** **

**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**Washington, DC 20549**

** **

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**FORM 10-Q**

** **

**(MARK ONE)**

 
| **x**                                                       | ** ** | **QUARTERLY REPORT  PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF  1934**  |
|-------------------------------------------------------------|------------|----------------------------------------------------------------------------------------------------------|
| ** **                                                  | ** ** | ** **                                                                                               |
| **For the quarterly period ended September 30,  2007** |
| ** **                                                  | ** ** | ** **                                                                                               |
| **o**                                                       | ** ** | **TRANSITION REPORT  PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF  1934** |

 

**For the transition period from    to    **

** **

**Commission File Number 0-28308**

** **

**CollaGenex Pharmaceuticals, Inc.**

(Exact Name ofRegistrant as Specified in Its Charter)

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

 

**(215) 579-7388**

(Registrant’sTelephone Number, Including Area Code)

 

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

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

 

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

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

 

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

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

 

Indicate the number ofshares outstanding of each of the issuer’s classes of common stock as of November 1,2007:

 
| Class                        | ** ** | **Number of Shares** |
|------------------------------|------------|----------------------|
| Common  Stock $.01 par value |       | 21,473,546           |

 

 

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**COLLAGENEXPHARMACEUTICALS, INC.**

 

**TABLEOF CONTENTS**

 
| PART I.    FINANCIAL  INFORMATION |                                                                                                                      |   |
|--------------------------------------------------|---------------------------------------------------------------------------------------------------------------------------|--------|
|                                             |                                                                                                                      |   |   |
| Item  1.                                         | Financial  Statements (unaudited)                                                                                         |   |   |
|                                             |                                                                                                                      |   |   |
|                                             | Condensed  Consolidated Balance Sheets as of September 30, 2007 (unaudited) and December 31,  2006              |   |   |
|                                             |                                                                                                                      |   |   |
|                                             | Condensed  Consolidated Statements of Operations for the Three Months Ended September 30,  2007 and 2006 (unaudited) |   |   |
|                                             |                                                                                                                      |   |   |
|                                             | Condensed  Consolidated Statements of Operations for the Nine Months Ended September 30,  2007 and 2006 (unaudited)  |   |   |
|                                             |                                                                                                                      |   |   |
|                                             | Condensed  Consolidated Statements of Cash Flows for the Nine Months Ended September 30,  2007 and 2006 (unaudited)  |   |   |
|                                             |                                                                                                                      |   |   |
|                                             | Notes  to Condensed Consolidated Financial Statements (unaudited)                                                         |   |   |
|                                             |                                                                                                                      |   |   |
| Item 2.                                          | Management’s Discussion and  Analysis of Financial Condition and Results of Operations                               |   |   |
|                                             |                                                                                                                      |   |   |
|                                             | Results of  Operations                                                                                                    |   |   |
|                                             |                                                                                                                      |   |   |
|                                             | Liquidity and Capital Resources                                                                                           |   |   |
|                                             |                                                                                                                      |   |   |
| Item 3.                                          | Quantitative  and Qualitative Disclosures About Market Risk                                                               |   |   |
|                                             |                                                                                                                      |   |   |
| Item 4.                                          | Controls and  Procedures                                                                                                  |   |   |
|                                             |                                                                                                                      |   |   |
| PART II.  OTHER INFORMATION                 |                                                                                                                      |   |
|                                             |                                                                                                                      |   |   |
| Item 1A.                                         | Risk Factors                                                                                                              |   |   |
|                                             |                                                                                                                      |   |   |
| Item 5.                                          | Other Information                                                                                                         |   |   |
|                                             |                                                                                                                      |   |   |
| Item 6.                                          | Exhibits                                                                                                                  |   |   |
|                                             |                                                                                                                      |   |   |
| SIGNATURES                                       |                                                                                                                      |   |

 

**CollaGenexPharmaceuticals, Inc. trademarks:**

 

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

 

Marks listed asregistered herein may be registered in the United States or in otherjurisdictions. All other trade names, trademarks or service marks appearing inthis Quarterly Report on Form 10-Q are the property of their respectiveowners and are not property of CollaGenex Pharmaceuticals, Inc. or any ofour subsidiaries.

 

2

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**COLLAGENEXPHARMACEUTICALS, INC.**

**ANDSUBSIDIARIES**

CondensedConsolidated Balance Sheets

September 30, 2007 and December 31,2006

(dollars in thousands, exceptshare data)

(unaudited)

 
| ** **                                                                                                                                                                                                                                                                                                                | ** ** | **September 30,** | ** ** | **December 31,** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------|------------|-----------------------|------------|
| ** **                                                                                                                                                                                                                                                                                                                | ** ** | **2007**               | ** ** | **2006**              | ** ** |
| **Assets**                                                                                                                                                                                                                                                                                                                |       |                   |       |                  |       |
| Current  assets:                                                                                                                                                                                                                                                                                                          |       |                   |       |                  |       |
| Cash and  cash equivalents                                                                                                                                                                                                                                                                                                |       | $                      | 31,344     |                  | $          | 46,493 |   |
| Short-term  investments                                                                                                                                                                                                                                                                                                   |       | 25,552                 |       | 19,337                |       |
| Accounts  receivable, net of allowances of $306 and $187 at September 30, 2007 and  December 31, 2006, respectively                                                                                                                                                                                             |       | 10,768                 |       | 6,071                 |       |
| Inventories                                                                                                                                                                                                                                                                                                               |       | 2,006                  |       | 1,959                 |       |
| Prepaid  expenses and other current assets                                                                                                                                                                                                                                                                                |       | 2,949                  |       | 2,416                 |       |
| Total  current assets                                                                                                                                                                                                                                                                                                     |       | 72,619                 |       | 76,276                |       |
| Equipment  and leasehold improvements, net                                                                                                                                                                                                                                                                                |       | 1,350                  |       | 1,008                 |       |
| Intangible  assets, net                                                                                                                                                                                                                                                                                                   |       | 1,582                  |       | 1,882                 |       |
| Other assets                                                                                                                                                                                                                                                                                                              |       | 43                     |       | 41                    |       |
| Total assets                                                                                                                                                                                                                                                                                                              |       | $                      | 75,594     |                  | $          | 79,207 |   |
| **Liabilities  and Stockholders’ Equity**                                                                                                                                                                                                                                                                            |       |                   |       |                  |       |
| Current  liabilities:                                                                                                                                                                                                                                                                                                     |       |                   |       |                  |       |
| Accounts  payable                                                                                                                                                                                                                                                                                                         |       | $                      | 5,590      |                  | $          | 9,066 |   |
| Accrued  expenses                                                                                                                                                                                                                                                                                                         |       | 8,541                  |       | 7,574                 |       |
| Total  current liabilities                                                                                                                                                                                                                                                                                                |       | 14,131                 |       | 16,640                |       |
| Deferred  licensing revenue                                                                                                                                                                                                                                                                                               |       | 5,300                  |       | —                |       |
| Other  non-current liabilities                                                                                                                                                                                                                                                                                            |       | 182                    |       | 265                   |       |
| Total  liabilities                                                                                                                                                                                                                                                                                                        |       | 19,613                 |       | 16,905                |       |
| Commitments  and contingencies (Notes 6 and 11)                                                                                                                                                                                                                                                                           |       |                   |       |                  |       |
| Stockholders’  equity (deficit):                                                                                                                                                                                                                                                                                     |       |                   |       |                  |       |
| Preferred  stock, $0.01 par value, 5,000,000 shares authorized, 200,000 shares of Series D-1  Cumulative Convertible Preferred Stock issued and outstanding at September 30,  2007 and December 31, 2006 (liquidation value of $20,000 at September 30,  2007 and $21,000 at December 31, 2006); |       | 2                      |       | 2                     |       |
|                                                                                                                                                                                                                                                                                                                      |       |                   |       |                  |       |
| 150,000  shares of Series A Participating Preferred Stock, designated and no  shares issued and outstanding at September 30, 2007 and December 31,  2006                                                                                                                                                   |       | —                 |       | —                |       |
|                                                                                                                                                                                                                                                                                                                      |       |                   |       |                  |       |
| Common  stock, $0.01 par value; 75,000,000 shares authorized and 21,472,646 and  21,191,724 shares issued and outstanding at September 30, 2007 and December 31,  2006, respectively                                                                                                                            |       | 215                    |       | 212                   |       |
| Additional  paid-in capital                                                                                                                                                                                                                                                                                               |       | 190,128                |       | 185,581               |       |
| Accumulated  other comprehensive income                                                                                                                                                                                                                                                                                   |       | 2                      |       | 7                     |       |
| Accumulated  deficit                                                                                                                                                                                                                                                                                                      |       | (134,366               | )          | (123,500              | )          |
| Total  stockholders’ equity                                                                                                                                                                                                                                                                                          |       | 55,981                 |       | 62,302                |       |
| Total  liabilities and stockholders’ equity                                                                                                                                                                                                                                                                          |       | $                      | 75,594     |                  | $          | 79,207 |   |

 

See accompanying notes tounaudited condensed consolidated financial statements.

 

3

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**COLLAGENEXPHARMACEUTICALS, INC.**

**ANDSUBSIDIARIES**

CondensedConsolidated Statements of Operations

For the Three Months Ended September 30,2007 and 2006

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

(unaudited)

 
| ** **                                                                                                        | ** ** | **Three Months Ended September 30,** | ** ** |
|-------------------------------------------------------------------------------------------------------------------|------------|----------------------------------------------------------|------------|
| ** **                                                                                                        | ** ** | **2007**                                                 | ** ** | **2006** | ** ** |
| Revenues:                                                                                                         |       |                                                     |       |   |   |
| Net product  sales                                                                                                |       | $                                                        | 15,559     |   | $ | 4,991 |   |
| Contract  revenues                                                                                                |       | 267                                                      |       | 419 |   |
| License  revenues                                                                                                 |       | 47                                                       |       | 12 |   |
| Grant  revenues                                                                                                   |       | 60                                                       |       | 211 |   |
| Total  revenues                                                                                                   |       | 15,933                                                   |       | 5,633 |   |
|                                                                                                              |       |                                                     |       |   |   |
| Operating  expenses:                                                                                              |       |                                                     |       |   |   |
| Cost of  product sales                                                                                            |       | 2,363                                                    |       | 1,326 |   |
| Research and  development                                                                                         |       | 4,475                                                    |       | 3,991 |   |
| Selling,  general and administrative                                                                              |       | 10,913                                                   |       | 10,594 |   |
| Total  operating expenses                                                                                         |       | 17,751                                                   |       | 15,911 |   |
| Operating  loss                                                                                                   |       | (1,818                                                   | )          | (10,278 | ) |
| Other income  (expense):                                                                                          |       |                                                     |       |   |   |
| Interest  income                                                                                                  |       | 772                                                      |       | 409 |   |
| Interest  expense                                                                                                 |       | (8                                                       | )          | (6 | ) |
| Net loss                                                                                                          |       | (1,054                                                   | )          | (9,875 | ) |
| Preferred  stock dividend                                                                                         |       | 550                                                      |       | 500 |   |
|                                                                                                              |       |                                                     |       |   |   |
| Net loss  allocable to common stockholders                                                                        |       | $                                                        | (1,604     | ) | $ | (10,375 | ) |
| Net loss per  basic and diluted share allocable to common stockholders                                            |       | $                                                        | (0.07      | ) | $ | (0.59 | ) |
| Weighted  average shares used in computing net loss per basic and diluted share  allocable to common stockholders |       | 21,444,702                                               |       | 17,541,225 |   |

 

See accompanying notes tounaudited condensed consolidated financial statements.

