**UNITED STATES**

**SECURITIES AND EXCHANGE COMMISSION**

**Washington, DC 20549**

 

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**FORM 10-Q**

** **

| x      | QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF  THE SECURITIES EXCHANGE ACT OF 1934  |
|--------|-------------------------------------------------------------------------------------------|
|   |                                                                                      |
|   | For the  quarterly period ended June 30, 2006                                             |
|   |                                                                                      |
| o      | TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF  THE SECURITIES EXCHANGE ACT OF 1934 |

** **

** **

**Commission File Number0-28308**

**CollaGenex Pharmaceuticals, Inc.**

(Exact Name of Registrant as Specified in Its Charter)

 

 

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

 

**(215) 579-7388**

(Registrant’s Telephone Number, Including Area Code)

 

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

Yes: 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 acceleratedfiler   o      Acceleratedfiler    x      Non-acceleratedfiler   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

 

Indicatethe number of shares outstanding of each of the issuer’s classes of commonstock as of August 1, 2006:

| **Class**                    | ** ** | **Number  of Shares** |
|------------------------------|------------|-----------------------|
| Common Stock  $.01 par value |       | 17,525,876            |

 

 

 

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**COLLAGENEX PHARMACEUTICALS, INC.**

**TABLEOF CONTENTS**
|                                             | ** ** | ** **                                                                                                     | ** ** | **Page** |
|---------------------------------------------|------------|----------------------------------------------------------------------------------------------------------------|------------|----------|
| PART  I.   FINANCIAL  INFORMATION |       | 1                                                                                                              |
| Item 1.                                     |       | Financial Statements (unaudited)                                                                               |       | 1        |
|                                        |       | Condensed Consolidated Balance Sheets as of June 30,  2006 and December 31, 2005 (unaudited)                   |       | 2        |
|                                        |       | Condensed Consolidated Statements of Operations for  the Three Months Ended June 30, 2006 and 2005 (unaudited) |       | 3        |
|                                        |       | Condensed Consolidated Statements of Operations for  the Six Months Ended June 30, 2006 and 2005 (unaudited)   |       | 4        |
|                                        |       | Condensed Consolidated Statements of Cash Flows for  the Six Months Ended June 30, 2006 and 2005 (unaudited)   |       | 5        |
|                                        |       | Notes to Condensed Consolidated Financial Statements  (unaudited)                                              |       | 6        |
| Item 2.                                     |       | Management’s Discussion and Analysis of Financial  Condition and Results of Operations                    |       | 18       |
|                                        |       | Results of Operations                                                                                          |       | 20       |
|                                        |       | Liquidity and Capital Resources                                                                                |       | 27       |
| Item 3.                                     |       | Quantitative and Qualitative Disclosures About Market  Risk                                                    |       | 31       |
| Item 4.                                     |       | Controls and Procedures                                                                                        |       | 31       |
| PART  II.   OTHER  INFORMATION    |       | 33                                                                                                             |
| Item  1A.                                   |       | Risk Factors                                                                                                   |       | 33       |
| Item 4.                                     |       | Submission of Matters to a Vote of Security Holders                                                            |       | 44       |
| Item 6.                                     |       | Exhibits                                                                                                       |       | 45       |
| SIGNATURES                                  |       | 46                                                                                                             |

 

 

 

**CollaGenexPharmaceuticals, Inc. - United States trademarks:**

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

** **

**CollaGenexPharmaceuticals, Inc. - European Community trademarks:**

Periostat®, Nephrostat®,Optistat®, Xerostat®, SansRosaTM, UnorthodoxyTM, AprecinTM, ZedaraTM and OraceaTM.

** **

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

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

** **

**CollaGenexInternational, Ltd. - European Community and United Kingdom trademarks:**

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

** **

**CollaGenexInternational, Ltd. - European Community Trademarks:**

PeriocyclineTM,RestoradermTM, and Periostat-MRTM.

 

Marks listed herein mayadditionally be registered in jurisdictions not specified in the above list.All other trade names, trademarks or service marks appearing in this QuarterlyReport are the property of their respective owners and are not property ofCollaGenex Pharmaceuticals, Inc. or any of our subsidiaries.

i

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** **

**PART I.   FINANCIAL INFORMATION**

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

** **

1

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** **

**COLLAGENEX PHARMACEUTICALS, INC.**

**AND SUBSIDIARIES**

 

Condensed Consolidated Balance Sheets

June30, 2006 and December 31, 2005

(dollars in thousands,except share data)(unaudited)
| **Assets**                                                                                                                                                                                                                                                                                                     | ** ** | **June 30,  2006** | ** ** | **December 31,  2005** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------|------------|-----------------------------|------------|
| Current assets:                                                                                                                                                                                                                                                                                                |       |                    |       |                        |       |
|                                                                                                                                                                                                                                                                                                           |       |                    |       |                        |       |
| Cash and cash equivalents                                                                                                                                                                                                                                                                                      |       | $                       | 15,929     |                        | $          | 26,219 |   |
| Short-term investments                                                                                                                                                                                                                                                                                         |       | 21,373                  |       | 18,206                      |       |
| Accounts receivable, net of allowances of $111 and  $104 at June 30, 2006 and December 31, 2005, respectively                                                                                                                                                                                                  |       | 2,056                   |       | 1,428                       |       |
| Inventories                                                                                                                                                                                                                                                                                                    |       | 991                     |       | 630                         |       |
| Prepaid expenses and other current assets                                                                                                                                                                                                                                                                      |       | 2,039                   |       | 1,832                       |       |
| Total current assets                                                                                                                                                                                                                                                                                           |       | 42,388                  |       | 48,315                      |       |
|                                                                                                                                                                                                                                                                                                           |       |                    |       |                        |       |
| Equipment and  leasehold improvements, net                                                                                                                                                                                                                                                                     |       | 598                     |       | 539                         |       |
| Intangible  assets, net                                                                                                                                                                                                                                                                                        |       | 1,067                   |       | 268                         |       |
| Other assets                                                                                                                                                                                                                                                                                                   |       | 27                      |       | 43                          |       |
| Total assets                                                                                                                                                                                                                                                                                                   |       | $                       | 44,080     |                        | $          | 49,165 |   |
|                                                                                                                                                                                                                                                                                                           |       |                    |       |                        |       |
| **Liabilities  and Stockholders’ Equity**                                                                                                                                                                                                                                                                 | ** ** | ** **              | ** ** | ** **                  | ** ** |
| Current liabilities:                                                                                                                                                                                                                                                                                           |       |                    |       |                        |       |
|                                                                                                                                                                                                                                                                                                           |       |                    |       |                        |       |
| Accounts payable                                                                                                                                                                                                                                                                                               |       | $                       | 4,530      |                        | $          | 5,411 |   |
| Accrued expenses                                                                                                                                                                                                                                                                                               |       | 7,308                   |       | 6,024                       |       |
| Accrued equity financing costs                                                                                                                                                                                                                                                                                 |       | —                  |       | 1,069                       |       |
| Preferred dividends payable                                                                                                                                                                                                                                                                                    |       | —                  |       | 900                         |       |
| Total current  liabilities                                                                                                                                                                                                                                                                                     |       | 11,838                  |       | 13,404                      |       |
| Deferred revenue                                                                                                                                                                                                                                                                                               |       | 29                      |       | 93                          |       |
|                                                                                                                                                                                                                                                                                                           |       |                    |       |                        |       |
| Commitments and  contingencies (Notes: 6 and 8)                                                                                                                                                                                                                                                                |       |                    |       |                        |       |
|                                                                                                                                                                                                                                                                                                           |       |                    |       |                        |       |
| 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 June 30, 2006 and December 31,  2005 (liquidation value of $20,928 at June 30, 2006 and $20,900 at  December 31, 2005) |       | 2                       |       | 2                           |       |
| 150,000 shares of Series A Participating Preferred  Stock, designated and no shares issued and outstanding at June 30, 2006 and  December 31, 2005                                                                                                                                                             |       | —                  |       | —                      |       |
|                                                                                                                                                                                                                                                                                                           |       |                    |       |                        |       |
| Common stock, $0.01 par value; 75,000,000 and  25,000,000 shares authorized, 17,512,277 and 16,054,797 shares issued and  outstanding at June 30, 2006 and December 31, 2005, respectively                                                                                                                     |       | 175                     |       | 161                         |       |
|                                                                                                                                                                                                                                                                                                           |       |                    |       |                        |       |
| Additional  paid-in capital                                                                                                                                                                                                                                                                                    |       | 139,936                 |       | 124,647                     |       |
| Accumulated  other comprehensive loss                                                                                                                                                                                                                                                                          |       | (33                     | )          | (4                          | )          |
| Accumulated  deficit                                                                                                                                                                                                                                                                                           |       | (107,867                | )          | (89,138                     | )          |
| Total stockholders’ equity                                                                                                                                                                                                                                                                                |       | 32,213                  |       | 35,668                      |       |
| Total  liabilities and stockholders’ equity                                                                                                                                                                                                                                                               |       | $                       | 44,080     |                        | $          | 49,165 |   |

 

See accompanying notes to unaudited condensed consolidated financial statements.

2

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**COLLAGENEX PHARMACEUTICALS, INC.**

**AND SUBSIDIARIES**

** **

CondensedConsolidated Statements of Operations

For the Three MonthsEnded June 30, 2006 and 2005

(amounts in thousands, except share and per sharedata)(unaudited)
| ** **                                                                                                        | ** ** | **Three Months Ended June 30,** | ** ** |
|-------------------------------------------------------------------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                                                                                        | ** ** | **2006**                                            | ** ** | **2005** | ** ** |
|                                                                                                              |       |                                                |       |   |   |
| Revenues:                                                                                                         |       |                                                |       |   |   |
| Net product sales                                                                                                 |       | $                                                   | 3,352      |   | $ | 6,872 |   |
| Contract and license revenues                                                                                     |       | 378                                                 |       | 45 |   |
| Grant revenues                                                                                                    |       | 62                                                  |       | — |   |
| Total revenues                                                                                                    |       | 3,792                                               |       | 6,917 |   |
|                                                                                                              |       |                                                |       |   |   |
| Operating expenses:                                                                                               |       |                                                |       |   |   |
| Cost of product sales                                                                                             |       | 1,091                                               |       | 1,701 |   |
| Research and development                                                                                          |       | 2,882                                               |       | 3,200 |   |
| Selling, general and administrative                                                                               |       | 10,186                                              |       | 6,510 |   |
| Restructuring charge                                                                                              |       | —                                              |       | 1,184 |   |
| Total operating expenses                                                                                          |       | 14,159                                              |       | 12,595 |   |
| Operating loss                                                                                                    |       | (10,367                                             | )          | (5,678 | ) |
|                                                                                                              |       |                                                |       |   |   |
| Other income (expense):                                                                                           |       |                                                |       |   |   |
| Interest income                                                                                                   |       | 490                                                 |       | 264 |   |
| Other expense                                                                                                     |       | —                                              |       | (1 | ) |
| Net loss                                                                                                          |       | (9,877                                              | )          | (5,415 | ) |
| Preferred stock  dividend                                                                                         |       | 464                                                 |       | 427 |   |
| Net loss  allocable to common stockholders                                                                        |       | (10,341                                             | )          | (5,842 | ) |
| Net loss per  basic and diluted share allocable to common stockholders                                            |       | $                                                   | (0.59      | ) | $ | (0.41 | ) |
| Weighted average shares  used in computing net loss per basic and diluted share allocable to common  stockholders |       | 17,490,374                                          |       | 14,414,767 |   |

 

See accompanying notes to unaudited condensed consolidated financial statements.

