participation of our chief executive officer and chief financialofficer, evaluated the effectiveness of the Company’s disclosure controls andprocedures as of March 31, 2006. The term “disclosure controls andprocedures,” as defined in Rules 13a-15(e) and 15d-15(e) underthe Exchange Act, means controls and other procedures of a company that aredesigned to ensure that information required to be disclosed by a company inthe reports that it files or submits under the Exchange Act is recorded,processed, summarized and reported, within the time periods specified in theSEC’s rules and forms. Disclosure controls and procedures include, withoutlimitation, controls and procedures designed to ensure that informationrequired to be disclosed by a company in the reports that it files or submitsunder the Exchange Act is accumulated and communicated to the company’smanagement, including its principal executive and principal financial officersas appropriate to allow timely decisions regarding required disclosure. Ourmanagement recognizes that any controls and procedures, no matter how welldesigned and operated, can provide only reasonable assurance of achieving theirobjectives and management necessarily applies its judgment in evaluating thecost-benefit relationship of possible controls and procedures. Based on theevaluation of our disclosure controls and procedures as of March 31, 2006,our chief executive officer and chief financial officer concluded that, as ofsuch date, our disclosure controls and procedures were effective at thereasonable assurance level.

No change in ourinternal control over financial reporting (as defined in Rules 13a-15(f) and15d-15(f) under the Exchange Act) occurred during the fiscal quarterended March 31, 2006 that has materially affected, or is reasonably likelyto materially affect, our internal control over financial reporting.

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**PART II.OTHER INFORMATION**

**Item 1A. Risk Factors**

*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 the ExchangeAct of 1934, as amended. These forward-looking statements regarding futureevents and our future results are based on current expectations, estimates,forecasts, and projections and the beliefs and assumptions of our managementincluding, without limitation, our expectations regarding results ofoperations, selling, general and administrative expenses, research anddevelopment expenses, the sufficiency of our cash for future operations, andthe success of our preclinical, clinical and development programs and ourdermatology franchise. Forward-looking statements may be identified by the useof forward-looking terminology such as “may,” “could,” “will,” “expect,” “estimate,”“anticipate,” “continue,” or similar terms, variations of such terms or thenegative of those terms.*

*Wecannot assure investors that our assumptions and expectations will prove tohave been correct. Important factors could cause our actual results to differmaterially from those indicated or implied by forward-looking statements. Suchfactors that could cause or contribute to such differences include thosefactors discussed below. We undertake no intention or obligation to update orrevise any forward-looking statements, whether as a result of new information,future events or otherwise. If any of the following risks actually occur, ourbusiness, financial condition or results of operations would likely suffer.*

*Thefollowing discussion includes one revised risk factor (“If we are not able toobtain and enforce patent protection for Oracea or our other discoveries, ourability to commercialize our product candidates successfully will be harmed andwe may not be able to operate our business profitably.”) that reflectsdevelopments subsequent to the discussion of risk factors included in our mostrecent Annual Report on Form 10-K.  Inaddition, we have deleted the risk factor entitled “Changes in stock optionaccounting rules may have a significant adverse affect on our operatingresults.”*

***We are dependingheavily on the success of our most advanced product candidate, Oracea, for thetreatment of rosacea, which is still under regulatory review. If we are unableto obtain approval for and commercialize Oracea, or experience significantdelays in doing so, our business will be materially harmed.***

We have invested asignificant portion of our recent efforts and financial resources in thedevelopment of our most advanced product candidate, Oracea, for the treatmentof rosacea. Our ability to generate substantial product revenues from Oracea,if ever, will depend heavily on the successful development andcommercialization of Oracea. The success of Oracea will depend on severalfactors, including the following:

·                  receipt ofmarketing approvals from the FDA and similar foreign regulatory authorities;and

·                  acceptance ofthe product by patients, the medical community and third party payors.

If we are unableto obtain FDA approval for and successfully commercialize Oracea, we may neverrealize revenue from this product candidate and we may have to curtail ourother product development programs. As a result, our business would bematerially harmed.

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

In connection withthe regulatory approval process, some approved new drug products can obtainexclusivity that will prevent generic versions of the products from enteringthe marketplace for a period of time. In the United States, market exclusivityis available for new chemical entities and for significant changes in alreadyapproved drug products, such as a new use.