 

4

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**COLLAGENEX PHARMACEUTICALS, INC.**

**AND SUBSIDIARIES**

Condensed Consolidated Statements of Operations

For the Nine Months Ended September 30, 2007 and 2006

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

(unaudited)

 
| ** **                                                                                                        | ** ** | **Nine Months Ended September 30,** | ** ** |
|-------------------------------------------------------------------------------------------------------------------|------------|---------------------------------------------------------|------------|
| ** **                                                                                                        | ** ** | **2007**                                                | ** ** | **2006** | ** ** |
| Revenues:                                                                                                         |       |                                                    |       |   |   |
| Net product  sales                                                                                                |       | $                                                       | 45,534     |   | $ | 11,686 |   |
| Contract  revenues                                                                                                |       | 734                                                     |       | 1,040 |   |
| License  revenues                                                                                                 |       | 92                                                      |       | 44 |   |
| Grant  revenues                                                                                                   |       | 211                                                     |       | 377 |   |
| Total  revenues                                                                                                   |       | 46,571                                                  |       | 13,147 |   |
| Operating  expenses:                                                                                              |       |                                                    |       |   |   |
| Cost of  product sales                                                                                            |       | 6,855                                                   |       | 3,311 |   |
| Research and  development                                                                                         |       | 16,164                                                  |       | 10,587 |   |
| Selling,  general and administrative                                                                              |       | 35,703                                                  |       | 29,291 |   |
| Total  operating expenses                                                                                         |       | 58,722                                                  |       | 43,189 |   |
| Operating  loss                                                                                                   |       | (12,151                                                 | )          | (30,042 | ) |
| Other income  (expense):                                                                                          |       |                                                    |       |   |   |
| Interest  income                                                                                                  |       | 2,393                                                   |       | 1,444 |   |
| Interest  expense                                                                                                 |       | (24                                                     | )          | (6 | ) |
| Net loss                                                                                                          |       | (9,782                                                  | )          | (28,604 | ) |
| Preferred  stock dividend                                                                                         |       | 1,578                                                   |       | 1,428 |   |
|                                                                                                              |       |                                                    |       |   |   |
| Net loss  allocable to common stockholders                                                                        |       | $                                                       | (11,360    | ) | $ | (30,032 | ) |
| Net loss per  basic and diluted share allocable to common stockholders                                            |       | $                                                       | (0.53      | ) | $ | (1.72 | ) |
| Weighted  average shares used in computing net loss per basic and diluted share  allocable to common stockholders |       | 21,340,488                                              |       | 17,460,749 |   |

 

See accompanying notes tounaudited condensed consolidated financial statements.

 

5

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**COLLAGENEXPHARMACEUTICALS, INC.**

**ANDSUBSIDIARIES**

CondensedConsolidated Statements of Cash Flows

For the Nine Months Ended September 30,2007 and 2006

(dollars in thousands)

(unaudited)

 
| ** **                                                                   | ** ** | **Nine Months Ended September 30,** | ** ** |
|------------------------------------------------------------------------------|------------|---------------------------------------------------------|------------|
| ** **                                                                   | ** ** | **2007**                                                | ** ** | **2006** | ** ** |
| Cash flows  from operating activities:                                       |       |                                                    |       |   |   |
| Net loss                                                                     |       | $                                                       | (9,782     | ) | $ | (28,604 | ) |
| Adjustments  to reconcile net loss to net cash used in operating activities: |       |                                                    |       |   |   |
| Stock-based  compensation                                                    |       | 2,040                                                   |       | 2,528 |   |
| Write-down  of inventories                                                   |       | 37                                                      |       | 250 |   |
| Depreciation  and amortization expense                                       |       | 752                                                     |       | 453 |   |
| Accounts  receivable provisions                                              |       | 119                                                     |       | 98 |   |
| Charge for  in-process research and development                              |       | 2,182                                                   |       | 300 |   |
| Changes in  operating assets and liabilities:                                |       | —                                                  |       | — |   |
| Accounts  receivable                                                         |       | (4,816                                                  | )          | (6,382 | ) |
| Inventories                                                                  |       | (84                                                     | )          | (970 | ) |
| Prepaid  expenses and other current assets                                   |       | (535                                                    | )          | (769 | ) |
| Accounts  payable                                                            |       | (3,476                                                  | )          | 672 |   |
| Accrued  expenses                                                            |       | 1,892                                                   |       | 1,292 |   |
| Other  non-current liabilities                                               |       | (51                                                     | )          | 2,679 |   |
| Deferred  licensing revenue                                                  |       | 5,300                                                   |       | — |   |
| Net cash  used in operating activities                                       |       | (6,422                                                  | )          | (28,453 | ) |
| Cash flows  from investing activities:                                       |       |                                                    |       |   |   |
| Capital  expenditures                                                        |       | (740                                                    | )          | (386 | ) |
| Purchase of  in-process research and development                             |       | (2,182                                                  | )          | (200 | ) |
| Payment of  Oracea milestone fees                                            |       | —                                                  |       | (1,000 | ) |
| Purchase of  short-term investments                                          |       | (48,640                                                 | )          | (27,155 | ) |
| Sale or  maturity of short-term investments                                  |       | 42,420                                                  |       | 29,074 |   |
| Net cash  (used in) provided by investing activities                         |       | (9,142                                                  | )          | 333 |   |
| Cash flows  from financing activities:                                       | ** ** | ** **                                              | ** ** | ** ** | ** ** |
| Net proceeds  from issuance of common stock                                  |       | —                                                  |       | 11,594 |   |
| Net proceeds  from the exercise of stock options                             |       | 2,133                                                   |       | 1,734 |   |
| Net proceeds  from the exercise of common stock warrants                     |       | 376                                                     |       | — |   |
| Payment of  preferred dividends                                              |       | (2,028                                                  | )          | (1,827 | ) |
| Principal  payments on capital leases                                        |       | (66                                                     | )          | — |   |
| Net cash  provided by financing activities                                   |       | 415                                                     |       | 11,501 |   |
| Net decrease  in cash and cash equivalents                                   |       | (15,149                                                 | )          | (16,619 | ) |
| Cash and  cash equivalents at beginning of period                            |       | 46,493                                                  |       | 26,219 |   |
| Cash and  cash equivalents at end of period                                  |       | $                                                       | 31,344     |   | $ | 9,600 |   |
| Supplemental  disclosure of cash flow information:                           |       |                                                    |       |   |   |
| Cash paid  for interest                                                      |       | $                                                       | 24         |   | $ | 6 |   |
| Accrued  liability for capital leases                                        |       | $                                                       | 230        |   | $ | 263 |   |
| Accrued  liability for capitalized product development milestone fees        |       | $                                                       | —     |   | $ | 670 |   |
| Accrued  liability for in-process research and development                   |       | $                                                       | —     |   | $ | 100 |   |
| Reversal of  liability for UK income tax payable (see Note 1)                |       | $                                                       | 945        |   | $ | — |   |

 

See accompanying notes tounaudited condensed consolidated financial statements.

 

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**COLLAGENEXPHARMACEUTICALS, INC.AND SUBSIDIARIES**

 

**NOTESTO CONDENSED CONSOLIDATED FINANCIAL STATEMENTSSeptember 30, 2007 and 2006(dollars in thousands, except per share data)(unaudited)**

 

**Note1 — Basis of Presentation**

** **

The unaudited condensedconsolidated financial statements included herein have been prepared byCollaGenex Pharmaceuticals, Inc. and subsidiaries, or the Company,pursuant to the rules and regulations of the Securities and ExchangeCommission and in accordance with accounting principles generally accepted inthe United States of America, or U.S. GAAP. Certain information and footnotedisclosures normally included in the annual consolidated financial statementsprepared in accordance with U.S. GAAP, have been condensed or omitted pursuantto such rules and the regulations of the Securities and ExchangeCommission. These unaudited condensed consolidated financial statements shouldbe read in conjunction with the Company’s 2006 audited consolidated financialstatements and footnotes included in its Annual Report on Form 10-K forthe year ended December 31, 2006.

 

The accompanyingunaudited condensed consolidated financial statements include the results ofoperations of the Company and its majority-owned subsidiaries. All intercompanyaccounts and transactions have been eliminated in consolidation.

 

In the opinion of theCompany’s management, the accompanying unaudited condensed consolidatedfinancial statements have been prepared on a basis substantially consistentwith the audited consolidated financial statements for the year ended December 31,2006 and contain adjustments, all of which are of a normal, recurring naturenecessary to present fairly the Company’s consolidated financial position at September 30,2007, the results of operations for the three and nine months ended September 30,2007 and 2006, and the cash flows for the nine months ended September 30,2007 and 2006. Interim results are not necessarily indicative of resultsanticipated for the full fiscal year.

 

The preparation ofconsolidated financial statements in conformity with U.S. GAAP requiresmanagement to make estimates and assumptions that affect the amounts reportedin the consolidated financial statements and accompanying notes. Actual resultscould differ from those estimates.

 

***Net Product Sales***

*** ***

The Company generallyrecognizes revenues for product sales upon shipment to wholesale customers, netof estimated returns and estimates for chargebacks, sales discounts andapplicable wholesale distribution fees and rebates provided that collection isprobable and no significant obligations remained. However, following the launchof a third party generic competitor to Periostat® in May 2005 andcommencing with the second quarter of 2005, the Company began recognizingPeriostat sales revenue based on product sales to end-users. For all otherproducts sold, the Company records sales discounts, allowances, rebates andreturns upon the recognition of product sales. The Company only accepts returnsof damaged or expired products. The return allowance, when estimatable, isbased on an analysis of the historical returns of the product and the Companyconsiders current end user demand and wholesale and retail inventory levels. Ifproduct returns are not estimatable, the Company defers revenue recognition forall outstanding products in the wholesale and retail channel that are subjectto return. Chargebacks, wholesale distribution fees and rebates are based on ananalysis of the applicable agreements and historical experience. In addition,the Company also considers the volume and price of the product in the channel,trends in wholesaler and retailer inventory levels, conditions that mightaffect end-user demand (such as generic competition) and other relevantfactors.

 

The Company currentlyutilizes a patient rebate program for Oracea® prescriptions. The Company accountsfor these patient rebates as a reduction of net product sales.

 

7

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***Contract and LicenseRevenues***

*** ***

Non-refundable, up-frontcontract and license fees are deferred and amortized to revenue over therelated performance period. The Company estimates the performance period basedon the specific terms of each of the license or contract agreements. TheCompany recognizes periodic payments over the period that the Company performsthe related activities under the terms of the agreements. Revenue resultingfrom the achievement of milestone events stipulated in the agreements isrecognized when the milestone is achieved if reliable, verifiable andobjectively determinable evidence of fair value is established. If suchevidence of fair value cannot be established, the total revenue resulting fromany such agreement will be recognized over the total performance period of suchagreement.