3

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** **

**COLLAGENEX PHARMACEUTICALS, INC.**

**AND SUBSIDIARIES**

 

Condensed ConsolidatedStatements of Operations

For the Six Months EndedJune 30, 2006 and 2005

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

 
| ** **                                                                                                        | ** ** | **Six Months Ended June 30,** | ** ** |
|-------------------------------------------------------------------------------------------------------------------|------------|---------------------------------------------------|------------|
| ** **                                                                                                        | ** ** | **2006**                                          | ** ** | **2005** | ** ** |
|                                                                                                              |       |                                              |       |   |   |
| Revenues:                                                                                                         |       |                                              |       |   |   |
| Net product sales                                                                                                 |       | $                                                 | 6,693      |   | $ | 18,708 |   |
| Contract and license revenues                                                                                     |       | 653                                               |       | 244 |   |
| Grant revenues                                                                                                    |       | 167                                               |       | — |   |
| Total revenues                                                                                                    |       | 7,513                                             |       | 18,952 |   |
|                                                                                                              |       |                                              |       |   |   |
| Operating expenses:                                                                                               |       |                                              |       |   |   |
| Cost of product sales                                                                                             |       | 1,986                                             |       | 4,166 |   |
| Research and development                                                                                          |       | 6,595                                             |       | 7,294 |   |
| Selling, general and administrative                                                                               |       | 18,697                                            |       | 14,256 |   |
| Restructuring charge                                                                                              |       | —                                            |       | 1,184 |   |
| Total operating expenses                                                                                          |       | 27,278                                            |       | 26,900 |   |
| Operating loss                                                                                                    |       | (19,765                                           | )          | (7,948 | ) |
|                                                                                                              |       |                                              |       |   |   |
| Other income (expense):                                                                                           |       |                                              |       |   |   |
| Interest income                                                                                                   |       | 1,036                                             |       | 476 |   |
| Other expense                                                                                                     |       | —                                            |       | (1 | ) |
| Net loss                                                                                                          |       | (18,729                                           | )          | (7,473 | ) |
| Preferred stock  dividend                                                                                         |       | 928                                               |       | 827 |   |
| Net loss  allocable to common stockholders                                                                        |       | (19,657                                           | )          | (8,300 | ) |
| Net loss per  basic and diluted share allocable to common stockholders                                            |       | $                                                 | (1.13      | ) | $ | (0.58 | ) |
| Weighted average shares  used in computing net loss per basic and diluted share allocable to common  stockholders |       | 17,417,524                                        |       | 14,409,719 |   |

 

See accompanying notes to unaudited condensed consolidated financial statements.

4

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**COLLAGENEX PHARMACEUTICALS, INC.**

**AND SUBSIDIARIES**

 

Condensed Consolidated Statements of Cash Flows

Forthe Six Months Ended June 30, 2006 and 2005

(dollarsin thousands)

(unaudited)
| ** **                                                                   | ** ** | **Six Months Ended June 30,** | ** ** |
|------------------------------------------------------------------------------|------------|---------------------------------------------------|------------|
| ** **                                                                   | ** ** | **2006**                                          | ** ** | **2005** | ** ** |
| Cash flows from  operating activities:                                       |       |                                              |       |   |   |
| Net loss                                                                     |       | $                                                 | (18,729    | ) | $ | (7,473 | ) |
| Adjustments to  reconcile net loss to net cash used in operating activities: |       |                                              |       |   |   |
| Share-based compensation                                                     |       | 1,668                                             |       | — |   |
| Write-down of inventory                                                      |       | 90                                                |       | 979 |   |
| Write-down of fixed assets                                                   |       | —                                            |       | 96 |   |
| Depreciation and amortization expense                                        |       | 255                                               |       | 464 |   |
| Accounts receivable provisions                                               |       | 7                                                 |       | 102 |   |
| Charge for in-process research and development                               |       | 200                                               |       | — |   |
| Changes in  operating assets and liabilities:                                |       |                                              |       |   |   |
| Accounts receivable                                                          |       | (635                                              | )          | 1,090 |   |
| Inventories                                                                  |       | (451                                              | )          | 838 |   |
| Prepaid expenses and other assets                                            |       | (124                                              | )          | 198 |   |
| Accounts payable                                                             |       | (881                                              | )          | (661 | ) |
| Accrued expenses                                                             |       | 284                                               |       | 2,670 |   |
| Deferred revenue                                                             |       | (64                                               | )          | (98 | ) |
| Net cash used in operating activities                                        |       | (18,380                                           | )          | (1,795 | ) |
|                                                                         |       |                                              |       |   |   |
| Cash flows from  investing activities:                                       |       |                                              |       |   |   |
| Capital expenditures                                                         |       | (180                                              | )          | (196 | ) |
| Purchase of in-process research and development                              |       | (200                                              | )          | (150 | ) |
| Purchase of short-term investments                                           |       | (21,380                                           | )          | (16,011 | ) |
| Maturities of short-term investments                                         |       | 18,184                                            |       | 22,998 |   |
| Net cash (used in) provided by investing activities                          |       | (3,576                                            | )          | 6,641 |   |
| Cash flows from  financing activities:                                       |       |                                              | ** ** | ** ** | ** ** |
| Net proceeds from issuance of common stock                                   |       | 11,594                                            |       | — |   |
| Net proceeds from the exercise of stock options                              |       | 972                                               |       | 36 |   |
| Payment of preferred dividends                                               |       | (900                                              | )          | (800 | ) |
| Net cash provided by (used in) financing activities                          |       | 11,666                                            |       | (764 | ) |
| Net (decrease) increase in cash and cash equivalents                         |       | (10,290                                           | )          | 4,082 |   |
|                                                                         |       |                                              |       |   |   |
| Cash and cash  equivalents at beginning of period                            |       | 26,219                                            |       | 11,889 |   |
| Cash and cash  equivalents at end of period                                  |       | $                                                 | 15,929     |   | $ | 15,971 |   |
| Supplemental disclosure  of non-cash investing activities:                   |       |                                              |       |   |   |
| Accrued  liability for capitalized product development fees                  |       | $                                                 | 1,000      |   | — |   |

 

See accompanying notes to unaudited condensed consolidated financial statements.

5

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**COLLAGENEXPHARMACEUTICALS, INC.AND SUBSIDIARIES**

**NOTES TO CONDENSED CONSOLIDATEDFINANCIAL STATEMENTSJune 30, 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, pursuantto the rules and regulations of the Securities and Exchange Commission and inaccordance with accounting principles generally accepted in the United Statesof America. Certain information and footnote disclosures normally included inthe annual consolidated financial statements prepared in accordance withaccounting principles generally accepted in the United States of America havebeen condensed or omitted pursuant to such rules and the regulations of theSecurities and Exchange Commission. These unaudited condensed consolidatedfinancial statements should be read in conjunction with the Company’s 2005audited consolidated financial statements and footnotes included in its AnnualReport 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 endedDecember 31, 2005 and contain adjustments, all of which are of a normalrecurring nature, necessary to present fairly the Company’s consolidatedfinancial position at June 30, 2006, the results of operations for the threeand six months ended June 30, 2006 and 2005, and the cash flows for the sixmonths ended June 30, 2006 and 2005. Interim results are not necessarilyindicative of results anticipated for the 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 quarter of 

6

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2005, the Company began recognizing Periostat salesrevenue based on sales to end-users, which are estimated using prescriptiondispensing data generated by a leading independent prescription trackingservice, as well as on-hand inventory estimates in the distribution channel. Sincethe launch of generic competition to Periostat could result in increased productreturns from the wholesale and retail channels, the Company has accrued anestimated liability of $830 for potential Periostat and other product returnsin accrued expenses on the Condensed Consolidated Balance Sheet at June 30,2006.

For new productlaunches, the Company’s policy is to recognize revenue on a net prescriptionvalue basis estimated using dispensing data until its wholesalers can reducetheir new product inventories to our targeted wholesaler inventory stockinglevels (generally between three and five weeks of sales). When wholesalers’inventories have been reduced to this targeted level, the Company willrecognize product revenue upon shipment, net of the applicable allowances.

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 on 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. The Company recognized $167 in grant revenues duringsix months ended June 30, 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.

***Share-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 recognized thefair 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.

7

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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. AtJune 30, 2006, all of the Company’s short-term investments, carried at fairvalue, were classified as available-for-sale with unrealized gains and lossesincluded as a separate component of stockholders’ equity. The accumulated netunrealized loss on short-term investments was $33 and $4 at June 30, 2006 andDecember 31, 2005, respectively.

***RecentlyIssued Accounting Pronouncements***

In November 2005, the FASB issued FASB Staff PositionSFAS 123(R)-3, *Transition Election Relatedto Accounting for the Tax Effects of Share-based Payment Awards*,that provides an elective alternative transition method of calculating the poolof excess tax benefits available to absorb tax deficiencies recognizedsubsequent to the adoption of SFAS No. 123R to the method otherwise required byparagraph 81 of SFAS No. 123R. The Company may take up to one year from theeffective date of the FSP to evaluate its available alternatives and make itsone-time election. The Company is currently evaluating the alternative methodsin connection with its adoption of SFAS No. 123(R)-3.

**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 and OraceaTM tablets and has anagreement with a single company to supply the active ingredient in suchtablets. A single company also provides all warehousing and distributionservices to the Company.

Amajority of the Company’s revenue has historically been derived from a smallnumber of wholesale drug distributors and United Research Laboratories,Inc./Mutual Pharmaceutical Company, Inc., or Mutual. The following tablesdetail the Company’s customer concentrations in net product sales and grosstrade accounts receivable that are greater than 10% of the relative total, foreach of the six months ended June 30, 2006 and 2005.

8

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| ** **        | ** ** | **Percentage of  Net Product Sales  Six Months Ended June 30,** | ** ** |
|-------------------|------------|----------------------------------------------------------------------------------------------------|------------|
| **Customer**      | ** ** | **2006**                                                                                           | ** ** | **2005** | ** ** |
| Cardinal Health   |       | 51                                                                                                 | %          | 32 | % |
| McKesson          |       | 25                                                                                                 | %          | 19 | % |
| AmerisourceBergen |       | 15                                                                                                 | %          | 11 | % |
| URL/Mutual        |       | *                                                                                                  |       | 29 | % |

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*                    *less than 10%*
| ** **      | ** ** | **Percentage of  Gross Trade Accounts Receivable  Balance at June 30,** | ** ** |
|-----------------|------------|------------------------------------------------------------------------------------------------------------|------------|
| **Customer**    | ** ** | **2006**                                                                                                   | ** ** | **2005** | ** ** |
| Cardinal Health |       | 33                                                                                                         | %          | 24 | % |
| McKesson        |       | 24                                                                                                         | %          | 5 | % |
| Primus          |       | 17                                                                                                         | %          | * |   |
| OTN             |       | 12                                                                                                         | %          | * |   |
| URL/Mutual      |       | *                                                                                                          |       | 62 | % |

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*                    *less than 10%*

During the sixmonths ended June 30, 2006, Periostat accounted for approximately 42% of theCompany’s total revenues. During the six months ended June 30, 2005, Periostatand Mutual’s branded version of Periostat accounted for approximately 83% ofthe Company’s total revenues.