Market exclusivityis, however, not available to drugs that contain an active ingredient that hasalready been approved as an antibiotic. On January 19, 2005, the UnitedStates District Court for the District of Columbia upheld the FDA’s applicationof this principle to Periostat and determined that Periostat was not entitledto market exclusivity because its active ingredient, doxycycline, hadpreviously been approved as an antibiotic. Because Oracea also containsdoxycycline as its active ingredient, it will also not be entitled to marketexclusivity.

In the EuropeanCommunity regulatory market exclusivity is a function of how long the competentauthorities may determine that data submitted in marketing approvalapplications may not be referenced by others. The period of so-called dataexclusivity to which a new product may be entitled can vary from eleven yearsto none at all. This depends on how a product is classified and can turn on theapplication of regulatory standards of which there has been no authoritativeinterpretation to date. We cannot predict what period of data exclusivity, ifany, may be enjoyed by Oracea in the European Community.

With limited or nomarket exclusivity it can be more difficult for us to prevent competitors fromseeking approval for copies of our proprietary products, and in such a case thevalue of such products would be materially adversely affected. Without marketexclusivity, generic versions of our products could quickly gain market entryif they meet regulatory approval criteria. Thus, even if we gain approval ofOracea, because it will not be entitled to patent or non-patent marketexclusivity, third parties may enter the market which would materially harm ourbusiness.

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

Our 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 holdor obtain proprietary rights to some patents related to our current or futureproducts and technologies, and we may not, under relevant patent laws, beconsidered to be inventors of technologies we believe we have developed.

Becausepublications of discoveries in scientific literature lag behind actualdiscoveries, and such publications may not come to light despite diligentsearches, we cannot be certain that we were the first to make the inventionsclaimed in our issued patents or pending patent applications. Similarly,because patent applications in the United States and many foreign jurisdictionsare typically not published until 18 months after filing, or in some cases notat all, we cannot be certain that we were the first to make the inventionsclaimed or to file for protection of the inventions set forth in our patentapplications. As a result, we may not be

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granted additional patents or our existing patents maybe found to be invalid. We may also be required to obtain licenses underthird-party patents to market our proposed products. If licenses are notavailable to us on acceptable terms, or at all, we will not be able to marketthe affected products.

Our strategydepends on our ability to identify our discoveries rapidly and to seek patentprotection for them. This process is expensive and time consuming, and we maynot be able to file and prosecute all necessary or desirable patentapplications at a reasonable cost or in a timely manner. Despite our efforts toprotect our proprietary rights, unauthorized parties may be able to obtain anduse information that we regard as proprietary. The issuance of a patent doesnot guarantee that it is valid or enforceable, so even if we obtain patents,they may not be valid or enforceable against third parties. In addition, theissuance of a patent does not guarantee that we have the right to practice thepatented invention. Third parties may have blocking patents that could be usedto prevent us from marketing our own patented product and practicing our ownpatented technology.

Our pending patentapplications may not result in issued patents. The patent position ofpharmaceutical or biotechnology companies, including ours, is generallyuncertain and involves complex legal and factual considerations. The standardswhich the United States Patent and Trademark Office, or USPTO, and its foreigncounterparts use to grant patents are not always applied predictably oruniformly and can change. There is also no uniform, worldwide policy regardingthe subject matter and scope of claims granted or allowable in pharmaceuticalor biotechnology patents. The laws of some foreign countries do not protectproprietary information to the same extent as the laws of the United States,and many companies have encountered significant problems and costs inprotecting their proprietary information in these foreign countries. Accordingly,we do not know the degree of future protection for our proprietary rights orthe breadth of claims allowed in any patents issued to us or to others. Theallowance of broader claims may increase the incidence and cost of patentinterference proceedings and/or opposition proceedings. On the other hand, theallowance of narrower claims 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 of our 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 (includinggeneric), though non-approved, doxycycline products for indications covered byour patents. If our patents are invalidated or otherwise limited, othercompanies will be better able to develop products and technologies that competewith ours, which could adversely affect our competitive business position,business prospects and financial condition.