 

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

 

***GrantRevenues***

 

During 2005, the Companyreceived a grant from the National Institutes of Health, or NIH, to fundadditional research by the Company and its collaborators on theanti-inflammatory effects of incyclinide. The Company expenses such researchexpenditures as they are incurred and recognizes grant revenue when earned forthe portion of the expenditures that are reimbursable by the NIH. The Companyrecognized $60 and $211 in grant revenues for the three and nine months ended September 30,2007 and $211 and $377 in grant revenues for the three and nine months ended September 30,2006.

 

***Research and Development***

*** ***

Research and product developmentcosts are expensed as incurred. Research and development expenses consistprimarily of personnel costs and funds paid to third parties for the provisionof services and materials for drug development, manufacturing and formulationenhancements, clinical trials (including clinical trials conducted after FDAapproval of a product), statistical analysis and report writing and regulatorycompliance costs, including governmental filing fees.

 

As described above, someof the Company’s research and development is conducted by third parties,including contract research and development service providers. At the end ofeach quarter, the Company compares the payments made to each service providerto the estimated progress toward completion of the research or developmentobjectives. Such estimates are subject to change as additional informationbecomes available. Depending on the timing of payments to the service providersand the progress that the Company estimates has been made as a result of theservice provided, the Company may record net prepaid or accrued expenserelating to these costs.

 

Costs to acquirein-process research and development projects and technologies which have notachieved technical feasibility at the date of acquisition are expensed as researchand development expense as incurred. The Company expensed $2,182 of in-processresearch and development for the nine months ended September 30, 2007 and$300 for the nine months ended September 30, 2006.

 

***Inventories***

*** ***

Inventories are stated atthe lower of cost or market. Cost is determined using the first-in, first-outmethod. Critical accounting estimates and assumptions related to inventorycarrying values are evaluated periodically and consider the saleable quantitiesof inventory versus quantities of inventory on-hand.

 

The Company classifiescosts relating to the manufacture of product inventory and samples in advanceof a new product launch as research and development expense until the productis approved by the Food and Drug Administration, or FDA. Following FDAapproval, the Company’s policy is to capitalize any inventory costs that werenot previously recognized as a research and development expense.

 

8

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***Stock-Based Compensation***

*** ***

The Company recognizesthe fair value of stock-based compensation awards in the Company’s consolidatedfinancial statements using the modified prospective method. The Company appliesthe Black-Scholes option pricing model to determine the fair value of stockoptions on the date of grant and estimates key assumptions that are importantelements in the model, such as the expected stock-price volatility and expectedstock option life. The Company’s estimates of these key assumptions andexpected forfeiture rates are based on historical data and judgment regardingmarket trends and factors. These estimates are not intended to predict actualfuture events or the value ultimately realized by individuals who receiveequity awards.

 

***Cash, Cash Equivalentsand Short-Term Investments***

*** ***

The Company considers allhighly liquid investments with an original maturity of three months or less atthe date of acquisition to be cash equivalents. Cash equivalent investments areheld at amortized cost, which approximates fair value. All short-terminvestments have original maturity dates of between three months and one year.The Company’s short-term investments are primarily composed of commercialpaper, certificates of deposit and government notes. At September 30,2007, all of the Company’s short-term investments, carried at fair value, wereclassified as available-for-sale with unrealized gains and losses included as aseparate component of stockholders’ equity.

 

The accumulated netunrealized gain on short-term investments at September 30, 2007 was $2.The accumulated net unrealized gain on short-term investments was $7 at December 31,2006. 

 
| ** **                       | ** ** | **Amortized** | ** ** | **Gross**                | ** ** | **Gross**                | ** ** | ** **          | ** ** |
|----------------------------------|------------|---------------|------------|--------------------------|------------|--------------------------|------------|---------------------|------------|
| **September 30, 2007** | ** ** | **Cost**      | ** ** | **unrealized gain** | ** ** | **unrealized loss** | ** ** | **Fair value** | ** ** |
| Certificates  of Deposit         |       | $             | 7,001      |                     | $          | —                   |       | $                   | (3         | ) | $ | 6,998 |   |
| U.S. Agency  Notes(1)            |       | 7,435         |       | 3                        |       | —                   |       | 7,438               |       |
| Commercial  Paper                |       | 11,114        |       | 2                        |       | —                   |       | 11,116              |       |
| Total                            |       | $             | 25,550     |                     | $          | 5                        |       | $                   | (3         | ) | $ | 25,552 |   |

 
| ** **                      | ** ** | **Amortized** | ** ** | **Gross**                | ** ** | **Gross**                | ** ** | ** **          | ** ** |
|---------------------------------|------------|---------------|------------|--------------------------|------------|--------------------------|------------|---------------------|------------|
| **December 31, 2006** | ** ** | **Cost**      | ** ** | **unrealized gain** | ** ** | **unrealized loss** | ** ** | **Fair value** | ** ** |
| Certificates  of Deposit        |       | $             | 7,196      |                     | $          | —                   |       | $                   | (1         | ) | $ | 7,195 |   |
| U.S. Agency  Notes(1)           |       | 10,351        |       | 7                        |       | —                   |       | 10,358              |       |
| Commercial  Paper               |       | 1,783         |       | 1                        |       | $                        | —     |                | 1,784      |   |
| Total                           |       | $             | 19,330     |                     | $          | 8                        |       | $                   | (1         | ) | $ | 19,337 |   |

 

----

(1) U.S.Agency notes are comprised of Fannie Mae, Freddie Mac, Farmer Mac, Federal FarmCredit and Federal Home Loan bank. If held to maturity, these holdings allowthe issuer to settle the securities at a price no less than the amortized cost.

 

***Accounting Change***

*** ***

On January 1, 2007,the Company adopted the Financial Accounting Standards Board, or FASB,Interpretation No. 48, *Accounting for Uncertaintyin Income Taxes,* or FIN 48. FIN 48 clarifies the accounting foruncertainty in income taxes recognized in an enterprise’s financial statementsin accordance with SFAS No. 109, *Accounting for IncomeTaxes*. FIN 48 prescribes a recognition threshold and measurement forfinancial statement recognition and measurement of a tax position reported orexpected to be reported on a tax return. FIN 48 also provides guidance onderecognition, classification, interest and penalties, accounting in interimperiods, disclosure, and transition. Prior to the adoption of FIN 48, theCompany’s policy was to recognize tax benefits of uncertain tax positions onlyif it was “probable” that the position would be sustained. FIN 48 requiresapplication of a “more likely than not” threshold to the recognition andderecogntion of tax positions. As a result of the adoption of FIN 48, retainedearnings increased in the amount of $945 and accrued expenses decreased by thesame amount as of January 1, 2007 (see Note 10).

 

9

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The Company and itssubsidiaries file income tax returns in the U.S. federal jurisdiction and invarious states. The Company has tax net operating loss and credit carryforwardsthat are subject to examination for a number of years beyond the year in whichthey are utilized for tax purposes. Since a portion of these carryforwards willbe utilized in the future, many of these attribute carryforwards may remainsubject to examination. The Company’s policy is to record interest andpenalties on uncertain tax positions as income tax expense. At September 30,2007, the Company has no amounts recorded for uncertain tax positions, interestor penalties in the accompanying consolidated financial statements.

 

***Recently IssuedAccounting Pronouncements***

*** ***

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

 

In February 2007,the FASB issued SFAS No.159, *The Fair Value forFinancials Assets and Financial Liabilities or* SFAS No. 159. SFASNo. 159 permits entities to choose to measure financial assets andliabilities, with certain exceptions, at fair value at specified election dates.A business entity shall report unrealized gains and losses on items for whichthe fair value option has been elected in earnings at each subsequent reportingdate. SFAS No. 159 is effective as of the beginning of an entity’s firstfiscal year that begins after November 15, 2007. The Company is currentlyevaluating the impact, if any, SFAS No. 159 will have on its consolidatedfinancial statements.

 

In June 2007, theEmerging Issues Task Force (“EITF”) reached a final consensus on EITF Issue No.07-3, “Accounting for Nonrefundable Advance Payments for Goods or Services toBe Used in Future Research and Development Activities” (“EITF 07-3”). EITF 07-3is effective for fiscal years beginning after December 15, 2007.  EITF 07-3 requires that non-refundableadvance payments for future research and development activities should becapitalized until the goods have been delivered or related services have beenperformed.  Adoption is on a prospectivebasis and could impact the timing of expense recognition for agreements enteredinto after December 31, 2007.  TheCompany does not expect the adoption of EITF 07-3 to have a significant impacton the consolidated financial statements.

 

**Note2 — Concentration of Credit and Segment Information**

** **

The Company invests itsexcess cash in money market funds with major U.S. financial institutions,commercial paper, certificates of deposit and government notes, based on itsinvestment guidelines designed to protect the safety and liquidity of theseinvestments.

 

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

 

As indicated in the tablebelow, three customers accounted for 92% and 87%, respectively of net productsales for the three months ended September 30, 2007 and 2006. The samethree customers accounted for 91% and 88% of net product sales during the ninemonths ended September 30, 2007 and 2006.

 
| ** **        | ** ** | **% of Net Product Sales** | ** ** |
|-------------------|------------|------------------------------------------------|------------|
| ** **        | ** ** | **Three Months Ended**               | ** ** |
| ** **        | ** ** | **September 30,**                         | ** ** |
| **Customer**      | ** ** | **2007**                                       | ** ** | **2006** | ** ** |
| Cardinal  Health  |       | 40                                             | %          | 42 | % |
| McKesson          |       | 39                                             | %          | 33 | % |
| AmerisourceBergen |       | 13                                             | %          | 12 | % |
| Total             |       | 92                                             | %          | 87 | % |

 
| ** **        | ** ** | **% of Net Product Sales** | ** ** |
|-------------------|------------|------------------------------------------------|------------|
| ** **        | ** ** | **Nine Months Ended**                | ** ** |
| ** **        | ** ** | **September 30,**                         | ** ** |
| **Customer**      | ** ** | **2007**                                       | ** ** | **2006** | ** ** |
| Cardinal  Health  |       | 42                                             | %          | 46 | % |
| McKesson          |       | 36                                             | %          | 29 | % |
| AmerisourceBergen |       | 13                                             | %          | 13 | % |
| Total             |       | 91                                             | %          | 88 | % |

 

10

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As indicated in the table below threecustomers accounted for 94% of gross trade accounts receivable balance at September 30,2007 and at December 31, 2006.

 
| ** **        | ** ** | **% of Gross Trade Accounts** | ** ** |
|-------------------|------------|---------------------------------------------------|------------|
| ** **        | ** ** | **Receivable Balance at**               | ** ** |
| ** **        | ** ** | **September 30,**                            | ** ** | **December 31,** | ** ** |
| **Customer**      | ** ** | **2007**                                          | ** ** | **2006** | ** ** |
| Cardinal  Health  |       | 46                                                | %          | 58 | % |
| McKesson          |       | 39                                                | %          | 29 | % |
| AmerisourceBergen |       | 9                                                 | %          | 7 | % |
| Total             |       | 94                                                | %          | 94 | % |

 