**Note 3 —Share-Based Compensation**

At June 30, 2006, the Company had one activeshare-based employee compensation plan. Stock option awards to employees aregranted with an exercise price equal to the market value of the Company’scommon stock on the date of grant. The option awards have a term of ten yearsand generally vest over a period ranging from two to five years.  Certain options are subject to acceleratedvesting if there is a change in control (as defined in the Plans and change ofcontrol agreements, if applicable).

Prior to January 1,2006, the Company accounted for share-based employee compensation, includingstock options, using the method prescribed in Accounting Principles Board (APB)Opinion No. 25, “*Accounting for StockIssued to Employees*” and related Interpretations. Under APB OpinionNo. 25, no compensation cost was recognized for stock options with anexercise price equal to the fair market value of the Company’s common stock onthe date of grant, and a disclosure was made regarding the pro forma effect onnet earnings assuming compensation cost had been recognized in accordance withSFAS No. 123, “*Accounting forStock-Based Compensation*.”

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Thefollowing table illustrates the effect on net loss and basic and diluted netloss per common share if the Company had applied the fair value recognitionprovisions of SFAS No. 123 to stock-based employee compensation during thethree and six month period ended June 30, 2005 (option forfeitures areaccounted for as they occurred and no amounts of compensation expense have beencapitalized into inventory or other assets, but instead are considered periodexpenses in the pro forma amounts):
| ** **                                                                                             | ** ** | **Six Months Ended  June 30, 2005** | ** ** | **Three Months Ended  June 30, 2005** | ** ** |
|--------------------------------------------------------------------------------------------------------|------------|---------------------------------------------------------|------------|-----------------------------------------------------------|------------|
| Net loss  allocable to common stockholders - as reported                                               |       | $                                                       | (8,300     | )                                                         | $          | (5,842 | ) |
| Add: Stock-based  compensation included in the determination of net loss as reported                   |       | —                                                  |       | —                                                    |       |
| Deduct: Total  stock-based compensation expense determined under the fair value method for  all grants |       | (1,548                                                  | )(1)       | (737                                                      | )(1)       |
| Net loss  allocable to common stockholders - pro forma                                                 |       | $                                                       | (9,848     | )                                                         | $          | (6,579 | ) |
| Basic and  diluted net loss per share   As reported                                                    |       | $                                                       | (0.58      | )                                                         | $          | (0.41 | ) |
| Pro forma                                                                                              |       | $                                                       | (0.68      | )                                                         | $          | (0.46 | ) |

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

On December 16,2004, the Financial Accounting Standards Board issued SFAS No. 123R,which requires companies to measure and recognize compensation expense for allshare-based payments at fair value. SFAS No. 123R eliminates accountingfor share-based compensation transactions using APB Opinion No. 25, andgenerally requires that such transactions be accounted for using prescribedfair-value-based methods. Effective January 1, 2006, the Company adoptedSFAS No. 123R using the modified prospective method. Under APBOpinion No. 25, no compensation expense related to stock option grants wasrecorded in the consolidated statement of operations for the three or sixmonths ended June 30, 2005. The results for prior periods have not beenrestated. Under the “modified prospective” method, compensation costs arerecognized for all newly granted or modified share-based awards and for theunvested portion of all awards granted prior to the effective date.

TheCompany is using the straight-line method to recognize stock-based compensationexpense. The amount of stock-based compensation recognized during a period isbased on the value of the awards that vest in that period. 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 for the three and six months ended June 30, 2006. Thisanalysis is re-evaluated quarterly and the forfeiture rate is adjusted asnecessary. Ultimately, the actual expense recognized over the vesting periodwill only be for those shares that vest.

Duringthe six months ended June 30, 2006, the Company recorded $1,668 of stockcompensation expense. This amount is composed of $210 related to research anddevelopment expenses and $1,458 related to selling, general and administrativeexpenses. No amounts of share-based compensation cost have been capitalizedinto inventory or other assets during the six month period ended June 30, 2006.

10

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As aresult of adopting SFAS No. 123R, the Company’s loss allocable to commonstockholders for the three and six months ended June 30, 2006 respectively, was$875 and $1,668 greater than if it had continued to account for share-basedcompensation under APB Opinion No. 25. Basic and diluted loss per shareallocable to common stockholders for the three and six months ended June 30,2006, respectively, would have been $0.54 and $1.03 per share if the Companyhad not adopted SFAS No. 123R, compared to reported basic and diluted loss pershare allocable to common stockholders of $0.59 and $1.13 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 June 30, 2006 is the 2005 Equity Incentive Plan, or the 2005Plan.

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. Unissuedshares under the Non-Employee Director Plan were eligible to be reissued intoother 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 

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shares of the Company’s common stock at a price, forthe incentive options, not less than the fair value of the common stock on thedate of grant. Such options are exercisable for a period of ten years from thegrant date and generally vest over a two-to-five-year period, although vestingfor options granted to certain Company officers is subject to accelerationunder certain circumstances, as these options are performance-based. The 1996Plan expired in March 2006, at which time all unissued options were rolled overto the 2005 Plan.

The2005 Plan provides for the issuance of incentive and nonqualified options,restricted stock awards, restricted stock units and other share-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 stockon the grant date. The number of shares of common stock that can be issuedpursuant to the 2005 Plan is 1,000,000 shares plus the rollover of 476,555remaining shares of common stock reserved for issuance under the 1996 Plan uponits expiration in March 2006. At June 30, 2006, stock options were onlyavailable for issuance under the 2005 Plan. Such options are exercisable for aperiod of ten years from the grant date and generally vest over a five-yearperiod. At June 30, 2006, 904,455 shares of common stock were available forissuance pursuant to outstanding awards 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 areperformance-based and it is anticipated that the performance criteria will bemet prior to straight-line vesting.

In May 2006, the Companyaccelerated the vesting of certain options held by a former member of theCompany’s Board of Directors. Accordingly, a charge of $92 was recorded for thethree and six month periods ended June 30, 2006 to reflect the fair value ofsuch options on the date of modification.

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

|                                                                    | ** ** | **Six Months Ended** | ** ** |
|--------------------------------------------------------------------|------------|--------------------------------|------------|
| **(In thousands, except per share data)** | ** ** | **June 30,  2006**        | ** ** | **June 30,  2005** | ** ** |
| Weighted-average  fair value of options granted per share          |       | $                              | 7.69       |   | $ | 3.67 |   |
| Intrinsic value of  options exercised                              |       | $                              | 446        |   | $ | 141 |   |

 

AtJune 30, 2006, the value of the unvested portion of all outstandingstock-related awards was $8,280, which the Company expects to amortize andrecognize as compensation expense over the weighted-average service period ofapproximately 3 years.

Theamount of cash received during the six months ended June 30, 2006 from theexercise of options was $972. No related tax benefit from the exercise of suchoptions was realized as a result of the Company’s net operating losscarryforwards and full valuation allowance.

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The fair values ofthe options granted during the three and six months ended June 30, 2006 and2005 were determined using the Black-Scholes option pricing model, whichincorporates various assumptions. The risk-free rate of interest for theaverage contractual life of the option is based on U.S. Government SecuritiesTreasury Constant Maturities. Expected volatility is based on the historicaldaily volatility of the Company’s stock. The expected life is determined usingthe short-cut method permitted under Staff Accounting Bulletin No. 107, *Share-Based Payment*. The expected dividendrate yield is zero because the Company currently does not pay or expect to paydividends to common stockholders. The following are the weighted averageassumptions used during the respective periods:

|                          | ** ** | **Three Months Ended  June 30,** | ** ** | **Six Months Ended  June 30,** | ** ** |
|--------------------------|------------|-------------------------------------------------|------------|-----------------------------------------------|------------|
| ** **               | ** ** | **2006**                                        | ** ** | **2005**                                      | ** ** | **2006** | ** ** | **2005** | ** ** |
| Expected life in  years  |       | 6.50                                            |       | 5.15                                          |       | 6.50 |   | 6.15 |   |
| Risk-free  interest rate |       | 4.92                                            | %          | 3.87                                          | %          | 4.62 | % | 4.04 | % |
| Volatility               |       | 66.5                                            | %          | 72.8                                          | %          | 69.0 | % | 72.5 | % |
| Expected dividend yield  |       | —                                          |       | —                                        |       | — |   | — |   |

 

Stock optionactivity under all plans during the six months ended June 30, 2006 is asfollows:
| ** **                     | ** ** | **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                |       | 493,700                    |       | $                                                      | 11.37      |                                                             |       |                               |       |   |
| Options exercised              |       | (107,480                   | )          | $                                                      | 9.04       |                                                             |       |                               |       |   |
| Options forfeited or cancelled |       | (31,050                    | )          | $                                                      | 9.38       |                                                             |       |                               |       |   |
| Balance at June  30, 2006      |       | 3,660,437                  |       | $                                                      | 9.63       |                                                             | 6.25       |                               | $          | 8,602 |   |
| Exercisable at June 30,  2006  |       | 2,155,789                  |       | $                                                      | 9.93       |                                                             | 4.62       |                               | $          | 4,419 |   |

----

(1)             Theaggregate intrinsic value on this table was calculated based on the positivedifference between the closing sales price of the Company’s common stock($11.98 per share) on June 30, 2006 and the exercise prices of the underlyingoptions.

**Note 4 —Inventories**

Inventories at June 30, 2006 and December 31,2005 consist of the following:

|                | ** ** | **   2006   ** | ** ** | **   2005   ** | ** ** |
|----------------|------------|----------------------------------------------|------------|----------------------------------------------|------------|
| Raw materials  |       | $                                            | 95         |                                         | $          | 77 |   |
| Finished goods |       | 896                                          |       | 553                                          |       |
|           |       | $                                            | 991        |                                         | $          | 630 |   |

 

During the sixmonths ended June 30, 2006, the Company recorded a charge of $90 related toexcess Periostat inventories. During the six months ended June 30, 2005, theCompany recorded a charge of $979 for the excess inventory of Periostat andMutual’s branded 

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version of Periostat due to the anticipated decreaseddemand following the introduction of a third party generic version of Periostatthat occurred in May 2005.

**Note 5 — Intangible Assets, Net**

Intangible assets, net at June 30, 2006 and December31, 2005 consisted of the following:
| ** **                            | ** ** | **       2006      ** | ** ** | **       2005      ** | ** ** |
|---------------------------------------|------------|-----------------------------------------------------------------------------------|------------|-----------------------------------------------------------------------------------|------------|
| Acquired product  rights, net         |       | $                                                                                 | 134        |                                                                              | $          | 268 |   |
| Capitalized  product development fees |       | 933                                                                               |       | —                                                                            |       |
|                                  |       | $                                                                                 | 1,067      |                                                                              | $          | 268 |   |

 

Acquiredproduct rights fees represent the unamortized long-term component of thelicensing fee of $1,000 paid to Atrix in 2001 in exchange for the rights tomarket the Atrix Products in the United States.

Capitalizedproduct development fees represent the unamortized long-term component ofOracea formulation milestones. (See Note 10) The Company will beginamortizing this intangible asset upon the Oracea trade launch (July 2006).

Thecurrent portion of both acquired product rights, net and capitalized productdevelopment fees are reflected in prepaid expenses and other current assets onthe Company’s Consolidated Balance Sheet.