***We cannot assure you that our pursuit of business in thedermatology market will be successful.***

We continue toimplement our plans to expand into the dermatology market. We recentlysubmitted a New Drug Application with the FDA for Oracea to treat rosacea, andwe continue to seek additional product licensing opportunities to enhance ournear-term offerings to the dermatology market. We have also been allowedpatents by the USPTO and European patent

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office for the useof sub-anti-microbial 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 someof our competitors have substantially greater resources than we have. Ourfuture 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 same time,new product development is a lengthy, complex and uncertain process that willrequire significant attention and resources from management. A productcandidate can fail at any stage of the development process due to, among otherthings, efficacy or safety concerns, the inability to obtain necessaryregulatory approvals, the difficulty or excessive cost to manufacture and/orthe infringement of patents or intellectual property rights of others. Furthermore,the sales of new products may prove to be disappointing and fail to reachanticipated levels. We therefore cannot assure you that we will be successfulin our pursuit of business in the dermatology market, or that we can sustainany business in which we achieve initial success.

The success of ourcurrent technology platforms, and that of any other future technology platformswe may purchase or in-license, will depend on the quality and integrity of thetechnologies licensed or sold to us. Despite our due diligence and thesafeguards we have in place, we cannot guarantee the effectiveness or integrityof such technologies, nor can we be certain that others do not have interveningrights in such technologies. If any of our in-licensed technologies provedineffective, or if a third party successfully asserted any right to suchtechnologies, our ability to develop new products and implement our strategieswould 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.***

Failure to obtainregulatory approval for a product candidate will prevent us fromcommercializing the product candidate. Other than Periostat, we have notreceived regulatory approval to market any of our product candidates in anyjurisdiction. We have only limited experience in filing and prosecuting theapplications necessary to gain regulatory approvals. Securing FDA approvalrequires the submission of extensive preclinical and clinical data, informationabout product manufacturing processes and inspection of facilities andsupporting information to the FDA for each therapeutic indication to establishthe product candidate’s safety and efficacy. Our future products may not beeffective, may be only moderately effective or may prove to have undesirable orunintended side effects, toxicities or other characteristics that may precludeour obtaining regulatory approval or prevent or limit commercial 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 candidates involved. Changesin the regulatory approval policy during the development period, changes in orthe enactment of additional statutes or

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regulations, or changes in regulatory review for eachsubmitted product application, may cause delays in the approval or rejection ofan application.

The FDA, andcomparable authorities in other countries, have substantial discretion in theapproval process and may refuse to accept any application or may decide thatour data is insufficient for approval and require additional preclinical,clinical or other studies. In addition, varying interpretations of the dataobtained from preclinical and clinical testing could influence how a productcandidate is classified and delay, limit or prevent regulatory approval of aproduct candidate. Any regulatory approval we ultimately obtain may be limitedor subject to restrictions or post-approval commitments that render the productnot commercially viable.

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.

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

We do not have theresources, facilities or capabilities to manufacture any of our products orproduct candidates. We have no current plans to establish a manufacturingfacility. We expect that we will be dependent, to a significant extent, oncontract manufacturers for commercial scale manufacturing of our products orproduct candidates in accordance with regulatory standards.

We rely on asupplier, Hovione International Limited, or Hovione, as our sole supplier fordoxycycline, the active ingredient in Oracea. We are seeking a back-upsupplier, but there are relatively few alternative suppliers of doxycycline,and Hovione produces the majority of the doxycycline used in the United States.Our current supply agreement with Hovione expires on May 14, 2006 andthereafter automatically renews for successive two-year periods unless, 90 daysprior to the expiration of any such periods, either party gives the other partywritten notice of termination. In addition, in the event of a default, uncuredfor 90 days, the non-defaulting party can terminate the supply agreementeffective immediately at the end of such ninety-day period. Although Hovionemaintains two manufacturing locations, if we achieve FDA approval for Oraceaand are unable to procure a commercial quantity of doxycycline from Hovione onan ongoing basis at a competitive price, if Hovione fails to comply withcurrent Good Manufacturing Practices or if we cannot find a replacementsupplier in a timely manner or with favorable pricing terms, our costs mayincrease significantly and we may experience delays in the supply of Oracea.