The Company operates asone business that is managed by a single management team reporting to the chiefexecutive officer. The Company does not prepare discrete financial informationwith respect to separate product or product candidate areas or by location anddoes not have separately reportable segments. During each of the three and ninemonths ended September 30, 2007 and 2006, the Company’s total net revenueswere comprised of the following:

 
| ** **         | ** ** | **Three Months Ended** | ** ** |
|--------------------|------------|----------------------------------|------------|
| ** **         | ** ** | **September 30,**           | ** ** |
| ** **         | ** ** | **2007**                         | ** ** | **2006** | ** ** |
| Oracea             |       | 82                               | %          | 40 | % |
| Other  dermatology |       | 10                               | %          | 27 | % |
| Dental             |       | 7                                | %          | 30 | % |
| Grant  revenue     |       | 1                                | %          | 3 | % |
| Total              |       | 100                              | %          | 100 | % |

 
| ** **         | ** ** | **Nine Months Ended** | ** ** |
|--------------------|------------|---------------------------------|------------|
| ** **         | ** ** | **September 30,**          | ** ** |
| ** **         | ** ** | **2007**                        | ** ** | **2006** | ** ** |
| Oracea             |       | 80                              | %          | 17 | % |
| Other  dermatology |       | 11                              | %          | 34 | % |
| Dental             |       | 9                               | %          | 46 | % |
| Grant  revenue     |       | —                          | %          | 3 | % |
| Total              |       | 100                             | %          | 100 | % |

 

**Note3 — Stock-Based Compensation**

** **

At September 30,2007, the Company had one active stock-based employee compensation plan. Stockoption awards to employees are granted with an exercise price equal to the fairmarket value of the Company’s common stock on the date of grant. The optionawards typically have a term of ten years and generally vest over a periodranging from two to five years. Certain options are subject to acceleratedvesting if there is a change in control (as defined in the plan and change ofcontrol agreements, if applicable).

 

Stock-based compensationfor the three and nine months ended September 30, 2007 and 2006 are asfollows:

 

11

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| ** **                           | ** ** | **Three Months Ended** | ** ** |
|--------------------------------------|------------|----------------------------------|------------|
| ** **                           | ** ** | **September 30,**           | ** ** |
| ** **                           | ** ** | **2007**                         | ** ** | **2006** | ** ** |
| Research and  development            |       | $                                | 139        |   | $ | 111 |   |
| Selling,  general and administrative |       | 579                              |       | 739 |   |
| Total                                |       | $                                | 718        |   | $ | 850 |   |

 
| ** **                           | ** ** | **Nine Months Ended** | ** ** |
|--------------------------------------|------------|---------------------------------|------------|
| ** **                           | ** ** | **September 30,**          | ** ** |
| ** **                           | ** ** | **2007**                        | ** ** | **2006** | ** ** |
| Research and  development            |       | $                               | 383        |   | $ | 317 |   |
| Selling,  general and administrative |       | 1,657                           |       | 2,211 |   |
| Total                                |       | $                               | 2,040      |   | $ | 2,528 |   |

 

No amount of stock-basedcompensation cost has been capitalized into inventory or other assets duringthe three and nine months ended September 30, 2007 and 2006.

 

Certain options grantedin 2003 have been amortized at an accelerated rate versus the contractualvesting period of such options as these options are performance-based and itwas anticipated that the performance criteria would be met prior tostraight-line vesting. Such options were fully amortized at December 31,2006.

 

In May 2006, theCompany accelerated the vesting of certain options held by a former member ofthe Company’s Board of Directors. Accordingly, a charge of $92 was recordedduring the nine months ended September 30, 2006 to reflect the fair valueof such options on the date of modification.

 

The following tablesummarizes activity under all stock option plans. 

 
| ** **                                                                      | ** ** | **Nine Months Ended** | ** ** |
|---------------------------------------------------------------------------------|------------|---------------------------------|------------|
| ** **                                                                      | ** ** | **September 30,**          | ** ** |
| **(dollars in thousands, except per share data)** | ** ** | **2007**                        | ** ** | **2006** | ** ** |
| Weighted-average  fair value of options granted per share                       |       | $                               | 8.55       |   | $ | 7.70 |   |
| Intrinsic  value of options exercised                                           |       | $                               | 1,132      |   | $ | 795 |   |

 

At September 30,2007, the value of the unvested portion of all outstanding stock-related awardswas $7,617 which the Company expects to amortize and recognize as compensationexpense over the weighted-average service period of approximately two years.

 

The amount of cashreceived during the nine months ended September 30, 2007 and 2006 from theexercise of options was $2,133 and $1,734, respectively. No related tax benefitfrom the exercise of such options was realized as a result of the Company’s netoperating loss carryforwards and full valuation allowance.

 

The Company received $376in cash during the nine months ended September 30, 2007 as a result of theexercise of 40,000 warrants on June 28, 2007. As of September 30,2007, the Company had no outstanding warrants.

 

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

 

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

 

12

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| ** **               | ** ** | **Three Months Ended** | ** ** |
|--------------------------|------------|----------------------------------|------------|
| ** **               | ** ** | **September 30,**           | ** ** |
| ** **               | ** ** | **2007**                         | ** ** | **2006** | ** ** |
| Expected  life in years  |       | 6.50                             |       | 6.50 |   |
| Risk-free interest  rate |       | 4.43                             | %          | 4.77 | % |
| Volatility               |       | 56.77                            | %          | 65.00 | % |
| Expected  dividend yield |       | —                           |       | — |   |

 
| ** **               | ** ** | **Nine Months Ended** | ** ** |
|--------------------------|------------|---------------------------------|------------|
| ** **               | ** ** | **September 30,**          | ** ** |
| ** **               | ** ** | **2007**                        | ** ** | **2006** | ** ** |
| Expected  life in years  |       | 6.50                            |       | 6.50 |   |
| Risk-free  interest rate |       | 4.66                            | %          | 4.63 | % |
| Volatility               |       | 61.15                           | %          | 68.90 | % |
| Expected  dividend yield |       | —                          |       | — |   |

 

Stock optionactivity during the nine months ended September 30, 2007 was as follows: 

 
| ** **                              | ** ** | ** **         | ** ** | **Weighted**            | ** ** | **Average**           | ** ** | ** **         | ** ** |
|-----------------------------------------|------------|--------------------|------------|-------------------------|------------|-----------------------|------------|--------------------|------------|
| ** **                              | ** ** | ** **         | ** ** | **Average**             | ** ** | **Remaining**         | ** ** | **Aggregate**      | ** ** |
| ** **                              | ** ** | **Number of** | ** ** | **Exercise Price** | ** ** | **Contractual**       | ** ** | **Intrinsic**      | ** ** |
| ** **                              | ** ** | **Shares**         | ** ** | **per Share**      | ** ** | **Term (years)** | ** ** | **Value (1)** | ** ** |
| Outstanding  at December 31, 2006  |       | 3,478,590          |       | $                       | 9.69       |                  |       |               |       |   |
| Options  granted                        |       | 498,710            |       | 13.58                   |       |                  |       |               |       |
| Options  exercised                      |       | (240,922           | )          | 8.85                    |       |                  |       |               |       |
| Options  forfeited or cancelled         |       | (54,403            | )          | 12.70                   |       |                  |       |               |       |
| Outstanding  at September 30, 2007 |       | 3,681,975          |       | $                       | 10.23      |                  | 6.07       |               | $          | 4,602 |   |
| Unvested at September 30,  2007    |       | 1,453,598          |       | $                       | 10.75      |                  | 8.22       |               | $          | 2,574 |   |
| Exercisable  at September 30, 2007 |       | 2,228,377          |       | $                       | 9.89       |                  | 4.66       |               | $          | 2,028 |   |

 

----

(1)             The aggregateintrinsic value was calculated based on the positive difference between theclosing sales price of the Company’s common stock ($8.98 per share) on September 28,2007 and the exercise prices of the underlying options.

 

**Note 4 —Inventories**

 

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

 
| ** **        | ** ** | **September 30,** | ** ** | **December 31,** | ** ** |
|-------------------|------------|------------------------|------------|-----------------------|------------|
| ** **        | ** ** | **2007**               | ** ** | **2006**              | ** ** |
| Raw  materials    |       | $                      | 838        |                  | $          | 978 |   |
| Work in  processs |       | 227                    |       | 339                   |       |
| Finished  goods   |       | 941                    |       | 642                   |       |
| Total             |       | $                      | 2,006      |                  | $          | 1,959 |   |

 

The Company recorded acharge of $37 to cost of product sales related to excess inventories of theAtrix and Pandel products during the three months ended September 30, 2007.During the three and nine months ended September 2006, the Companyrecorded a charge to cost of product sales of $160 and $250 related to excessinventories. During the three months ended September 30, 2007, the Companyrecorded a charge of $180 to cost of product sales related to validation costsfrom the manufacturer of the Company’s inventory.

 

13

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**Note5— Intangible Assets, Net**

** **

Intangible assets, net atSeptember 30, 2007 and December 31, 2006 consist of the following:

 
| ** **                          | ** ** | **September 30,** | ** ** | **December 31,** | ** ** |
|-------------------------------------|------------|------------------------|------------|-----------------------|------------|
| ** **                          | ** ** | **2007**               | ** ** | **2006**              | ** ** |
| Oracea  milestone fees              |       | $                      | 1,670      |                  | $          | 1,670 |   |
| Accumulated  amortization           |       | (139                   | )          | (56                   | )          |
| Oracea  milestone fees, net         |       | $                      | 1,531      |                  | $          | 1,614 |   |
| Atrix  acquired product rights      |       | $                      | 1,876      |                  | $          | 1,876 |   |
| Accumulated  amortization           |       | (1,825                 | )          | (1,608                | )          |
| Atrix  acquired product rights, net |       | $                      | 51         |                  | $          | 268 |   |
| Total  intangible assets, net       |       | $                      | 1,582      |                  | $          | 1,882 |   |

 

In August 2001, theCompany signed a license agreement with Atrix Laboratories, Inc. (nowknown as Tolmar Inc., a subsidiary of Technofarma, S.A.), for the rights tomarket Atridox®, Atrisorb FreeFlow® and Atrisorb-D®in the United States. On May 14, 2007, the Company received written noticeof termination effective November 14, 2007 of the Company’s LicenseAgreement with Tolmar Inc. The amortization of acquired product rights has beenadjusted to coincide with the termination date of the contract.

 

Oracea milestone feesrepresent the unamortized component of Oracea formulation milestones paidpost-FDA approval of Oracea and are being amortized on a straight-line basisover a fifteen year period commencing in July 2006.

 

Amortization expense,which is included in cost of product sales, was $105 and $300 for the three andnine months ended September 30, 2007 and $83 and $284 for the three andnine months ended September 30, 2006.