**Note 6 — Line of Credit**

OnMay 31, 2006, the Company entered into a Fifth Loan Modification Agreement withSilicon Valley Bank, or the Modification Agreement, to amend and renew itsrevolving credit facility, which had expired on such date. Pursuant to theterms of the Modification Agreement, (i) the expiration date of the amendedcredit facility has been extended to May 31, 2007 and (ii) covenants requiringthe Company to (A) maintain a minimum adjusted quick ratio, as defined therein,and (B) maintain a minimum of $2,000 in cash, net of borrowings, wereeliminated. Under the amended credit facility, the Company may borrow up to thelesser of $5,000 or 80% of eligible accounts receivable, as defined under theamended credit facility. The amount available to the Company is reduced by anyoutstanding letters of credit which may be issued under the amended creditfacility in amounts totaling up to $2,000. As the Company pays down amountsunder any letter of credit, the amount available to the Company under thecredit facility increases. No letters of credit were outstanding at June 30,2006 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 8.25% at June 30,2006. The Company is charged an unused line credit fee of 0.25% of the unusedline per annum. As of June 30, 2006 and December 31, 2005, the Company had noborrowings outstanding.

**Note 7 —Contract and License Revenues**

The Companyrecorded contract and license revenues of $378 and $653****for the three and six months ended June30, 2006, respectively. During the six months ended June 30, 2005, $160 oflicense 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.  In June 2005, the Company entered into thePromotion Agreement with Primus, under which the Company will promote Alcortin,a prescription topical antifungal 

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steroid combination, and Novacort, a prescriptiontopical steroid and anesthetic. Under the Promotion Agreement, the Company willreceive a percentage of the gross profit arising from prescriptions written bydermatology professionals (or offices) that result in sales of the products inthe United States. The majority of marketing expenses, excluding sales forcecompensation and sample product costs, related to the promotion of the Primusproducts are funded by Primus. The majority of product sample costs and allsales force compensation are funded by the Company.

Under the Promotion Agreement, the Company is required to achieveannual sales minimums on a contractual year basis and the Company did not reachthese minimums during the first contract year which ended on June 30, 2006. Primushas notified the Company that it will not enforce its right to terminate thecontract as a result of the failure by the Company to meet the minimum for thefirst year of the contract.

***Note 8 — Legal Settlements and Proceedings***

***Mutual***

In July 2003, theCompany commenced an action against Mutual in the United States District Courtfor the Eastern District of New York seeking to prevent Mutual from introducing20 mg tablets of doxycycline hyclate into the market in the United States. TheCompany’s suit alleged infringement of patents covering the Company’s Periostatproduct. On April 8, 2004, the Company settled all pending litigation withMutual. As part of the settlement, the Company paid to Mutual $2,000, whichrepresented a portion of the anticipated fees and expenses that the Companywould save as a result of the 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.

On May 13, 2005,the FDA approved a third party generic version of Periostat that was launchedin late May 2005. Upon this generic launch, the License and Supply Agreementterminated and Mutual was no longer obligated to purchase its branded versionof Periostat from the Company and ceased purchasing from the Company in June2005.

***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 Abbreviated New Drug Applications byeach of IVAX and CorePharma for 20 mg tablets of doxycycline hyclate infringedUnited States Patent RE 34,656, for which the Company is the exclusive licensee.The Company also alleged that any 

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

**Note 9 —Legal Expenses to Defend Periostat Patents**

Under the Company’s license agreement with the Research Foundation ofthe State University of New York, or SUNY, covering Periostat, the Company isentitled to deduct costs incurred to defend its patents, including the $2,000settlement payment to Mutual in April 2004, from current and future royaltiesdue to SUNY on net sales of Periostat and sales to Mutual of its brandedversion of Periostat. The cumulative legal patent defense, litigation andsettlement costs incurred as of June 30, 2006 exceed the amount of theroyalties earned and payable to SUNY by $3,984. These amounts, which have beenexpensed, will be available to offset future royalties earned by SUNY, if any,on net sales of products based on the SUNY technology.

**Note 10 — Accrued Expenses**

Accruedexpenses at June 30, 2006 and December 31, 2005 consist of the following:

|                                         | ** ** | **      2006      ** | ** ** | **      2005      ** | ** ** |
|-----------------------------------------|------------|----------------------------------------------------------------------------------|------------|----------------------------------------------------------------------------------|------------|
| Research and  development project costs |       | $                                                                                | 1,378      |                                                                             | $          | 739 |   |
| Product  development milestone fee(1)   |       | 1,000                                                                            |       | —                                                                           |       |
| Sales and  marketing costs              |       | 717                                                                              |       | 239                                                                              |       |
| Payroll and  related costs              |       | 1,417                                                                            |       | 2,097                                                                            |       |
| Professional and  consulting fees       |       | 395                                                                              |       | 232                                                                              |       |
| Current portion  of deferred revenue    |       | 85                                                                               |       | 58                                                                               |       |
| Foreign taxes                           |       | 945                                                                              |       | 945                                                                              |       |
| Product returns                         |       | 830                                                                              |       | 1,267                                                                            |       |
| State and  franchise taxes              |       | 125                                                                              |       | 110                                                                              |       |
| Restructuring                           |       | 55                                                                               |       | 96                                                                               |       |
| Distribution  fees and rebates          |       | 211                                                                              |       | 237                                                                              |       |
| Other                                   |       | 150                                                                              |       | 4                                                                                |       |
|                                    |       | $                                                                                | 7,308      |                                                                             | $          | 6,024 |   |

 

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(1)             InMay of 2006, the FDA approved Oracea for the treatment of rosacea. Upon suchapproval, the Company was obligated to pay a product development milestone feeof $1,000 to Supernus Pharmaceuticals, Inc.

**Note 11— 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 Company closedon the first tranche of the offering and issued 1,550,000 shares of commonstock in exchange for proceeds of $14,388, net of approximately $1,069 inplacement agency fees and other estimated offering expenses that were accruedby the Company at December 31, 2005. All placement agency fees 

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and related expenses accrued at December 31, 2005 werepaid in the first quarter of 2006. On January 6, 2006, the Company closed onthe second tranche of the offering and issued 1,350,000 shares of common stockin exchange for $12,663 of net proceeds.

**Note12 — Restructuring**

On May 16, 2005,the Company announced the restructuring of the Company’s sales force followingthe FDA’s approval of a third party generic version of Periostat. As a resultof the restructuring, the Company ceased all sales activities related toPeriostat. The Company incurred a $1,184 restructuring charge during the threemonths ended June 30, 2005. Of this charge, $813 related to employee severancecosts while the remaining portion was primarily related to the write-off ofassets associated with the Company’s dental sales and marketing activities thatcould no longer be utilized by the Company. As of June 30, 2006, $55 of therestructuring charge had not yet been paid and is a component of accruedexpenses on the Company’s Condensed Consolidated Balance Sheet.

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

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

**Overview**

CollaGenexPharmaceuticals, Inc. and subsidiaries is a specialty pharmaceutical companycurrently focused on developing and marketing innovative proprietary medicaltherapies to the dermatology market.  Wecurrently market four prescription pharmaceutical products to the dermatologymarket through our professional dermatology sales force and generate revenuesfrom four other prescription pharmaceutical products that we continue to sellto the dental market.  In May 2006, theU.S. Food and Drug Administration, or the FDA, granted us marketing approvalfor OraceaTM for the treatment of inflammatory lesions (papules and pustules) ofrosacea in adult patients.  Oracea is thefirst FDA approved, orally-administered, systemically delivered drug to treatrosacea.  In July 2006, we launchedOracea to the dermatology community.

Our strategy is tobecome a leading developer and marketer of innovative prescriptionpharmaceutical products to the dermatology market.  We intend to continue to market our currentproducts, including Oracea, and develop and launch new products based on ourproprietary platform technologies as well as other technologies.  Our lead development candidates are:incyclinide (formerly known as COL-3), which is currently in Phase IIdose-finding clinical trials for the treatment of acne; COL-118, a pre-clinicaltopical compound based on the SansRosaTM technology that we are developing forthe treatment of erythema (skin redness) associated with dermatologicalconditions; and our Restoraderm® dermal drug delivery system, which iscurrently under development.

Our marketed dermatology products are: Oracea, Pandel®, a prescriptioncorticosteroid we licensed from Altana, Inc. in May 2002, AlcortinTM, aprescription topical antifungal steroid combination, and NovacortTM, aprescription topical steroid and anesthetic. In June 2005, we executed a Promotion and Cooperation Agreement withPrimus Pharmaceuticals Inc., or Primus, to market Alcortin and Novacort todermatologists.  Under the Promotion andCooperation Agreement, we are required to achieve annual sales minimums on acontractual year basis and we did not reach these minimums during the firstcontract year which ended on June 30, 2006. Primus has notified us that it will not enforce its right to terminatethe contract as a result of the failure by us to meet the minimum for the firstyear of the contract.

Our originaldental product, Periostat®, is an orally administered, prescriptionpharmaceutical product that was approved by the FDA in September 1998 for thetreatment of adult periodontitis.  Welaunched Periostat in January 1999, and by 2005 Periostat was the largestbranded prescription pharmaceutical product in the dental market. Between April2004 and June 2005, we also sold a separately branded version of Periostat toUnited Research Laboratories, Inc./Mutual Pharmaceutical Company, Inc., orMutual, pursuant to a License and Supply Agreement executed in April 2004 aspart of a settlement of our outstanding patent litigation with Mutual.  On May 20, 2005, we terminated our dentalsales force and promotional activities for Periostat following the introductionof a third party generic version of the product 

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and, as a resultof this generic launch, Mutual ceased purchasing product from us during June2005.  We also discontinued the promotionof our other dental products on May 20, 2005. We continue to generate sales from Periostat and three other dentalproducts, which include Atridox®, Atrisorb FreeFlow® and Atrisorb-D®, alsoreferred to as the Atrix Products, and are licensed from Atrix Laboratories,Inc. (now known as QLT USA, Inc.).  Basedon data provided by a leading independent prescription tracking service, weestimate that Periostat’s share of the 20 mg doxycycline market wasapproximately 7.4% at June 30, 2006.

In addition to ourmarketed products, we have a pipeline of product candidates in clinical andpreclinical development.  These productsare based on our proprietary platform technologies, IMPACSTM, SansRosa****and Restoraderm.  IMPACS (Inhibitors of Multiple Proteases AndCytokineS) are a group of compounds that demonstrate a range ofanti-inflammatory activities as well as the ability to inhibit the breakdown ofconnective tissue.  Periostat and Oraceaare our FDA-approved IMPACS products. incyclinide is an IMPACS compound currently in clinical development forthe treatment of acne.  Our IMPACStechnology is licensed on a perpetual basis from the Research Foundation of theState University of New York at Stony Brook, or SUNY.  Our SansRosa technology was acquired inconnection with our acquisition of SansRosa Pharmaceutical Development Inc., orSansRosa, and is an early stage project to develop a topical treatment(COL-118) for the redness associated with rosacea.  Our Restoraderm technology is a proprietary,foam-based, topical drug delivery technology that originated from a Swedishcollaborator.  We have acquired allrights, title and interest to the Restoraderm 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 latest stages of clinical development or the commerciallaunch of any of these products.

We were founded in1992 and completed an initial public offering of our common stock in 1996.  We recorded our first profit in the thirdquarter of 2002.  We incurred net lossesallocable to common stockholders of $19.7 million for the six months ended June30, 2006 and $18.8 million for the year ended December 31, 2005, respectively.  Although we achieved net income of $6.5million and $6.4 million for the years ended December 31, 2004 and 2003,respectively, we have incurred losses in every other year since inception andhave an accumulated deficit of $107.9 million at June 30, 2006.  We do not expect to generate profits for theyear ending December 31, 2006.