We entered into anagreement effective December 31, 2005 with Cardinal Health PTS, LLC, orPTS, pursuant to which PTS has agreed to manufacture Oracea for us. Pursuant tothe terms of the agreement, we agree to (i) furnish to PTS on a monthlybasis a rolling forecast of product quantities for the subsequent twelve-monthperiod, the first three months of which shall become binding, and (ii) payPTS a fee for the product, subject to an annual adjustment. The agreement hasan initial term of four years unless terminated earlier pursuant to its terms.

We intend tocontract with additional manufacturers for the commercial manufacture of anOracea capsule. We believe, however, that it could take up to one year tovalidate successfully a secondary manufacturer. We cannot be certain that wewill be able to enter into

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additional agreements on acceptable terms, if at all. Inthe event that Oracea is approved by the FDA and we are unable to obtainsufficient quantities of doxycycline or Oracea on commercially reasonableterms, or in a timely manner, our business, financial condition and results ofoperations would be materially adversely affected.

***If the federal regulatory status ofAlcortin or Novacort changes, we may be unable to continue to market one orboth of these products.***

We market twoproducts, Alcortin and Novacort, under a Promotion and Cooperation Agreementwith Primus. The majority of sample product costs and all sales forcecompensation related to our promotion of Alcortin and Novacort are funded by us.Primus is responsible for the manufacture of Alcortin and Novacort and it hasnot sought FDA approval for these products because it believes that no approvalis required. We cannot be sure that FDA will not object to the lack of approvalfor these products. If the FDA were to assert that these products requiredapproval, it could at any time seek to take administrative or judicial actionswhich could prevent us from marketing these products. Our inability to marketthese products could result in a temporary or permanent loss of revenue, whichmay be partially offset by a reduction in our promotional expenses related tothese products.

***Our products could be subject to restrictions or withdrawalfrom the market and we may be subject to penalties if we fail to comply withregulatory requirements. Both before and after approval or clearance, we, ourvendors and suppliers, and our products and product candidates are subject toextensive regulatory requirements. Failure to comply with these requirementscould subject us to administrative and judicial sanctions.***

Both before andafter approval or clearance of our products, we, our products, and ourmanufacturers are subject to extensive regulatory requirements covering, amongother things, manufacturing, advertising and promotion, labeling, adverse eventreporting, post-approval commitments, registration, record-keeping, export, anddistribution of samples. Failure to comply with regulatory requirements mayresult in:

·                  restrictions onsuch products, manufacturers or manufacturing processes;

·                  warning letters;

·                  withdrawal ofthe products from the market;

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

·                  recall;

·                  fines;

·                  suspension orwithdrawal of regulatory approvals;

·                  refusal topermit the import or export of our products;

·                  product seizure;and

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·                  injunctions orthe 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 three months ended March 31,2006 and each of the years ended December 31, 2005, 2004 and 2003,Periostat and Mutual’s branded version of Periostat supplied by us (withrespect to the three months ended March 31, 2006 and the years ended December 31,2005 and 2004), accounted for approximately 42%, 76%, 88% and 82% of our totalnet 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 genericlaunch, Mutual was no longer obligated to purchase and is not expected topurchase their branded product from us. We do not anticipate future shipmentsof Mutual’s branded version of Periostat supplied by us. In addition, we havehad to disband our dental sales force and delay or discontinue certain researchand development activities in the dental business. Consequently, while wecontinue to generate cash flow from our dental business, our revenues andmargins from Periostat and the other dental products we sell have decreasedsignificantly and will likely continue to decrease as a result of the thirdparty introduction of a generic version of Periostat. If this decrease is moresignificant than we expect, and is combined with slow growth in, or a lack ofrevenues, if any, from new products, we may experience difficulty in managingour cash, which could have a material adverse effect on our ability execute ourstrategies and develop our dermatology business.

***We will need substantial additional funding and may beunable to raise capital when needed, which would force us to delay, reduce oreliminate our product development programs and commercialization efforts.***

We expect that ourresearch and development expenses will increase in connection with our ongoingactivities and that we will incur significant commercialization expenses as weexpand our marketing and sales efforts. We will need substantial additionalfunding and may be unable to raise capital when needed or on attractive terms,which would force us to delay, reduce or eliminate our research and developmentprograms and commercialization activities.