 

**Note6 — Line of Credit**

** **

On October 9, 2006,the Company entered into a Sixth Loan Modification Agreement with SiliconValley Bank. Pursuant to the terms of this agreement, the expiration date ofthe amended credit facility has been extended to October 9, 2008. Underthe amended credit facility, the Company may borrow up to the lesser of (i) $10,000or (ii) 80% of eligible receivables plus certain specified amounts,subject to reduction during the period October 9, 2006 through December 31,2007. The amount available to the Company is reduced by any outstanding lettersof credit that may be issued under the amended credit facility in amountstotaling up to $2,000. As the Company pays down amounts under any letter ofcredit, the amount available to it under the credit facility increases. TheCompany is not obligated to draw down any amounts under the amended creditfacility and any borrowings shall bear interest, payable monthly, at SiliconValley Bank’s prime rate, or 7.75%, at September 30, 2007. Under the SixthLoan Modification Agreement, the Company is charged an unused line credit feeof 0.25% per annum. In addition, under the amended credit facility, the Companyis subject to financial covenants that require the Company to maintain certainminimum liquidity and tangible net worth levels on a quarterly basis. Duringthe nine months ended September 30, 2007 and 2006, the Company’s unusedline of credit fee was $45 and $18, respectively. As of September 30, 2007the Company had no borrowings outstanding.

 

14

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**Note7— Contract and License Revenues**

** **

The Company recordedcontract and license revenues of $314 and $826 for the three and nine months,ended September 30, 2007, respectively, and $431 and $1,084 for the threeand nine months ended September 30, 2006, respectively. In June 2005,the Company entered into the Promotion Agreement with Primus, under which theCompany promotes Alcortin, a prescription topical antifungal steroidcombination, and Novacort, a prescription topical steroid and anesthetic. Underthe Promotion Agreement, the Company receives a percentage of the gross profitarising from prescriptions written by dermatology professionals (or offices)that result in sales of the products in the United States. Through June 30,2006, the majority of marketing expenses, excluding sales force compensationand sample product costs, related to the promotion of the Primus products werefunded by Primus and the majority of product sample costs and all sales forcecompensation were funded by the Company. Effective July 1, 2006, the Companyand Primus amended the Promotion Agreement. As a result of the amendment,sample expenses and marketing costs, excluding sales force compensation, arefunded 60% by the Company and 40% by Primus.

 

On December 18,2006, the Company executed a License and Supply Agreement with MediGene AG, orMediGene, a corporation existing under the laws of Germany, that becameeffective on January 1, 2007. Under this agreement, MediGene has the rightto manufacture, register, market and sell Oracea in the European Union, certaincontiguous countries and Russia. MediGene may exercise its right tomanufacture Oracea at any time during the term of the agreement upon twelvemonths notice to the Company. During the nine months ended September 30,2007, the Company classified the up front non-refundable fee of $5,000 asnon-current deferred licensing revenue. In accordance with the Company’s revenue recognition policy, the Companywould begin amortizing this deferred revenue to revenue over the term of theagreement once EU approval for Oracea has been received. Additionally,the Company may be entitled to an additional $7,500 in milestone paymentsupon the achievement of certain annual sales thresholds achieved by MediGene.In addition, the Company will receive an agreed upon transfer price and aroyalty of 12% of annual net sales up to $10,000 and 15% of annual net sales inexcess of $10,000 in the specified territories. The Company’s application forEuropean marketing authorization for Oraceawas recently referred to the Committee for Medicinal Products for Human Use, orCHMP. Referral to the CHMP may be a lengthy process and the Company cannotpredict when, or if, this body will approve the Company’s application.

 

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

 

**Note8 — Legal Proceedings**

** **

The Company is involvedin, or has been involved in, arbitrations or various other legal proceedingsthat arise from the normal course of business. The Company cannot predict thetiming or outcome of these claims and other proceedings. At September 30,2007, the Company is not involved in any arbitration and/or other legal proceedingsthat it expects to have a material adverse effect on the business, financialcondition, results of operations or liquidity of the Company. All legal costsare expensed as incurred.

 

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

** **

Under the Company’slicense agreement with The State University of New York at Stony Brook, orSUNY, covering Periostat and Oracea, the Company is entitled to deduct costsincurred to defend its patents from current and future royalties due to SUNY onnet sales of Oracea and Periostat. The cumulative legal patent defense,litigation and settlement costs incurred during the litigation period through September 30,2007 currently exceeds the amount of the royalties earned by SUNY, since theinception of litigation, by $2,902. This excess amount, which has beenpreviously expensed, may be available to offset future royalties earned bySUNY, if any, on sales of products based on the SUNY technology. The Companyrecorded $215 and $764 in product royalty expense and credited legal expensefor $215 and $764 related to previously expensed legal fees for the three andnine months ended September 30, 2007. Accordingly, $215 and $764 werededucted from royalty payments earned by SUNY during the three and nine monthsended September 30, 2007. The 

 

15

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Company recorded$183 and $335 in product royalty expense and credited legal expense for $183and $335 related to previously expensed legal fees for the three and ninemonths ended September 30, 2006. Accordingly, $183 and $335 were deductedfrom royalty payments earned by SUNY during the three and nine months ended September 30,2006.

 

**Note 10 —Accrued Expenses**

 

Accrued expenses at September 30, 2007 and December 31,2006 consist of the following: 

 
| ** **                                | ** ** | **September 30,** | ** ** | **December 31,** | ** ** |
|-------------------------------------------|------------|------------------------|------------|-----------------------|------------|
| ** **                                | ** ** | **2007**               | ** ** | **2006**              | ** ** |
| Research and  development costs           |       | $                      | 2,215      |                  | $          | 1,257 |   |
| Payroll and  related costs                |       | 2,242                  |       | 3,041                 |       |
| Sales and  marketing costs                |       | 1,277                  |       | 786                   |       |
| Product  returns                          |       | 1,490                  |       | 996                   |       |
| Patient  rebates                          |       | 435                    |       | 78                    |       |
| Government  rebates and distribution fees |       | 129                    |       | 80                    |       |
| Managed Care  rebates                     |       | 280                    |       | —                |       |
| Professional  and consulting fees         |       | 190                    |       | 132                   |       |
| State and  franchise taxes                |       | 158                    |       | 161                   |       |
| Foreign  taxes (1)                        |       | —                 |       | 945                   |       |
| Other                                     |       | 125                    |       | 98                    |       |
| Total                                     |       | $                      | 8,541      |                  | $          | 7,574 |   |

 

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(1)             In November 2004,the Company sold its U.K. and European dental assets to Alliance Pharma plc, aU.K. specialty pharmaceuticals company. As part of this sale in 2004, theCompany recorded a liability of $945 within accrued expenses for anticipatedU.K. income taxes due on this sale. As described in Note 1, the Company adoptedFIN 48 on January 1, 2007. As a result of the adoption, this liability wasreversed on January 1, 2007, as the threshold for this tax uncertainty wasabove more-likely-than not. On January 19, 2007, the Company received anotice from the U.K. taxing authorities stating that no amendments were neededto the Company’s previously filed tax return. Accordingly, no additional incometaxes were due related to this transaction.

 

**Note 11 — Commitments**

 

On July 17, 2007, the Company entered into acapital lease for certain telecommunication equipment. The lease term isthirty-six months with annual payments of $22. At September 30, 2007, thegross amount of equipment related to this capital lease amounted to $54.

 

**Note 12 — Common Stock Offering**

 

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

 

16

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**Item2.**           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 may predictor anticipate future business or financial results. There are important factorsthat could cause our actual results to differ materially from those indicated.See “Part II, Item 1A., Risk Factors.”

 

**Overview**

** **

CollaGenexPharmaceuticals, Inc. and subsidiaries is a specialty pharmaceuticalcompany currently focused on developing and marketing innovative proprietarymedical therapies to the dermatology market. We currently market fourprescription pharmaceutical products to the dermatology market through ourprofessional dermatology sales force and generate revenues from four otherprescription pharmaceutical products that we continue to sell to the dentalmarket. In May 2006, the U.S. Food and Drug Administration, or the FDA,granted us marketing approval for Oracea® for the treatment of inflammatory lesions (papules andpustules) of rosacea in adult patients. Oracea is the first FDA approved,orally-administered, systemically-delivered drug to treat rosacea. In July 2006,we launched Oracea to the U.S. dermatology community.

 

Our strategy is to becomea leading developer and marketer of innovative prescription pharmaceuticalproducts 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 leaddevelopment candidates are: COL-118, a topical compound that we are developingfor the treatment of erythema (skin redness) associated with dermatologicalconditions. We recently reported favorable results from a Phase II clinicaltrial of this compound and we are in discussions with FDA concerning theconclusion of Phase II and the design and timing of Phase III clinical trials,which we expect to initiate in the middle of 2008; becocalcidiol, arecently licensed vitamin D analogue for the topical treatment of psoriasis;and Restoraderm®, a foam-based, topical dermal drug delivery system, which iscurrently in formulation development.

 

Our marketed dermatologyproducts are: Oracea; Pandel®, a prescription corticosteroid we licensed in2002 from Altana Inc., a member of the Nycomed Group; AlcortinTM, a prescriptiontopical antifungal steroid combination; and NovacortTM, a prescription topicalsteroid and anesthetic. In June 2005, we executed a Promotion andCooperation Agreement with Primus Pharmaceuticals Inc., or Primus, to marketAlcortin and Novacort to dermatologists. On February 1, 2007, we receivedwritten notice of termination of the Sublicense Agreement relating to Pandel. EffectiveNovember 1, 2007, we will no longer generate sales from the Pandelproduct.

 

Our original dental product,Periostat®, is an orally-administered, prescription pharmaceutical product thatwas approved by the FDA in September 1998 for the treatment of adultperiodontitis. On May 20, 2005, we terminated our dental sales force andpromotional activities for Periostat following the introduction of a thirdparty generic version of the product. We also discontinued the promotion of ourother dental products on May 20, 2005. We continue to generate sales fromPeriostat and three other dental products, which include Atridox®, AtrisorbFreeFlow® and Atrisorb-D®, also referred to as the Atrix Products, each ofwhich is licensed from Tolmar Inc., a subsidiary of Tecnofarma, S.A. Effective November 14,2007, our License Agreement with Tolmar, Inc. will terminate and we willno longer generate sales from the Atrix Products.

 

In addition to ourmarketed products, we have a pipeline of product candidates in clinical andpreclinical development. These products are based on our proprietary platform technologies,SansRosa® and Restoraderm, or are licensed from third parties.

 

We were founded in 1992and completed an initial public offering of our common stock in 1996. Althoughwe achieved net income for the years ended December 31, 2004, 2003 and2002, we have incurred losses in every other year since inception and have anaccumulated deficit of $134.4 million at September 30, 2007. We do notexpect to generate a profit for the year ending December 31, 2007.

 

**Our Technology**

** **

IMPACSTM(Inhibitors of Multiple Proteases And CytokineS) are a group of compounds thatdemonstrate a range of anti-inflammatory activities as well as the ability toinhibit the breakdown of connective tissue. Periostat and Oracea are our firstFDA-approved IMPACS products. Our IMPACS technology is licensed on a perpetualbasis from the Research 

 

17

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Foundation of the StateUniversity of New York at Stony Brook, or SUNY. SUNY also conducts research anddevelopment on other potential applications of this technology on a projectbasis.

 

Our SansRosa technology,which we acquired in connection with the acquisition of SansRosa PharmaceuticalDevelopment Inc., or SansRosa, in December 2005,****is a class of compounds that have shown promise inreducing the redness associated with rosacea, and we intend to formulate anddevelop a topical treatment for erythema based on one or more of thesecompounds.