**Significant Recent Developments**

In May 2006, theFDA approved Oracea for the treatment of inflammatory lesions (papules andpustules) of rosacea in adult patients. Oracea is the first FDA approved, orally-administered, systemicallydelivered drug to treat rosacea.  In July2006, we commenced our trade launch of Oracea to the dermatology community.

On May 17, 2006,we announced that we had submitted additional references to the U.S. Patent andTrademark Office, or the USPTO, that may be relevant to the examination of U.S.Patent Application, Serial No. 10/117,709 and other applications basedthereon.  This application relates to theuse of sub-antimicrobial and non-antimicrobial tetracyclines for the treatmentof acne and acne rosacea, including Oracea and incyclinide.  The USPTO had previously issued a Notice ofAllowance of this application in August 2005, and a patent was scheduledto issue on May 23, 2006, but the application was withdrawn from issuancefor consideration of the 

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additionalreferences.  The continued examinationwill delay any issuance of the patent and is expected to take at least sixmonths.  On July 20, 2006, weannounced that the USPTO had issued a non-final rejection of this patentapplication directed to methods for treating acne with Oracea.  A non-final rejection is not dispositive ofthe patentability of an application’s subject matter.

## **Results of Operations**

*ThreeMonths Ended June 30, 2006 Compared to Three Months Ended June 30,2005*

**Revenues**

*Revenues*
| **(dollars in thousands)** | ** ** | **2006** | ** ** | **Change** | ** ** | **2005** | ** ** |
|--------------------------------------|------------|----------|------------|------------|------------|----------|------------|
| Net Product  Sales                   |       | $        | 3,352      |       | (51.2      | )%       | $          | 6,872 |   |
| Contract and  License Revenues       |       | 378      |       | 740        | %          | 45       |       |
| Grant Revenues                       |       | 62       |       | 100        | %          | —   |       |
| Total                                |       | $        | 3,792      |       | (45.2      | )%       | $          | 6,917 |   |

Net product salesof Periostat, Pandel and the Atrix Products during the three months ended June30, 2006 were approximately $3.4 million. The decrease in net product sales was primarily due to lower Periostatnet sales and the elimination of sales of Mutual’s branded version of Periostatas a result of the launch of a third party generic competitor in May 2005.  Based on data provided by a leadingindependent prescription tracking service, we estimate that Periostat’s shareof the 20 mg doxycycline market was 7.4% at June 30, 2006 as compared to 34% atJune 30, 2005.  Contract revenues duringthe three months ended June 30, 2006 were derived primarily from our Promotionand Cooperation Agreement with Primus for the Alcortin and Novacort products.  During the three months ended June 30, 2005,contract revenues were primarily derived from residual contract revenue fromour expired agreement with Merck & Co., Inc. for Vioxx®.  License revenues during three month periodsended June 30, 2006 and 2005 consisted primarily of international licensingrevenues for Periostat.  Grant revenuesof $62,000 recognized during the three months ended June 30, 2006, representreimbursements received during the quarter from the National Institutes ofHealth, or NIH, pursuant to the November 2005 grant funding a portion of ourincyclinide development program.

**Cost ofProduct Sales**

*Cost ofProduct Sales*
| **(dollars in thousands)** | ** ** | **2006** | ** ** | **Change** | ** ** | **2005** | ** ** |
|--------------------------------------|------------|----------|------------|------------|------------|----------|------------|
| Cost of Product  Sales               |       | $        | 1,091      |       | (35.9      | )%       | $          | 1,701 |   |
| Percent of Net Product  Sales        |       | 32.5     | %          | N/A        |       | 24.8     | %          |
|                                      |            |          |            |            |            |          |            |  |  |

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.

Cost of productsales during the three months ended June 30, 2006 includes a charge of $90,000associated with excess Periosat inventories. Cost of product sales for thethree months ended June 30, 2005 includes a charge of approximately $117,000associated with excess 

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inventories ofPeriostat and Mutual’s branded version of Periostat following the launch by athird party generic competitor which occurred in May 2005.  The increase in cost of product sales as apercentage of net product sales is a direct result of decreased Periostatrevenues in 2006, which is a higher margin product than our other existingproducts.

## **Research and Development**

*Research and Development*
| **(dollars in thousands)** | ** ** | **2006** | ** ** | **Change** | ** ** | **2005** | ** ** |
|--------------------------------------|------------|----------|------------|------------|------------|----------|------------|
| Research and  development            |       | $        | 2,882      |       | (9.9       | )%       | $          | 3,200 |   |
|                                      |            |          |            |            |            |          |            |  |  |

Research anddevelopment expenses consist primarily of funds paid to third parties for theprovision of services and materials for drug development, pre-FDA approvalmanufacturing 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 drug approval submission and filingfees).

Significantdevelopment projects conducted during the three months ended June 30, 2006included:

•                    clinicaland manufacturing development work for incyclinide of approximately $1.5million;

•                    continuingclinical and manufacturing development work and regulatory compliance costs forOracea of approximately $192,000; and

•                    researchand development costs related to COL-118 of approximately $147,000.

Personnel anddirect internal overhead expenses, including consulting, regulatory andstock-based compensation costs incurred during the three months ended June 30,2006, were approximately $1.0 million.

We estimate thatif incyclinide is developed to the point of commercialization, the additionalformulation and clinical development expenses and milestone fees expected to beincurred over the next five years would be approximately $25.0 million.  We have discontinued all development work onPeriostat-MRTM following the launch of generic competition to Periostat in May2005 and our decision to exit the dental business.  We are currently conducting formulation andstability work on various products incorporating our Restoraderm technology,and we are reviewing product options and the timetable associated with clinicaldevelopment or commercial launch.  It ispremature to estimate future costs associated with the Restoraderm and SansRosatechnologies, both of which are in preclinical development.

Significant development projects conducted during thethree months ended June 30, 2005 included:

•                    ourclinical and manufacturing development work for Oracea, which accounted fortotal costs of approximately $937,000;

•                    ourclinical and manufacturing development and formulation work for Periostat-MR, 

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which accounted for total costs of approximately $502,000;

•                    our clinicaland manufacturing development work for incyclinide, totaling $698,000; and

•                    stabilitytesting and formulation costs related to our Restoraderm technology, whichaccounted for total costs of approximately $255,000.

Personnel anddirect internal overhead expenses, including consulting and regulatory incurredduring the three months ended June 30, 2005, were approximately $808,000.

## **Selling,General and Administrative**

*Selling, General and Administrative*
| **(dollars in thousands)** | ** ** | **2006** | ** ** | **Change** | ** ** | **2005** | ** ** |
|--------------------------------------|------------|----------|------------|------------|------------|----------|------------|
| Selling, General  and Administrative |       | $        | 10,186     |       | 56.5       | %        | $          | 6,510 |   |
| Restructuring  charge                |       | —   |       | (100       | )%         | 1,184    |       |
| Total                                |       | $        | 10,186     |       | 32.4       | %        | $          | 7,694 |   |

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.

Significant components of selling, general and administrativeexpenses incurred during the three months ended June 30, 2006 includedapproximately $4.4 million in direct selling and sales training expenses,approximately $3.2 million in marketing expenses (including advertising andpromotion expenditures related to the pre-launch costs associated with theOracea trade launch, the Primus products and Pandel) and approximately $2.6million in general and administrative expenses, which include businessdevelopment, finance, legal and corporate activities.  Significant components of selling, generaland administrative expenses incurred during the three months ended June 30,2005 included approximately $2.8****million in direct selling and salestraining expenses, approximately $1.9million in marketing expenses (including advertising and promotion expendituresfor Periostat, the Atrix Products, the Primus Products and Pandel) andapproximately $1.8****million in general andadministrative expenses, which include business development, finance, legal andcorporate activities.  The increase inselling, general and administrative expense of approximately $3.7 millionduring the three months ended June 30, 2006 compared to the three months endedJune 30, 2005, was primarily due to non-cash, share-based compensation expensein 2006 of approximately $772,000, increased marketing costs of approximately$1.3 million primarily associated with Oracea pre-launch activities, andincreased direct sales force and sales training costs of approximately $1.7million.

Restructuring charges during the three months ended June 30,2005 consisted of a $1.2 million charge related to a reorganization followingthe approval of a third party generic version of Periostat.  As aresult of the restructuring, we ceased all sales activities related toPeriostat and our dental franchise.

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**OtherIncome/Expense**

*Other Income/Expense*
| **(dollars in thousands)** | ** ** | **2006** | ** ** | **Change** | ** ** | **2005** | ** ** |
|--------------------------------------|------------|----------|------------|------------|------------|----------|------------|
| Interest income                      |       | $        | 490        |       | 85.6       | %        | $          | 264 |   |
|                                      |            |          |            |            |            |          |            |  |  |

The increase in interest income was due to higher averageinvestment balances and yields in 2006.

## **Preferred StockDividend**

Preferred stock dividends included in net loss allocable to commonstockholders were $464,000 during the three months ended June 30, 2006 and$427,000 during the three months ended June 30, 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 D Stock, inMay 1999.  On December 15, 2005, weexecuted a Restructuring and Exchange Agreement with each of the holders of ouroutstanding Series D Stock, pursuant to which, among other things, the Series Dstockholders agreed to effect an exchange, whereby we exchanged all 200,000outstanding shares of our Series D Stock for 200,000 shares of our Series D-1Cumulative Convertible Preferred Stock, or the Series D-1 Stock.

Pursuant to the terms of our Series D-1 Stock, the holders of theSeries D-1 Stock are entitled to dividends payable in cash at a current rate of10.0% per annum, which are declared and paid every six months.  The annual dividend rate increased by 1.0% onMay 19, 2006 and will increase by 1% per annum each subsequent anniversarythereof 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.

*Six Months Ended June 30, 2006 Compared to Six MonthsEnded June 30, 2005 *

**Revenues**

*Revenues*
| **(dollars in thousands)** | ** ** | **2006** | ** ** | **Change** | ** ** | **2005** | ** ** |
|--------------------------------------|------------|----------|------------|------------|------------|----------|------------|
| Net Product  Sales                   |       | $        | 6,693      |       | (64.2      | )%       | $          | 18,708 |   |
| Contract and  License Revenues       |       | 653      |       | 167.6      | %          | 244      |       |
| Grant Revenues                       |       | 167      |       | 100%       |       | —   |       |
| Total                                |       | $        | 7,513      |       | (60.4)%    |     | $          | 18,952 |   |

 

Net product sales during the six months ended June 30, 2006included approximately $6.7 million in net product sales of Periostat, Pandeland the Atrix Products.  The decrease innet product sales was primarily due to lower Periostat net sales and theelimination of sales of the branded version of Periostat to Mutual as a resultof the launch of a third party generic competitor in May 2005.  Based on data provided by a leadingindependent prescription tracking service, we estimate that Periostat’s shareof the 20 mg doxycycline market was 7.4% at June 30, 2006 as compared to 34% atJune 30, 2005.  Contract revenues duringthe six months ended June 30, 2006 were derived primarily from our Promotionand Cooperation Agreement with Primus for the Alcortin and Novacort products.  During the six months ended June 30, 2005,contract revenues were primarily derived from residual contract revenue fromour expired agreement with Merck & Co., Inc. for Vioxx.  Licensing revenues during the six monthsended June 30, 2006 

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## consisted of international licensing revenues forPeriostat.  Licensing revenues during thesix months ended June 30, 2005 consisted primarily of international licensingrevenues for Periostat and $160,000 in license revenue representing theunamortized portion of upfront license revenue received in 2000 from theLicense and Supply Agreement with Showa Yakuhin Kako Co., Ltd., which wasterminated in March 2005.  Grant revenuesof $167,000 recognized during the six month period ended June 30, 2006represent reimbursements received from the NIH related to the November 2005grant associated with our on-going incyclinide development program.