We anticipate thatour current cash, cash equivalents and short-term investments at March 31,2006 will be sufficient to fund our operations through at least mid-2007.However, our forecast of the period of time through which our financialresources will be adequate to support our operations involves risks anduncertainties, and actual results could vary materially. Our future fundingrequirements will depend on many factors, including:

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

·                  the success ofour dermatology franchise;

·                  the success ofour preclinical, clinical and development programs;

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·                  revenues andprofits from sales of Periostat, Pandel and our other product candidates, aswell as the products we co-promote;

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

·                  our ability tocontinue to meet the covenant requirements under our revolving credit facilitywith Silicon Valley Bank;

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

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

·                  the costsinvolved in obtaining regulatory approvals and clearances required to marketand sell our products;

·                  our ability toestablish and maintain additional collaborations; and

·                  the receptivityof the capital markets to our future financings.

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

***We cannot assure you that our clinical trials will becompleted 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 testing for our products in development will becompleted successfully within any specified period of time, if at all. Manyproducts that initially appear promising are found, after clinical evaluation,not to be safe and effective. Also, we, or the FDA, may suspend clinical trialsat any time on various grounds, including a finding that the subjects orpatients are being exposed to an unacceptable health risk.

Delays in patientenrollment in clinical trials may result in increased costs and delays, whichcould have a harmful effect on our ability to develop products.

Itmay take several years to complete the testing of a product, and failure canoccur at any stage of testing. For example:

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·                  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;

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

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

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

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

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

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

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

If we are requiredto conduct additional clinical trials or other studies beyond those that wecurrently contemplate, if we are unable to successfully complete our clinicaltrials or other studies or if the results of these trials or studies are notpositive or are only modestly positive, we may be delayed in obtainingmarketing approval, we may not be able to obtain marketing approval or we mayobtain approval for indications that are not as broad as intended. Our productdevelopment costs will also increase if we experience delays in testing orapprovals. Significant clinical trial delays could allow our competitors tobring products to market before we do and impair our ability to commercializeour 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 or control these patents and patentapplications in the United States and abroad. These

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third parties could bring claims against us or ourcollaborators that would cause us to incur substantial expenses and, ifsuccessful against us, could cause us to pay substantial damages. Further, if apatent infringement suit were brought against us or our collaborators, we orthey could be forced to stop or delay research, development, manufacturing orsales of 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 maynot be available on acceptable terms, or at all. Even if we or ourcollaborators were able to obtain a license, the rights may be nonexclusive,which could result in our competitors gaining access to the same intellectualproperty. Ultimately, we could be prevented from commercializing a product, orbe forced to cease some aspect of our business operations, if, as a result ofactual or threatened patent infringement claims, we or our collaborators areunable to enter into licenses on acceptable terms. This could harm our businesssignificantly.

There has beensubstantial litigation and other proceedings regarding patent and otherintellectual property rights in the pharmaceutical and biotechnology industries.In addition to infringement claims against us, we may become a party to otherpatent litigation and other proceedings, including interference proceedingsdeclared by the USPTO and opposition proceedings in the European Patent Office,regarding intellectual property rights with respect to our products andtechnology. The cost to us of any patent litigation or other proceeding, evenif resolved in our favor, could be substantial. Some of our competitors may beable to sustain the costs of such litigation or proceedings more effectivelythan we can because of their substantially greater financial resources. Uncertaintiesresulting from the initiation and continuation of patent litigation or otherproceedings could have a material adverse effect on our ability to compete inthe marketplace. Patent litigation and other proceedings may also absorbsignificant management time.

***We depend upon third party researchers and providers ofclinical services to perform as contractually required if we are to besuccessful in bringing new products to market.***

We do not have theability independently to conduct the clinical trials required to obtainregulatory approval for our products. We rely on independent clinicalinvestigators, contract research organizations and other third party serviceproviders for successful execution of our clinical trials, but do not controlmany aspects of their activities. We 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 with standards, commonly referred to as GoodClinical Practices, for conducting and recording and reporting the results ofclinical trials to assure that data and reported results are credible andaccurate and that the rights, integrity and confidentiality of trialparticipants are protected. Our reliance on third parties that we do notcontrol does not relieve us of these responsibilities and requirements. Thirdparties may not, however, complete activities on schedule, or may not conductour clinical trials in accordance with regulatory requirements or our statedprotocols. Furthermore the data that they generate may not 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