 

Our Restoradermtechnology is a proprietary, foam-based, topical drug delivery technology thatoriginated from a Swedish collaborator. We have acquired all rights, title andinterest to the Restoraderm technology. We have formulated various prescriptionand over the counter products based on the Restoraderm technology. We do notcurrently have a timetable for either the initiation of clinical development orthe launch of any Restoraderm products.

 

Our becocalcidiol productcandidate uses technology covered by various patents and patent applicationslicensed from QuatRx Pharmaceuticals Company, or QuatRx, pursuant to a Sub-LicenseAgreement, or the Sub-License Agreement.

 

**SignificantRecent Developments**

 

On August 23, 2007,we announced results of a Phase II dose-finding study designed to evaluate thesafety and efficacy of COL-118 for the treatment of erythema. The Phase II clinicalstudy demonstrated a highly statistically significant dose-responserelationship of COL-118 in the reduction of erythema with a side effect profilesimilar to placebo. We are in discussions with FDA concerning the conclusion ofPhase II and the design and timing of Phase III clinical trials, which weexpect to initiate in the middle of 2008.

 

On March 29, 2007,we announced that we had commenced enrollment of patients in a 40 mg cohort ofour Phase II double-blinded, placebo-controlled, dose-finding clinical trial todetermine the appropriate dose for Phase III testing of incyclinide in thetreatment of acne. On May 2, 2007, we learned that one patient hadexperienced apparent significant photo-toxicity, a known side effect oftetracyclines, while participating in the 40 mg cohort and we suspendedenrollment of all new patients in this study. On May 7, 2007, we learnedof another patient who had experienced apparent photo-toxicity and we announcedthat we had discontinued treatment of all enrolled patients.

 

On September 26,2007, we announced results of a Phase II dose-finding study designed toevaluate the safety and determine the therapeutic range of incyclinide for thetreatment of rosacea. The study demonstrated that incyclinide was welltolerated with most adverse events being mild to moderate. However, thepatients administered incyclinide did not demonstrate greater reduction ininflammatory lesions than the patients on placebo at any time point during thestudy and we discontinued all development work on incyclinide for a rosaceaindication.

 

On November 6, 2007,we announced that, following a detailed cost, benefit and risk analysis in thefourth quarter of 2007, we had decided to discontinue all development work onincyclinide for an acne indication in order to focus our resources and energieson those projects in our pipeline that we believe have the greatest potential.

 

18

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**Results of Operations**

** **

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

 

**Revenues**

** **
| **Revenues**                         | ** ** | ** ** | ** ** | ** ** | ** ** | **Change** | ** ** |
|--------------------------------------|------------|------------|------------|------------|------------|------------|------------|
| **(dollars in thousands)** | ** ** | **2007**   | ** ** | **2006**   | ** ** | **$**      | ** ** | **%** | ** ** |
| Net Oracea  Product Sales            |       | $          | 13,080     |       | $          | 2,236      |       | $ | 10,844 |   | 485.0 | % |
| Other Net  Product Sales             |       | 2,479      |       | 2,755      |       | (276       | )          | (10.0 | )% |
| Total Net  Product Sales             |       | 15,559     |       | 4,991      |       | 10,568     |       | 211.7 | % |
| Contract  Revenues                   |       | 267        |       | 419        |       | (152       | )          | (36.3 | )% |
| License  Revenues                    |       | 47         |       | 12         |       | 35         |       | 291.7 | % |
| Grant  Revenue                       |       | 60         |       | 211        |       | (151       | )          | (71.6 | )% |
| Total  Revenues                      |       | $          | 15,933     |       | $          | 5,633      |       | $ | 10,300 |   | 182.9 | % |

 

During the three monthsended September 30, 2007, total net product sales which included net salesof Oracea, Pandel, Periostat and the Atrix Products, increased $10.6 million,or 211.7%, as compared to the three months ended September 30, 2006, dueprimarily to sales from Oracea, which was launched in July 2006. Netrevenues from dermatological products were 92.3% of total net revenues in thethree months ended September 30, 2007 compared to 66.3% for the threemonths ended September 30, 2006. Total deductions from gross sales forestimated product returns, trade cash discounts, managed care rebates,government and patient rebates and wholesale distribution fees for Oracea wereapproximately 14.7% of gross sales during the three months ended September 30,2007 compared to 37.8% during the three months ended September 30, 2006.Prescriptions for Oracea as reported by an independent industry data sourcewere approximately 100,504 during the three months ended September 30,2007, representing a 252% increase in prescriptions compared to 28,545prescriptions during the three months ended September 30, 2006. At September 30,2007, Oracea wholesaler inventory level was approximately 4.1 weeks of sales ascompared to approximately 3.3 weeks of sales at June 30, 2007.

 

Effective November 1,2007, our Sublicense Agreement with Altana Inc., will terminate and we will nolonger generate other net product sales from the Pandel product. Effective November 14,2007, our License Agreement with Tolmar, Inc. will terminate and we willno longer generate sales from the Atrix Products.

 

**Cost ofProduct Sales**

 

Cost of productsales for the three months ended September 30, consist of the following:

 
| **Cost of Product Sales** | ** ** | ** ** | ** ** | ** ** | ** ** | **Change** | ** ** |
|------------------------------------------|------------|------------|------------|------------|------------|------------|------------|
| **(dollars in thousands)**     | ** ** | **2007**   | ** ** | **2006**   | ** ** | **$**      | ** ** | **%** | ** ** |
| Manufacturing  Costs                     |       | $          | 1,009      |       | $          | 710        |       | $ | 299 |   | 42.1 | % |
| Product  Royalties                       |       | 1,250      |       | 549        |       | 701        |       | 127.7 | % |
| Amortization  of Licensing Fees          |       | 104        |       | 67         |       | 37         |       | 55.2 | % |
| Cost of  Product Sales                   |       | $          | 2,363      |       | $          | 1,326      |       | $ | 1,037 |   | 78.2 | % |
| Percent of  Net Product Sales            |       | 15.2       | %          | 26.6       | %          |       |       |   |   |

 

Manufacturing costsinclude contract manufacturing costs (Periostat and Oracea), transfer price(Pandel and the Atrix Products), manufacturing facility FDA validation costs,costs associated with excess inventories, overhead costs and internal costs.

 

19

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Under our licenseagreement with SUNY, covering Periostat and Oracea, we are entitled to deductprior legal costs incurred to defend SUNY’s patents from current and futureroyalties due SUNY on net sales of products based on SUNY technology. Duringthe three months ended September 30, 2007, we recorded $215 in productroyalty expense and credited legal expense for $215 related to previouslyexpensed legal fees. Accordingly, $215 was deducted from royalty paymentsearned by SUNY during the three months ended September 30, 2007. Duringthe three months ended September 30, 2006, we recorded $183 in productroyalty expense and credited legal expense for $183 related to previouslyexpensed legal fees. Accordingly, $183 was deducted from royalty paymentsearned by SUNY during the three months ended September 30, 2006. (see Note9)

 

Cost of product salesincreased $1.0 million during the three months ended September 30, 2007compared to the three months ended September 30, 2006 due primarily to asignificant increase in Oracea sales as well as approximately $180,000 inmanufacturing development costs incurred during the three months ended September 30,2007. Cost of product sales as a percent of net product sales was 15.2% for thethree months ended September 30, 2007 and 26.6% for the three months endedSeptember 30, 2006. The decrease in the cost of product sales as a percentof net product sales during the three months ended September 30, 2007 isprimarily due to the addition of Oracea sales, which have higher gross marginsthan our other products.

 

Effective November 1,2007, our Sublicense Agreement with Altana Inc. will terminate and we will nolonger generate other net product sales from the Pandel product. As part ofthe termination agreement, we expect to receive $1.7 million from Altana Inc.that will be credited to cost of product sales during the fourth quarter of2007.

 

**Research and Development**

 

**Research and development for thethree months ended September 30, consist of the following:**

** **
| **Research and Development** | ** ** | ** ** | ** ** | ** ** | ** ** | **Change** | ** ** |
|----------------------------------------|------------|------------|------------|------------|------------|------------|------------|
| **(dollars in thousands)**   | ** ** | **2007**   | ** ** | **2006**   | ** ** | **$**      | ** ** | **%** | ** ** |
| incyclinide                            |       | $          | 1,268      |       | $          | 2,306      |       | $ | (1,038 | ) | (45.0 | )% |
| COL-118                                |       | 1,283      |       | 119        |       | 1,164      |       | 978.2 | % |
| Oracea                                 |       | 686        |       | 481        |       | 205        |       | 42.6 | % |
| becocalcidiol                          |       | 212        |       | —     |       | 212        |       | N/A |   |
| Internal and  Other Costs              |       | 1,026      |       | 1,085      |       | (59        | )          | (5.4 | )% |
| Total  Research and Development        |       | $          | 4,475      |       | $          | 3,991      |       | $ | 484 |   | 12.1 | % |

** **

Internal and other costsinclude personnel costs, stock option expense, regulatory compliance costs andother project development costs and other departmental costs.

 

Research and developmentexpenses consist primarily of costs incurred for services and materials fordrug development, manufacturing and formulation enhancements, clinical trials,purchased in-process research and development, statistical analysis and reportwriting and regulatory compliance costs (including drug approval submission andfiling fees).

 

We estimate that futuredevelopment and clinical costs associated with COL-118 will be approximately**$**18 to $22 million.It is premature to estimate future development and clinical costs forbecocalcidiol. We are currently conducting formulation and stability work onproducts incorporating our Restoraderm technology, and we are reviewing productoptions and the timetable associated with clinical development orcommercialization.

 

On September 26,2007 and November 6, 2007, we announced that we had discontinued alldevelopment work on incyclinide for rosacea and acne indications, respectively.

 

During the fourth quarterof 2007, we expect to incur cancellation fees and other termination costsassociated with the discontinuation of the incyclinide acne and rosaceadevelopment projects.

 

20

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 **Selling, General andAdministrative**

 

**Selling, general and administrativefor the three months ended September 30, consist of the following:**

** **
| **Selling, General and Administrative** | ** ** | ** ** | ** ** | ** ** | ** ** | **Change** | ** ** |
|--------------------------------------------------------|------------|------------|------------|------------|------------|------------|------------|
| **(dollars in thousands)**                   | ** ** | **2007**   | ** ** | **2006**   | ** ** | **$**      | ** ** | **%** | ** ** |
| Marketing  Expense                                     |       | $          | 4,411      |       | $          | 3,934      |       | $ | 477 |   | 12.1 | % |
| Selling  Expense                                       |       | 4,009      |       | 4,141      |       | (132       | )          | (3.2 | )% |
| Corporate &  Administrative Expense           |       | 1,914      |       | 1,780      |       | 134        |       | 7.5 | % |
| Stock Option  Expense                                  |       | 579        |       | 739        |       | (160       | )          | (21.7 | )% |
| Total  Selling, General and Administrative             |       | $          | 10,913     |       | $          | 10,594     |       | $ | 319 |   | 3.0 | % |

 

**Marketingexpenses include personnel salaries and benefits, managed care expenses andmarket research, advertising and promotional expenses related to Oracea, thePrimus products and Pandel.**

** **

Selling expenses includepersonnel salaries and benefits, direct selling expenses and sales trainingexpenses.