**Cost of ProductSales**

*Cost of Product Sales*
| **(dollars in thousands)** | ** ** | **2006** | ** ** | **Change** | ** ** | **2005** | ** ** |
|--------------------------------------|------------|----------|------------|------------|------------|----------|------------|
| Cost of Product  Sales               |       | $        | 1,986      |       | (52.3      | )%       | $          | 4,166 |   |
| Percent of Net Product  Sales        |       | 29.7     | %          | N/A        |       | 22.3     | %          |
|                                      |            |          |            |            |            |          |            |  |  |

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.

Cost of productsales during the six months ended June 30, 2006 includes a charge of $90,000associated with excess Periostat inventories. Cost of product sales for the six months ended June 30, 2005 includes acharge of approximately $979,000 associated with the excess inventories ofPeriostat and Mutual’s branded version of Periostat following the launch by athird party generic competitor which occurred in May 2005.  The increase in cost of product sales as apercentage of net product sales is a direct result of decreased Periostatrevenues in 2006, which is a higher margin product than our other existingproducts.

## **Research and Development**

*Research and Development*
| **(dollars in thousands)** | ** ** | **2006** | ** ** | **Change** | ** ** | **2005** | ** ** |
|--------------------------------------|------------|----------|------------|------------|------------|----------|------------|
| Research and  development            |       | $        | 6,595      |       | (9.6       | )%       | $          | 7,294 |   |
|                                      |            |          |            |            |            |          |            |  |  |

Research anddevelopment expenses consist primarily of funds paid to third parties for theprovision of services and materials for drug development, pre-FDA approvalmanufacturing and production costs related to Oracea, prior to May 26, 2006,including milestone fees, manufacturing and formulation enhancements, clinicaltrials, purchased in-process research and development, statistical analysis andreport writing and regulatory compliance costs (including drug approvalsubmission and filing fees).

Significantdevelopment projects conducted during the six months ended June 30, 2006included:

•                    clinical and manufacturingdevelopment work for incyclinide of approximately $3.0 million;

•                    continuing clinical andmanufacturing development work and regulatory compliance costs for Oracea ofapproximately $1.4 million; and

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•                    in-process research and developmentcosts related to COL-118 of approximately $347,000.

Personnel anddirect internal overhead expenses, including consulting, regulatory andstock-based compensation costs incurred during the six months ended June 30,2006, were approximately $1.8 million.

We estimate thatif incyclinide is developed to the point of commercialization, the additionalformulation and clinical development expenses and milestone fees expected to beincurred over the next five years would be approximately $25.0 million.  We have discontinued all development work onPeriostat-MR following the launch of generic competition to Periostat in May2005 and our decision to exit the dental business.  We are currently conducting some formulationand stability work on various products incorporating our Restoraderm technology,and we are reviewing product options and the timetable associated with clinicaldevelopment or commercial launch. Accordingly, it is premature to estimate other future costs associatedwith the Restoraderm technology.** **It is also premature to estimate futuredevelopment and clinical costs associated with the SansRosa technology.

Significantdevelopment projects conducted during the six months ended June 30, 2005included:

•                    ourclinical and manufacturing development work for Oracea, accounted for total costsof approximately $3.2 million;

•                    our clinical and manufacturingdevelopment and formulation work for Periostat-MR, accounted for total costs ofapproximately $1.0 million;

•                    ourclinical and manufacturing development work for inclycinide, a secondgeneration IMPACS compound, totaling approximately $1.2 million; and

•                    stabilitytesting and formulation costs for related to our Restoraderm technology, whichaccounted for total costs of approximately $503,000.

Personnel anddirect internal overhead expenses, including consulting, and regulatoryincurred during the six months ended June 30, 2005, were approximately $1.4million.

## **Selling, General and Administrative**

*Selling, General and Administrative*
| **(dollars in thousands)** | ** ** | **2006** | ** ** | **Change** | ** ** | **2005** | ** ** |
|--------------------------------------|------------|----------|------------|------------|------------|----------|------------|
| Selling, General  and Administrative |       | $        | 18,697     |       | 31.2       | %        | $          | 14,256 |   |
| Restructuring  charge                |       | $        | —     |       | (100       | )%       | $          | 1,184 |   |
| Total                                |       | $        | 18,697     |       | 21.1       | %        | $          | 15,440 |   |

 

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.

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Significant components of selling, general and administrativeexpenses incurred during the six months ended June 30, 2006 includedapproximately $7.9 million in direct selling and sales training expenses,approximately $5.7 million in marketing expenses (including advertising andpromotion expenditures related to the pre-launch costs associated with theOracea trade launch, the Primus products and Pandel) and approximately $5.1million in general and administrative expenses, which include business development,finance, legal and corporate activities. Significant components of selling, general and administrative expensesincurred during the six months ended June 30, 2005 included approximately $6.6****millionin direct selling and sales training expenses, approximately $3.8 million in marketing expenses(including advertising and promotion expenditures related to Periostat, theAtrix Products, the Primus products and Pandel) and approximately $3.9****millionin general and administrative expenses, which include business development,finance, legal and corporate activities. The increase in selling, general and administrative expense ofapproximately $4.4 million during the six months ended June 30, 2006 comparedto the six months ended June 30, 2005, was primarily due to increased generaland administrative costs of $1.2 million, of which $1.0 millionrelated to non-cash share-based compensation expense, increased marketing costsof $1.9 million primarily associated with Oracea pre-launch activities andincreased direct sales force and sales training costs of approximately $1.3 million.

Restructuring charges during the six months ended June 30, 2005consisted of a $1.2 million charge related to a reorganization following theapproval of a third party generic version of Periostat.  As aresult of the restructuring, we ceased all sales activities related toPeriostat and our dental franchise.

## **OtherIncome/Expense**

*Other Income/Expense*
| **(dollars in thousands)** | ** ** | **   2006   ** | ** ** | **   Change   ** | ** ** | **   2005   ** | ** ** |
|--------------------------------------|------------|----------------------------------------------|------------|------------------------------------------------|------------|----------------------------------------------|------------|
| Interest income                      |       | $                                            | 1,036      |                                           | 117.6      | %                                            | $          | 476 |   |
|                                      |            |                                              |            |                                                |            |                                              |            |  |  |

 

Theincrease in interest income was due to higher average investment balances andyields in 2006.

**Preferred StockDividend**

Preferred stock dividends included in net loss allocable to commonstockholders were $928,000 during the six months ended June 30, 2006 and$827,000 during the six months ended June 30, 2005.  Such preferred stock dividends are paid incash and are the result of our obligations in connection with the issuance ofour Series D Stock in May 1999.  OnDecember 15, 2005, we executed a Restructuring and Exchange Agreement with eachof the holders of our outstanding Series D Stock, pursuant to which, among otherthings, the Series D stockholders agreed to effect an exchange, whereby weexchanged all 200,000 outstanding shares of our Series D Stock for 200,000shares of our Series D-1 Stock.

Pursuant to the terms of our Series D-1 Stock, the holders of theSeries D-1 Stock are entitled to dividends payable in cash at a current rate of10.0% per annum, which are declared and paid every six months.  The annual dividend rate increased by 1.0% onMay 19, 2006 and will increase by 1% per annum on each subsequent anniversarythereof 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.

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**Liquidity andCapital Resources**

***CashRequirements/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 historicallyfunded our cash requirements primarily through the following:

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

·                  Cash flows fromoperations; and

·                  Exercise ofstock options and warrants.

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

·                  The successfulcommercialization of Oracea;

·                  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 $16.0 million in 2006);

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

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

·                  Our ability tocontinue to meet the covenant requirements under our revolving credit facilitywith Silicon Valley Bank; 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 paid by us from thesale of 2.9 million shares of our common stock at a price of $10.00 per share.

At June 30, 2006,we had cash, cash equivalents and short-term investments of approximately $37.3 million compared to theapproximately $44.4 million balance at December 31, 2005.

On May 31, 2006,we entered into a Fifth Loan Modification Agreement, or the ModificationAgreement, with Silicon Valley Bank, or SVB, to amend and renew our Loan andSecurity Agreement with SVB dated March 19, 2001, as previously amended, or theLoan Agreement, which expired on May 31, 2006. Pursuant to the terms of theModification

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Agreement, among other things, (i) the expiration dateof amended credit facility has been extended to May 31, 2007 and (ii) covenantsrequiring us to (A) maintain a Minimum Adjusted Quick Ratio, as definedtherein, and (B) maintain a minimum of $2.0 million in cash, net of borrowingsunder the Loan Agreement, were eliminated. Under the amended credit facility,we may borrow up to the lesser of $5.0 million or 80% of eligible receivables,as defined under the Loan Agreement. The amount available to us is reduced byany outstanding letters of credit that may be issued under the amended creditfacility in amounts totaling up to $2.0 million. As we pay down amounts underany letter of credit, the amount available to us under the credit facilityincreases. We had no letters of credit outstanding at June 30, 2006. We are notobligated to draw down any amounts under the amended credit facility and anyborrowings shall bear interest, payable monthly, at the current prime rate, or8.25%, at June 30, 2006. Under the Modification Agreement, we are charged anunused line credit fee of 0.25% of the unused line per annum. We had noborrowings outstanding at June 30, 2006.

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, certificates of deposit and money market funds. Ourworking capital at June 30, 2006 was $30.3million compared to $34.6 million at December 31, 2005. During the sixmonths ended June 30, 2006, we invested approximately $180,000 in capital expenditures and $200,000 for in-processresearch and development, paid $900,000in cash dividends to the holders of our Series D-1 Stock and purchasedapproximately $3.2 million (net of sales) of short-term investments.

We anticipate thatour current cash, cash equivalents and short-term investments at June 30, 2006,will be sufficient to fund our operations through at least mid-2007. However,our forecast of the period of time through which our financial resources willbe adequate to support our operations is a forward-looking statement thatinvolves risks and uncertainties, and actual results could vary materially.

***Cash Flows/CashManagement***

The principal useof cash in operating activities during the six months ended June 30, 2006 wasthe payment of operating expenses and related working capital liabilities. Cashflows from operations can vary significantly due to various factors includingthe timing of payments made to our vendors, including research and developmentvendors, vendor payment terms, customer mix and customer payment terms.

Investingactivities during the six months ended June 30, 2006 consisted primarily ofpurchases and sales of short-term investments, capital purchases and acquiredin-process research and development. Financing activities during the six monthsended June 30, 2006 consisted primarily of the cash inflows from the completionof the second tranche of our common stock offering, and stock option exercisesand cash outflows from the payment of preferred dividends to the holders of ourSeries D-1 Stock.

***ContractualObligations***

Our majoroutstanding contractual obligations relate to cash dividends on our outstandingSeries D-1 preferred stock and operating leases for our office space. Thedisclosures relating to our contractual obligations in our Annual Report onForm 10-K for the year ended December 31, 2005 have not materially changedsince we filed that report.