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cannot guarantee the authenticity or accuracy of suchdata, nor can we be certain that such data has not been fraudulently generated.The failure of these third parties to carry out their obligations wouldmaterially adversely affect our ability to develop and market new products andimplement our 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, referred to herein as the SUNY License, andother academic and research institutions collaborating with SUNY. Under theSUNY License, we have an exclusive worldwide license to SUNY’s rights incertain patents and patent applications to make and sell products employingtetracyclines to treat certain disease conditions. The SUNY License imposesvarious payment and reporting obligations on us, and our failure to comply withthese requirements permits SUNY to terminate the SUNY License. If the SUNYLicense is terminated, we would lose our right to exclude competitors fromcommercializing similar products, and we could be excluded from marketing thesame products if SUNY licensed the underlying technology to a competitor afterterminating the SUNY License. The SUNY License is terminable by SUNY on 90 daysprior notice only upon our failure to make timely payments, reimbursements orreports, if the failure is not cured by us within 90 days. The termination ofthe SUNY License, or the failure to obtain and maintain patent protection forour technologies, would have a material adverse effect on our business,financial condition, liquidity and results of operations.

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

Our business maybe adversely affected by potential product liability claims arising out of thetesting, manufacturing and marketing of Periostat and other products developedby or for us or for which we have licensing or promotion and cooperation rights.We have an aggregate of $10.0 million in product liability insurancecovering Periostat and Mutual’s branded version of Periostat, our productcandidates and products for which we have licensing or promotion andcooperation rights.

Our insurer hasalso 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 does not affect our rights under theCo-Promotion Agreement with Merck, which provides for indemnification of us byMerck against any claims arising from manufacturing or design defects in theVioxx product or for which we, as the seller of the product, may be strictlyliable as a seller of an inherently dangerous product.

Our insurance maynot adequately protect us against product liability claims. Insufficientinsurance coverage or the failure to obtain indemnification from third partiesfor their respective liabilities may expose us to product liability claimsand/or recalls and could cause our business, financial condition and results ofoperations to decline.

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

The market priceof our common stock has fluctuated and may continue to fluctuate as a result ofvariations in our quarterly operating results. These fluctuations may beexaggerated if the trading volume of our common stock is low. In addition, thestock market in general has

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experienced dramatic price and volume fluctuationsfrom time to time. These fluctuations may or may not be based upon any businessor operating results. Our common stock may experience similar or even moredramatic price and volume fluctuations that may continue indefinitely.

The followingtable sets forth the high and low last sale prices per share for our commonstock for each of the quarters in the period beginning April 1, 2004through March 31, 2006, as reported on the Nasdaq National Market:

| Quarter Ended       | ** ** | **High** | ** ** | **Low** | ** ** |
|--------------------------|------------|----------|------------|---------|------------|
| 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 |   |
| December 31,  2005  |       | $        | 12.07      |    | $          | 8.50 |   |
|                     |       |     |       |    |       |
| March 31, 2006      |       | $        | 14.80      |    | $          | 11.27 |   |

**Item 6.    Exhibits.**
| 31.1   |   | Certification pursuant to Section 302 of the  Sarbanes-Oxley Act of 2002. |
|--------|--------|--------------------------------------------------------------------------------|
|   |   |                                                                           |
| 31.2   |   | Certification pursuant to Section 302 of the  Sarbanes-Oxley Act of 2002. |
|   |   |                                                                           |
| 32.1   |   | Certification Pursuant to 18 U.S.C.  Section 1350.                        |

 

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**SIGNATURES**

Pursuantto the 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: May 8, 2006 |   | By:    |   | /s/ Colin W. Stewart                  |
|                   |   |   |   | Colin W. Stewart                      |
|                   |   |   |   | President and Chief Executive Officer |
|                   |   |   |   |  (Principal  Executive Officer)  |
|                   |   |   |   |                                  |
|                   |   |   |   |                                  |
| Date: May 8, 2006 |   | By:    |   | /s/ Nancy C. Broadbent                |
|                   |   |   |   | Nancy C. Broadbent                    |
|                   |   |   |   | Chief Financial Officer (Principal    |
|                   |   |   |   | Financial and Accounting Officer)     |

 

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