 

Corporate andadministrative expenses include personnel salaries and benefits professional,legal and consulting fees, insurance, general office expenses, businessdevelopment expenses and accounting expenses.

 

Selling, general andadministrative expenses increased approximately $319,000, or 3.0%, during thethree months ended September 30, 2007 as compared to the three monthsended September 30, 2006, mainly due to an increase in managed caremarketing and Oracea promotional costs. During the three months ended September 30,2007, stock option expense decreased approximately $160,000, due primarily toperformance-based awards amortized during the three months ended September 30,2006. Such options were fully amortized at December 31, 2006.

 

We do not anticipate thetermination during the fourth quarter of 2007 of our Sublicense Agreement withAltana Inc. and the termination of our License Agreement with Tolmar, Inc.to materially affect our selling and marketing expenses in the fourth quarterof 2007.

 

**InterestIncome (Expense)**

** **
| **Interest Income (Expense)** | ** ** | ** ** | ** ** | ** ** | ** ** | **Change** | ** ** |
|-----------------------------------------|------------|------------|------------|------------|------------|------------|------------|
| **(dollars in thousands)**    | ** ** | **2007**   | ** ** | **2006**   | ** ** | **$**      | ** ** | **%** | ** ** |
| Interest  Income                        |       | $          | 772        |       | $          | 409        |       | $ | 363 |   | 88.8 | % |
| Interest  Expense                       |       | (8         | )          | (6         | )          | (2         | )          | 33.3 | % |
| Total Other  Income (Expense)           |       | $          | 764        |       | $          | 403        |       | $ | 361 |   | 89.6 | % |

** **

Interest income increased$363,000 or 88.8%, primarily due to higher average investment balances andyields for the nine months ended September 30, 2007 compared to thecomparable period in 2006.

 

**PreferredStock Dividend**

 

Preferred stock dividendsincluded in net loss allocable to common stockholders were $550,000 during thethree months ended September 30, 2007 and $500,000 during the three monthsended September 30, 2006.

 

Such preferred stockdividends are the result of our obligations in connection with the issuance ofour Series D Cumulative Convertible Preferred Stock, or the Series DStock, in May 1999. On December 15, 2005, we executed a 

 

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Restructuring andExchange Agreement with each of the holders of our outstanding Series DStock, pursuant to which, among other things, the Series D stockholdersagreed to effect an exchange, whereby we exchanged all 200,000 outstandingshares of our Series D Stock for 200,000 shares of our Series D-1Cumulative Convertible Preferred Stock, or the Series D-1 Stock.

 

Pursuant to the terms ofour Series D-1 Stock, the holders of the Series D-1 Stock areentitled to dividends payable in cash at a current rate of 11.0% per annum, whichare declared and paid every six months. The annual dividend rate increases by1.0% on May 19, 2008 and each subsequent anniversary thereof until theearlier of the date that all of the shares of Series D-1 Stock are (i) convertedinto shares of common stock, or (ii) redeemed.

 

*Comparisonof the Nine Months Ended September 30, 2007 and September 30, 2006*

 

**Revenues**

** **
| **Revenues**                         | ** ** | ** ** | ** ** | ** ** | ** ** | **Change** | ** ** |
|--------------------------------------|------------|------------|------------|------------|------------|------------|------------|
| **(dollars in thousands)** | ** ** | **2007**   | ** ** | **2006**   | ** ** | **$**      | ** ** | **%** | ** ** |
| Net Oracea  Product Sales            |       | $          | 37,277     |       | $          | 2,236      |       | $ | 35,041 |   | 1,567.1 | % |
| Other Net  Product Sales             |       | 8,257      |       | 9,450      |       | (1,193     | )          | (12.6 | )% |
| Total Net  Product Sales             |       | 45,534     |       | 11,686     |       | 33,848     |       | 289.6 | % |
| Contract  Revenues                   |       | 734        |       | 1,040      |       | (306       | )          | (29.4 | )% |
| License  Revenues                    |       | 92         |       | 44         |       | 48         |       | 109.1 | % |
| Grant  Revenue                       |       | 211        |       | 377        |       | (166       | )          | (44.0 | )% |
| Total Revenues                       |       | $          | 46,571     |       | $          | 13,147     |       | $ | 33,424 |   | 254.2 | % |

** **

During the nine monthsended September 30, 2007, total net product sales which included net salesof Oracea, Pandel, Periostat and the Atrix Products, increased $33.8 million,or 289.6%, due primarily to sales from Oracea, which was launched in July 2006.Net revenues from dermatological products were 90.7% of total net revenues inthe nine months ended September 30, 2007 compared to 51.5% for the ninemonths ended September 30, 2006. Total deductions from gross sales forestimated product returns, trade cash discounts, managed care rebates,government and patient rebates and wholesale distribution fees for Oracea wereapproximately 14.2% of gross sales during the nine months ended September 30,2007. Prescriptions for Oracea as reported by an independent industry datasource were approximately 276,325 during the nine months ended September 30,2007. At September 30, 2007, Oracea wholesaler inventory levels wereapproximately 4.1 weeks of sales as compared to approximately 1.0 weeks ofsales at December 31, 2006

 

Effective November 1,2007, our Sublicense Agreement with Altana Inc., a member of the Nycomed Group,will terminate and we will no longer generate other net product sales from thePandel product. Effective November 14, 2007, our License Agreement withTolmar, Inc. will terminate and we will no longer generate sales from theAtrix Products.

 

22

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**Cost ofProduct Sales**

 

Cost of productsales for the nine months ended September 30, consist of the following:

 
| **Cost of Product Sales** | ** ** | ** ** | ** ** | ** ** | ** ** | **Change** | ** ** |
|------------------------------------------|------------|------------|------------|------------|------------|------------|------------|
| **(dollars in thousands)**     | ** ** | **2007**   | ** ** | **2006**   | ** ** | **$**      | ** ** | **%** | ** ** |
| Manufacturing  Costs                     |       | $          | 2,765      |       | $          | 1,748      |       | 1,017 |   | 58.2 | % |
| Product  Royalties                       |       | 3,790      |       | 1,362      |       | 2,428      |       | 178.3 | % |
| Amortization  of Licensing Fees          |       | 300        |       | 201        |       | 99         |       | 49.3 | % |
| Cost of  Product Sales                   |       | $          | 6,855      |       | $          | 3,311      |       | $ | 3,544 |   | 107.0 | % |
| Percent of  Net Product Sales            |       | 15.1       | %          | 28.3       | %          |       |       |   |   |
|                                          |            |            |            |            |            |            |            |  |  |  |  |  |

 

Manufacturing costsinclude contract manufacturing costs (Periostat and Oracea), transfer price (Pandeland the Atrix Products), manufacturing facility FDA validation costs, costsassociated with excess inventories, overhead costs and internal costs.

 

Under our licenseagreement with SUNY, covering Periostat and Oracea, we are entitled to deductprior legal costs incurred to defend SUNY’s patents from current and futureroyalties due SUNY on net sales of products based on SUNY technology. Duringthe nine months ended September 30, 2007, we recorded $764 in productroyalty expense and credited legal expense for $764 related to previouslyexpensed legal fees. Accordingly, $764 was deducted from royalty paymentsearned by SUNY during the nine months ended September 30, 2007. During thenine months ended September 30, 2006, we recorded $335 in product royaltyexpense and credited legal expense for $335 related to previously expensedlegal fees. Accordingly, $335 was deducted from royalty payments earned by SUNYduring the nine months ended September 30, 2006. (see Note 9)

 

Cost of product salesincreased $3.5 million during the nine months ended September 30, 2007compared to the nine months ended September 30, 2006 due to increase inOracea sales as well as approximately $180,000 in manufacturing facility FDAvalidation costs. Cost of product sales as a percent of net product sales was15.1% for the nine months ended September 30, 2007 and 28.3% for the ninemonths ended September 30, 2006. The decrease in the cost of product salesas a percent of net product sales during the nine months ended September 30,2007 as compared to the nine months ended September 30, 2006 is primarilydue to the addition of Oracea sales, which have higher gross margins than ourother products.

 

Effective November 1,2007, our Sublicense Agreement with Altana Inc. will terminate and we will nolonger generate other net product sales from the Pandel product. As part ofthe termination agreement, we expect to receive $1.7 million from Altana Inc. thatwill be credited to cost of product sales during the fourth quarter of 2007.

 

**Researchand Development**

** **

**Research and development for thenine months ended September 30, consist of the following:**

** **
| **Research and Development** | ** ** | ** ** | ** ** | ** ** | ** ** | **Change** | ** ** |
|----------------------------------------|------------|------------|------------|------------|------------|------------|------------|
| **(dollars in thousands)**   | ** ** | **2007**   | ** ** | **2006**   | ** ** | **$**      | ** ** | **%** | ** ** |
| incyclinide                            |       | $          | 5,037      |       | $          | 5,218      |       | $ | (181 | ) | (3.5 | )% |
| COL-118                                |       | 3,710      |       | 494        |       | 3,216      |       | 651.0 | % |
| Oracea                                 |       | 2,093      |       | 2,173      |       | (80        | )          | (3.7 | )% |
| becocalcidiol                          |       | 1,712      |       | —     |       | 1,712      |       | N/A |   |
| Internal and  Other Costs              |       | 3,612      |       | 2,702      |       | 910        |       | 33.7 | % |
| Total  Research and Development        |       | $          | 16,164     |       | $          | 10,587     |       | $ | 5,577 |   | 52.7 | % |

** **

**23**

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** **

Internal and other costsinclude personnel costs, stock option expense, regulatory compliance costs andother project development costs and other departmental costs.

 

Research and developmentexpenses consist primarily of costs incurred for services and materials fordrug development, manufacturing and formulation enhancements, clinical trials,purchased in-process research and development, statistical analysis and reportwriting and regulatory compliance costs (including drug approval submission andfiling fees).

 

We estimate that futuredevelopment and clinical costs associated with COL-118 will be approximately**$**18 to $22 million.It is premature to estimate future development and clinical costs forbecocalcidiol. We are currently conducting formulation and stability work onproducts incorporating our Restoraderm technology, and we are reviewing productoptions and the timetable associated with clinical development orcommercialization.

 

On September 26,2007 and November 6, 2007, we announced that we had discontinued alldevelopment work on incyclinide for rosacea and acne indications, respectively.

 

During the fourth quarterof 2007 we expect to incur cancellation fees and other termination costsassociated with the discontinuation of the incyclinide acne and rosaceadevelopment projects.

 

**Selling,General and Administrative**

 

**Selling, general and administrativefor the nine months ended September 30, consist of the following:**

** **
| **Selling, General and Administrative** | ** ** | ** ** | ** ** | ** ** | ** ** | **Change** | ** ** |
|--------------------------------------------------------|------------|------------|------------|------------|------------|------------|------------|
| **(dollars in thousands)**                   | ** ** | **2007**   | ** ** | **2006**   | ** ** | **$**      | ** ** | **%** | ** ** |
| Marketing  Expense                                     |       | $          | 15,341     |       | $          | 9,858      |       | $ | 5,483 |   | 55.6 | % |
| Selling  Expense                                       |       | 12,127     |       | 11,350     |       | 777        |       | 6.8 | % |
| Corporate &  Administrative Expense           |       | 6,578      |       | 5,872      |       | 706        |       | 12.0 | % |
| Stock Option  Expense                                  |       | 1,657      |       | 2,211      |       | (554       | )          | (25.1 | )% |
| Total  Selling, General and Administrative             |       | $          | 35,703     |       | $          | 29,291     |       | $ | 6,412 |   | 21.9 | % |

** **

Marketing expensesinclude personnel salaries and benefits, managed care expenses and marketresearch, advertising and promotional expenses related to Oracea, the Primusproducts and Pandel.