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***CriticalAccounting Policies and Estimates***

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

***RevenueRecognition***

We historicallyrecognized product sales revenue upon shipment to wholesale customers, net ofestimated future returns and estimates for chargebacks, applicable wholesaledistribution fees, rebates and current inventory levels in the distributionchannel, provided that collection was probable and no significant obligationsremained. Following the launch of a third party generic competitor to Periostatin May 2005 and commencing with the second quarter of 2005, we beganrecognizing Periostat sales revenue based on sales to end-users, which areestimated using prescription dispensing data generated by a leading independentprescription tracking service, as well as on-hand inventory estimates in thedistribution channel. Since the launch of generic competition to Periostatcould result in increased product returns from the wholesale and retailchannels, we have accrued an estimated liability of $830,000 for potentialPeriostat and other product returns in accrued expenses on the Condensed ConsolidatedBalance Sheet at June 30, 2006.

For new productlaunches, such as Oracea which was launched in July 2006, the our policyis to recognize revenue on a net prescription value basis estimated usingdispensing data until its wholesalers can reduce their new product inventoriesto our targeted wholesaler inventory stocking levels (generally between threeand five weeks of sales). When wholesalers’ inventories have been reduced tothis targeted level, we will recognize product revenue upon shipment, net ofthe applicable allowances.

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.

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 suchexpenditures as research and development as they are incurred and recognizegrant revenue for the portion of the expenditures that are reimbursed by theNIH.

***Deferred Taxes***

In assessing the realizability of deferred tax assets,we consider the likelihood that part or all of the deferred tax assets will notbe realized. This assessment requires significant judgment and estimates. Theultimate realization of the deferred tax assets is dependent upon thegeneration of future taxable income during the period in which those temporarydifferences 

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become deductible. We consider our history of losses,scheduled reversal of deferred tax assets and liabilities and projected futuretaxable income over the periods in which the deferred tax asset items aredeductible. The Tax Reform Act of 1986 contains provisions that may limit thenet operating loss and research and experimentation credit carryforwardsavailable to be used in any given year upon the occurrence of certain events,including significant changes in ownership interest. We have incurred a netloss for the six months ended June 30, 2006 and for the year ended December 31,2005, and uncertainty regarding our future profitability has prevented us fromreaching the “more likely than not” conclusion required under the applicableliterature to recognize deferred tax assets on our Consolidated Balance Sheet.

***Intangible Assets***

***Product rights and capitalized product development fees are stated atcost, amortized over the shorter of the estimated useful life of the productsor the contract term which such rights have been licensed, using thestraight-line method. Amortization of product rights and capitalized productdevelopment fees is charged to cost of product sales.***

We are required to test for asset impairment ofacquired product rights and capitalized product development fees wheneverevents or circumstances indicate that the carrying value of an asset may not berecoverable. We apply SFAS No. 144, “Accounting for the Impairment or Disposalof Long-Lived Assets,” in order to determine whether or not an asset wasimpaired. 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 cash flow analyses of our acquiredproduct rights and capitalized product development fees we make assumptionsrelating to: (i) the intended use of the product and the expected future cashflows resulting directly from such use; (ii) generic competitor activities andregulatory initiatives that affect our products; and (iii) customer preferencesand expected managed care reimbursement.

***Inventories***

Critical accounting estimates and assumptions, relatedto inventory carrying values are evaluated periodically and consider thesaleable quantities of inventory versus quantities of inventory on-hand.

During the sixmonths ended June 30, 2006, we recorded a charge of $90,000 for excessPeriostat inventories. During the six months ended June 30, 2005, we recorded acharge of $979,000 for the excess inventory of Periostat and Mutual’s brandedversion of Periostat due to the anticipated decreased demand following theintroduction of a third party generic version of Periostat that occurred in May2005.

***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 

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receive an approval letter from the FDA for a newproduct, and then we begin to capitalize the inventory costs relating to thatproduct.

***Share-BasedCompensation***

As part of our adoption of SFAS No. 123R as ofJanuary 1, 2006, we recognized the fair value of share-based compensationawards in our consolidated financial statements using the modified prospectivemethod. We apply the Black-Scholes option-pricing model in order to determinethe fair value of stock options on the date of grant, and we apply judgment inestimating key assumptions that are important elements in the model, such asthe expected stock-price volatility and expected stock option life. Ourestimates of these important assumptions and expected forfeiture rates arebased on historical data and judgment regarding market trends and factors.

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.

***RecentlyIssued Accounting Pronouncements***

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 toone year from the effective date of the FSP to evaluate our availablealternatives and make our one-time election. We are currently evaluating thealternative methods in connection with our adoption of SFAS No. 123R.

**Item 3.                    Quantitative and QualitativeDisclosures About Market Risk.**

We had cash andcash equivalents and short-term investments at June 30, 2006 which are exposedto the impact of interest rate changes and our interest income fluctuates asinterest rates change. Due to the short-term nature of our investments in moneymarket funds, the carrying values of our cash equivalents approximate theirfair value at June 30, 2006. Our short-term investments in commercial papercertificates of deposit and government notes are carried at fair value.

**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 June 30, 2006. The term “disclosure controls and procedures,”as defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act, meanscontrols and other procedures of a company that are designed to ensure thatinformation required to be disclosed by a company in the reports that it filesor submits under the Exchange Act is recorded, processed, summarized andreported, within the time periods specified in the SEC’s rules and forms. Disclosurecontrols and procedures include, without limitation, controls and proceduresdesigned to ensure that information required 

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to be disclosed by a company in the reports that itfiles or submits under the Exchange Act is accumulated and communicated to thecompany’s management, including its principal executive and principal financialofficers as appropriate to allow timely decisions regarding requireddisclosure. Our management recognizes that any controls and procedures, nomatter how well designed and operated, can provide only reasonable assurance ofachieving their objectives and management necessarily applies its judgment inevaluating the cost-benefit relationship of possible controls and procedures. Basedon the evaluation of our disclosure controls and procedures as of June 30,2006, our chief executive officer and chief financial officer concluded that,as of such 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)and 15d-15(f) under the Exchange Act) occurred during the fiscal quarterended June 30, 2006 that has materially affected, or is reasonably likely tomaterially affect, our internal control over financial reporting.

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**PARTII.  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, Section27A of the Securities Act of 1933, as amended, and Section 21E of theSecurities Exchange Act of 1934, as amended. These forward-looking statementsregarding future events and our future results are based on current expectations,estimates, forecasts, and projections and the beliefs and assumptions of ourmanagement including, without limitation, our expectations regarding results ofoperations, selling, general and administrative expenses, research anddevelopment expenses, the sufficiency of our cash for future operations, ourintellectual property portfolio and the success of our preclinical, clinicaland development programs and our dermatology franchise. Forward-lookingstatements may be identified by the use of forward-looking terminology such as “may,”“could,” “will,” “expect,” “estimate,” “anticipate,” “continue,” or similarterms, variations of such terms or the negative 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, results of operations or liquidity would likelysuffer.*

The following discussion includes three revised riskfactors (“We are depending heavily on the commercial success Oracea. If we areunable to successfully commercialize Oracea our business will be materially harmed”,“If we are not able to obtain and enforce patent protection for Oracea or ourother discoveries, our ability to commercialize our product candidatessuccessfully will be harmed and we may not be able to operate our businessprofitably” and “If we lose our sole supplier of doxycycline or ourmanufacturer of Oracea, our sales of Oracea, if any, will be interrupted,halted or less profitable”) that reflect developments subsequent to thediscussion of risk factors included in our most recent Annual Report on Form10-K. In addition, we have deleted the risk factors entitled “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” and “Changes in stock optionaccounting rules may have a significant adverse affect on our operatingresults.”

***We are dependingheavily on the commercial success Oracea. If we are unable to successfullycommercialize Oracea our business will be materially harmed.***

We have invested a significant portion of our recentefforts and financial resources in the development of Oracea for the treatmentof rosacea. Our ability to generate substantial product revenues from Oraceawill depend heavily on the successful commercialization of Oracea. The successof Oracea will depend primarily on the acceptance of the product by patients,the medical community and third party payors.

Although we currently derive additional revenue frommarketing and/or selling other 

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products other than Oracea (Periostat, Atridox,Atrisorb FreeFlow, Atrisorb-D, the Primus products and Pandel) ourrevenue and profitability in the near future will depend on our ability tomarket and sell Oracea successfully.

***We cannot rely on regulatory protections toprevent the approval 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 United StatesDistrict Court for the District of Columbia upheld the FDA’s application ofthis principle to Periostat and determined that Periostat was not entitled tomarket exclusivity because its active ingredient, doxycycline, had previouslybeen approved as an antibiotic. Because Oracea also contains doxycycline as itsactive ingredient, it will also not be entitled to market exclusivity.

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, despite the FDA’s May 2006approval of Oracea, because it will not be entitled to market exclusivity,third parties may enter the market which would materially harm our business.

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

Our successdepends, in part, on our ability to protect proprietary methods andtechnologies that we develop under the patent and other intellectual propertylaws of the United States and other countries, so that we can prevent othersfrom using our inventions and proprietary information. However, we may not 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 

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applications. Similarly, because patent applicationsin the United States and many foreign jurisdictions are typically not publisheduntil 18 months after filing, or in some cases not at all, we cannot be certainthat we were the first to make the inventions claimed or to file for protectionof the inventions set forth in our patent applications. As a result, we may notbe granted additional patents or our existing patents may be found to beinvalid. We may also be required to obtain licenses under third-party patentsto market our proposed products. If licenses are not available to us onacceptable terms, or at all, we will not be able to market the affectedproducts.

Our 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 and useinformation that we regard as proprietary. The issuance of a patent does notguarantee that it is valid or enforceable, so even if we obtain patents, theymay 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 USPTO and its foreign counterparts use to grant patents are notalways applied predictably or uniformly and can change. There is also nouniform, worldwide policy regarding the subject matter and scope of claimsgranted or allowable in pharmaceutical or biotechnology patents. The laws ofsome foreign countries do not protect proprietary information to the sameextent as the laws of the United States, and many companies have encounteredsignificant problems and costs in protecting their proprietary information inthese foreign countries. Accordingly, we do not know the degree of futureprotection for our proprietary rights or the breadth of claims allowed in anypatents issued to us or to others. The allowance of broader claims may increasethe incidence and cost of patent interference proceedings and/or oppositionproceedings. On the other hand, the allowance of narrower claims may limit thevalue of our proprietary rights.

A number of ourpending patent applications are related and include claims that cover Oracea. OnMay 17, 2006, we announced that we had submitted additional references tothe USPTO that may be relevant to the examination of U.S. Patent Application,Serial No. 10/117,709 and other applications based thereon. Thisapplication relates to the use of sub-antimicrobial and non-antimicrobialtetracyclines for the treatment of acne and acne rosacea, including Oracea andincyclinide. The USPTO had previously issued a Notice of Allowance of thisapplication in August 2005, and a patent was scheduled to issue on May 23,2006, but the application was withdrawn from issuance for consideration of theadditional references, and continued examination is on-going. On July 20,2006, we announced the USPTO had issued a non-final rejection of our patentapplication directed to methods for treating acne with Oracea. A non-finalrejection is not dispositive of the patentability of an application’s subjectmatter. However, it is difficult to predict when or if this patent, or any ofthose covered in related applications will issue.

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If issued, ourpatents relating to Oracea may not contain claims sufficiently broad to protectus against third parties with similar products, or provide us with anycompetitive advantage. Moreover, once issued, any of our patents may bechallenged, narrowed, invalidated or circumvented. In addition, the patentrights in our products that derive from claims under method of use patents maybe hard to assert or enforce if medical professionals prescribe similar(including generic), though non-approved, doxycycline products for indicationscovered by our patents. If our patents are invalidated or otherwise limited,other companies will be better able to develop products and technologies thatcompete with ours, which could adversely affect our competitive businessposition, business prospects and financial condition.

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

We continue toimplement our plans to expand into the dermatology market. In May 2006, the FDAapproved Oracea for the treatment of rosacea in adults, and we continue to seekadditional product licensing opportunities to enhance our near-term offeringsto the dermatology market.

While we haveexperience in the sales and marketing of dental products, we have limited experiencein the dermatology market. This market is very competitive and some of ourcompetitors have substantially greater resources than we have. Our futuresuccess will depend on, among other things, our ability to: (i) achieve marketacceptance for any current or future dermatological offerings; (ii) hire andretain personnel with experience in the dermatology market; (iii) execute ourbusiness plan with respect to this market segment; and (iv) adapt to technicalor 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.

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***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 Oracea and Periostat, we havenot received 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 regulations, or changes in regulatoryreview for each submitted product application, may cause delays in the approvalor rejection of an 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, 2008 andthereafter automatically renews for successive two-year periods unless, 

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90 days prior to the expiration of any suchperiods, either party gives the other party written notice of termination. Inaddition, in the event of a default, uncured for 90 days, the non-defaultingparty can terminate the supply agreement effective immediately at the end ofsuch ninety-day period. Although Hovione maintains two manufacturing locations,if we are unable to procure a commercial quantity of doxycycline from Hovioneon an 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 and sale ofOracea.

We entered into anagreement effective December 31, 2005 with Cardinal Health PTS, LLC, or PTS,pursuant to which PTS has agreed to manufacture Oracea for us. 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 additional agreements on acceptable terms, if atall. In the event that we are unable to obtain sufficient quantities ofdoxycycline or Oracea on commercially reasonable terms, or in a timely manner,our business, financial condition and results of operations would be materiallyadversely affected.

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

Wemarket two products, Alcortin and Novacort, under a Promotion and CooperationAgreement with Primus. The majority of sample product costs and all sales forcecompensation related to our promotion of Alcortin and Novacort are funded byus. Primus is responsible for the manufacture of Alcortin and Novacort and ithas not sought FDA approval for these products because it believes that noapproval is required. We cannot be sure that FDA will not object to the lack ofapproval for these products. If the FDA were to assert that these productsrequired approval, it could at any time seek to take administrative or judicialactions which could prevent us from marketing these products. Our inability tomarket these products could result in a temporary or permanent loss of revenue,which may be partially offset by a reduction in our promotional expensesrelated to these 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;

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

·                  recall;

·                  fines;

·                  suspension orwithdrawal of regulatory approvals;

·                  refusal topermit the import or export of our products;

·                  product seizure;and

·                  injunctions orthe imposition of civil or criminal penalties.

***We 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 June 30, 2006will be sufficient to fund our operations through at least mid-2007. However,our forecast of the period of time through which our financial resources willbe adequate to support our operations involves risks and uncertainties, andactual results could vary materially. Our future funding requirements willdepend on many factors, including:

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

·                  the successfulcommercialization of Oracea;

·                  the success ofour dermatology franchise;

·                  the success ofour preclinical, clinical and development programs;

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

·                  revenues onsales or licenses of Oracea outside of the U.S.;

·                  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;

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·                  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.

It may take severalyears to complete the testing of a product, and failure can occur at any stageof testing. For example:

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

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

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·                  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 orare alleged to infringe intellectual property rights of third parties, it willadversely affect our business.***

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 third parties could bringclaims against us or our collaborators that would cause us to incur substantialexpenses and, if successful against us, could cause us to pay substantialdamages. Further, if a patent infringement suit were brought against us or ourcollaborators, we or they could be forced to stop or delay research,development, manufacturing or sales of the product or product candidate that isthe subject of the suit.

As a result 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 

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pay license fees or royalties or both. These licensesmay not 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 biotechnologyindustries. In addition to infringement claims against us, we may become aparty to other patent litigation and other proceedings, including interferenceproceedings declared by the USPTO and opposition proceedings in the EuropeanPatent Office, regarding intellectual property rights with respect to ourproducts and technology. The cost to us of any patent litigation or otherproceeding, even if resolved in our favor, could be substantial. Some of ourcompetitors may be able to sustain the costs of such litigation or proceedingsmore effectively than we can because of their substantially greater financialresources. Uncertainties resulting from the initiation and continuation ofpatent litigation or other proceedings could have a material adverse effect onour ability to compete in the marketplace. Patent litigation and otherproceedings may also absorb significant 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 cannot guarantee the authenticity or accuracy of such data,nor can we be certain that such data has not been fraudulently generated. Thefailure of these third parties to carry out their obligations would materiallyadversely affect our ability to develop and market new products and implementour strategies.

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***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 the SUNY License, we have an exclusiveworldwide license to SUNY’s rights in certain patents and patent applicationsto make and sell products employing tetracyclines to treat certain diseaseconditions.  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 SUNY License is terminated, we wouldlose our right to exclude competitors from commercializing similar products,and we could be excluded from marketing the same products if SUNY licensed theunderlying technology to a competitor after terminating the SUNY License.  The SUNY License is terminable by SUNY on 90days prior notice only upon our failure to make timely payments, reimbursementsor reports, if the failure is not cured by us within 90 days.  The termination of the SUNY License, or thefailure to obtain and maintain patent protection for our technologies, wouldhave a material adverse effect on our business, financial condition, liquidityand results of operations.

***If our products cause injuries, we mayincur significant expense and liability.***

Our business maybe adversely affected by potential product liability claims arising out of thetesting, manufacturing and marketing of Periostat, Oracea and other productsdeveloped by or for us or for which we have licensing or promotion andcooperation rights.  We have an aggregateof $10.0 million in product liability insurance covering Periostat, Mutual’sbranded version of Periostat and Oracea, our product candidates and productsfor which we have licensing or promotion and cooperation rights.

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

Our insurance maynot adequately protect us against product liability claims.  Insufficient insurance coverage or thefailure to obtain indemnification from third parties for their respectiveliabilities may expose us to product liability claims and/or recalls and couldcause our business, financial condition and results of operations to decline.

***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 be exaggerated if the trading volume of ourcommon stock is low.  In addition, thestock market in general has experienced dramatic price and volume fluctuationsfrom time to time.  These fluctuationsmay or may not be based upon any business or operating results.  Our common stock may experience similar oreven more dramatic price and volume fluctuations that may continueindefinitely.

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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 July 1, 2004 throughJune 30, 2006, as reported on the NASDAQ Global Market:

| Quarter Ended  | ** ** | **High** | ** ** | **Low** | ** ** |
|---------------------|------------|----------|------------|---------|------------|
| 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 |   |
| June 30, 2006       |       | $        | 14.67      |    | $          | 10.52 |   |

 

**Item 4.    Submission ofMatters to a Vote of Security Holders.**

OurAnnual Meeting of Stockholders was held on May 24, 2006.

Therewere present at the Annual Meeting in person or by proxy stockholders holdingan aggregate of 15,404,251 shares of common stock and 192,415 shares of SeriesD-1 Stock, which shares of Series D-1 Stock account for an additional 1,724,150shares of common stock on an as converted to common stock basis, assuming forsuch purpose a conversion price of $11.16 per share.  The results of the vote taken at the AnnualMeeting with respect to the election of the nominees to be the common stockdirectors were as follows:

| Common Stock Nominees              | ** ** | **For**           | ** ** | **Withheld**   |
|------------------------------------|------------|-------------------|------------|----------------|
|                               |       |              |       |           |
| Colin W. Stewart                   |       | 15,181,515 shares |       | 222,736 shares |
| Peter R. Barnett,  D.M.D.          |       | 15,181,515 shares |       | 222,736 shares |
| Robert C. Black                    |       | 15,177,015 shares |       | 227,236 shares |
| James E. Daverman                  |       | 14,927,127 shares |       | 477,124 shares |
| Robert J. Easton                   |       | 15,119,401 shares |       | 284,850 shares |
| W. James O’Shea               |       | 15,177,015 shares |       | 227,236 shares |
| George M. Lasezkay, Pharm.D., J.D. |       | 15,181,515 shares |       | 222,736 shares |

 

Theresults of the vote taken at the Annual Meeting with respect to the election ofthe nominee to be the Series D-1 Director, Robert A. Beardsley, Ph.D.,were as follows: 192,415 shares of Series D-1 Stock were voted for the SeriesD-1 Stock nominee, with no shares voting against or abstaining.

Avote of the stockholders was taken at the Annual Meeting with respect to theproposal to amend the Company’s Amended and Restated Certificate ofIncorporation, as amended, to increase the number of authorized shares ofcommon stock from 25,000,000 to 75,000,000. For the purposes of such vote, the holders of shares of common stock andthe holders of Series D-1 Stock (on an as converted to common stock basis)voted together as a single class.  Of such shares of common stock,13,961,339 shares voted in favor of such proposal, 2,796,111 shares were votedagainst such proposal and 8,512 shares abstained from voting.  In addition, for the 

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purposes of such vote, the holders of shares SeriesD-1 Stock voted as a separate class. Of such shares of Series D-1 Stock,192,415 shares voted in favor of such proposal, with no shares voting againstor abstaining.

Avote of the stockholders was also taken at the Annual Meeting with respect tothe proposal to issue greater than 2,900,814 shares of common stock, ifnecessary, upon conversion of the outstanding shares of Series D-1 Stockas required by NASDAQ Marketplace Rule 4350.  For the purposes of such vote, the holders ofshares of common stock voted together as a single class.  Of such shares,6,427,977 shares voted in favor of such proposal, 1,909,202 shares were votedagainst such proposal and 6,862 shares abstained from voting.

Inaddition, a vote of the stockholders was taken at the Annual Meeting withrespect to the proposal to ratify the selection by the Audit Committee of theappointment of KPMG LLP as the independent registered public accounting firm ofthe Company for the fiscal year ending December 31, 2006.  For the purpose of such vote, the holders ofshares of common stock and the holders of Series D-1 Stock (on an as convertedto common stock basis) voted together as a single class.  Of such shares, 16,686,684 shares voted infavor of such proposal, 50,967 shares were voted against such proposal and28,312 shares abstained from voting.

Eachof the foregoing proposals were duly passed with the exception of the proposalto issue greater than 2,900,814 shares of common stock upon conversion of theSeries D-1 Preferred Stock, which proposal did not achieve the affirmative voteof the holders of a majority of the shares of common stock represented at theAnnual Meeting.

**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:   August  4, 2006 | By:                              | /s/ Colin W. Stewart |
|                              |                             | Colin W. Stewart |
|                              |                             | President and  Chief Executive Officer |
|                              |                             | (Principal  Executive Officer) |
|                              |                             |   |
|                              |                             |   |
| Date:   August  4, 2006 | By:                              | /s/ Nancy C. Broadbent |
|                              |                             | Nancy C.  Broadbent |
|                              |                             | Chief Financial  Officer (Principal |
|                              |                             | Financial and  Accounting Officer) |

 

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