 

Selling expenses includepersonnel salaries and benefits, direct selling expenses and sales trainingexpenses.

 

Corporate andadministrative expenses include personnel salaries and benefits professional,legal and consulting fees, insurance, general office expenses, businessdevelopment expenses and accounting expenses.

 

Selling, general andadministrative expenses increased approximately $6.4 million, or 21.9%, duringthe nine months ended September 30, 2007, mainly due to higher promotioncosts for Oracea, which was launched in July 2006. During the nine monthsended September 30, 2007, personnel costs related to selling, general andadministrative functions increased by approximately $1.6 million as compared topersonnel costs during the nine months ended September 30, 2006. Duringthe nine months ended September 30, 2007, stock option expense decreasedapproximately $540,000 due primarily to amortization of performance-basedawards amortized during the nine months ended September 30, 2006. Suchoptions were fully amortized at December 31, 2006.

 

We do not anticipate thetermination during the fourth quarter of 2007 of our Sublicense Agreement withAltana Inc. and the termination of our License Agreement with Tolmar, Inc.to materially affect our selling and marketing expenses in the fourth quarterof 2007.

 

24

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**Interest Income(Expense)**

 
| **Interest Income (Expense)** | ** ** | ** ** | ** ** | ** ** | ** ** | **Change** | ** ** |
|-----------------------------------------|------------|------------|------------|------------|------------|------------|------------|
| **(dollars in thousands)**    | ** ** | **2007**   | ** ** | **2006**   | ** ** | **$**      | ** ** | **%** | ** ** |
| Interest Income                         |       | $          | 2,393      |       | $          | 1,444      |       | $ | 949 |   | 65.7 | % |
| Interest Expense                        |       | (24        | )          | (6         | )          | (18        | )          | 300.0 | % |
| Total Other Income (Expense)            |       | $          | 2,369      |       | $          | 1,438      |       | $ | 931 |   | 64.7 | % |

 

Interest income increased $949,000 or 65.7%, primarilydue to higher average investment balances and yields for the nine months endedSeptember 30, 2007 compared to the comparable period in 2006.

 

**Preferred Stock Dividend**

 

Preferred stock dividends included in net lossallocable to common stockholders were $1.6 million during the nine months endedSeptember 30, 2007 and $1.4 million during the nine months ended September 30,2006.

 

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

 

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

 

**Liquidity and Capital Resources**

** **

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

*** ***

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

 

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

 

•                  Cash flows from operations; and

 

•                  Exercise of stock options andwarrants.

 

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

 

•                  The cost of commercializationactivities, including product marketing and sales;

 

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

 

•                  The success of our dermatologyfranchise;

 

•                  The success of our prosecution of ourpatent applications related to the SansRosa technology and the use of COL-118for the treatment of erythema;

 

•                  Receipt and maintenance of marketingapprovals from the FDA and similar foreign regulatory authorities for ourproduct candidates;

 

25

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•                  The success of our preclinical, clinicaland development programs;

 

•                  Revenues and profits from sales ofOracea, and our other product candidates;

 

•                  The terms and conditions of ouroutstanding Series D-1 Stock;

 

•                  Ourability to continue to meet the covenant requirements under our amended revolvingcredit facility with Silicon Valley Bank, or SVB;

 

•                  The costs involved in preparing,filing, prosecuting, maintaining and enforcing patent claims and otherpatent-related costs, including potential litigation costs and the results ofsuch litigation;

 

•                  The extent to which we acquire orinvest in businesses, products and technologies;

 

•                  The success of our application forEuropean Union marketing authorization, for Oracea and in turn the success ofMediGene AG, our foreign marketing partner for Oracea, in commercializingOracea in the European Union;

 

•                  The costs involved in obtaining andmaintaining regulatory approvals and clearances required to market and sell ourproducts; and

 

•                  The receptivity of the capitalmarkets to any future financings.

 

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

 

On December 18, 2006, we executed a Product Licenseand Supply Agreement with MediGene AG, a corporation existing under the laws ofGermany, for the marketing rights to Oracea. Under the Product License andSupply Agreement, effective January 1, 2007, MediGene receives the right tomanufacture, register, market and sell Oracea in the European Union, certaincontiguous countries and Russia. MediGene may exercise its right to manufactureOracea at any time during the term of the agreement, upon twelve months noticeto us. During the nine months ended September 30, 2007, we received an upfrontnon-refundable fee of $5.0 million. Additionally, we may be entitled to an additional $7.5 million inmilestone payments upon the achievement of certain annual salesthresholds.  In addition, we will receivean agreed upon transfer price and a royalty of 12% of annual net sales up to$10 million and 15% of annual net sales in excess of $10 million in thespecified territories. Our application for European marketing authorization forOracea was recentlyreferred to the Committee for Medicinal Products for Human Use, or CHMP.Referral to the CHMP may be a lengthy process and we cannot predict when, orif, this body will approve our application.

 

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

 

26

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On October 9, 2006, we entered into a Sixth LoanModification Agreement with SVB, or the Modification Agreement.  Pursuant to the terms of the ModificationAgreement the expiration date of the credit facility has been extended toOctober 9, 2008.  Under the amendedcredit facility, we may borrow up to the lesser of (i) $10.0 million or (ii)80% of eligible receivables plus certain specified amounts, subject toreduction during the period October 9, 2006 through December 31, 2007.  The amount available to us is reduced by anyoutstanding letters of credit that may be issued under the amended creditfacility in amounts totaling up to $2.0 million. As we pay down amounts underany letter of credit, the amount available to us under the credit facilityincreases.  We are not obligated to drawdown any amounts under the amended credit facility and any borrowings shallbear interest, payable monthly, at SVB’s prime rate, or 7.75%, at September 30,2007. Under the Modification Agreement, we are charged an unused line creditfee of 0.25% per annum. In addition, under the amended credit facility, we aresubject to financial covenants that require us to maintain certain minimumliquidity and tangible net worth levels on a quarterly basis.  During the nine months ended September 30,2007 and 2006, our unused line of credit fee was $45,000 and $18,000respectively. As of September 30, 2007, we had no borrowings outstanding.

 

At September 30, 2007, we had cash, cash equivalentsand short-term investments of approximately $56.9 million compared to theapproximately $65.8 million balance at December 31, 2006.  This decrease is primarily a result of cashused in investing activities of approximately $9.1 million during the ninemonths ended September 30, 2007.  Inaccordance with investment guidelines approved by our Board of Directors, cashbalances in excess of those required to fund operations have been invested ingovernment notes, commercial paper, certificates of deposit and money marketfunds.  Our working capital at September30, 2007 was $58.5 million compared to $59.6 million at December 31, 2006.  During the nine months ended September 30,2007, we invested $740,000 in capital expenditures and $2.2 million forin-process research and development, paid $2.0 million in cash dividends to theholders of our Series D-1 Stock and received proceeds of $2.5 million from theexercise of common stock options and warrants. During the nine months endedSeptember 30, 2007 we also invested approximately $6.2 million in short-terminvestments (net of maturities).

 

We anticipate that our (i) current cash, cashequivalents and short-term investments at September 30, 2007, (ii) theavailability of funds from our line of credit with SVB and (iii) our ability tocontrol variable spending, will be sufficient to fund our operations through atleast 2008.****In addition, we may also financeour cash needs through public or private equity offerings, debt financings,corporate collaboration or licensing arrangements.  However, there is no assurance that thesefinancing alternatives will be available on attractive terms, if at all, whenneeded, or in amounts sufficient to fund our operations.  Our forecast of the period of time throughwhich our financial resources will be adequate to support our operations is aforward-looking statement that involves risks and uncertainties, and actualresults could vary materially.

 

***Cash Flows/Cash Management***

*** ***

Cash, cash equivalents and short-term investments atSeptember 30, 2007 were $56.9 million representing 75% of total assets comparedto $65.8 million, representing 83% of total assets at December 31, 2006.

 

The change in cash and cash equivalents for the ninemonths ended September 30, are as follows:

 
| **(dollars in millions)**                  | ** ** | **2007** | ** ** | **2006** | ** ** |
|------------------------------------------------------|------------|----------|------------|----------|------------|
| Net cash used in operating activities                |       | $        | (6.4       | )        | $          | (28.5 | ) |
| Net cash (used in) provided by investing  activities |       | (9.1     | )          | 0.3      |       |
| Net cash provided by financing activities            |       | 0.4      |       | 11.5     |       |
| Net decrease in cash and cash equivalents            |       | $        | (15.1      | )        | $          | (16.7 | ) |

 

Working capital at September 30, 2007 was $58.5million compared to $59.6 million at December 31, 2006.

 

***NetCash Used in Operating Activities***

 

Net cash used in operating activities was $6.4million, including a $9.8 million net loss, and a $5.0 million payment fromMediGene, during the nine months ended September 30, 2007 compared to $28.5million, including a $28.6 million net loss for the nine months ended September30, 2006.  Cash flows used in operationscan vary significantly due to various

 

27

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factors including thetiming of payments made to our vendors, including research and developmentvendors, vendor payment terms, customer mix and customer payment terms. Ouraccounts receivable balance at September 30, 2007 increased compared tothe balance at December 31, 2006 primarily as a result of increased Oraceasales.

 

***NetCash (Used In) Provided By Investing Activities***

 

Net cash used in investing activities was $9.1 millionfor the nine months ended September 30, 2007, compared to $333,000 provided byinvesting activities for the nine months ended September 30, 2006.  The change is due primarily to $8.1 millionin additional purchases of short-term investments (net of sales andmaturities), a $2.0 million increase in purchases of in-process research anddevelopment and a $354,000 increase in capital expenditures during the ninemonths ended September 30, 2007.

 

***NetCash Provided By Financing Activities***

 

Net cash provided by financing activities wasapproximately $415,000 for the nine months ended September 30, 2007, comparedto net cash provided by financing activities of $11.5 million for the ninemonths ended September 30, 2006. The change is due primarily to proceeds fromissuance of common stock that occurred in January 2006.

 

***Contractual Obligations***

*** ***

Our major outstanding contractual obligations relateto cash dividends on our outstanding Series D-1 Stock, operating leasesfor our office space, and operating lease for commercial vehicles to be used bycertain members of our sales force and capital leases for computer andtelecommunications equipment. The disclosures relating to our contractualobligations in our Annual Report on Form 10-K for the year ended December 31,2006 have not materially changed since we filed the report.

 

***CriticalAccounting Policies and Estimates***

** **

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

 

***RevenueRecognition***

 

We generally recognize revenues for product sales uponshipment to wholesale customers, net of estimated returns and estimates forchargebacks, applicable wholesale distribution fees and rebates provided thatcollection was probable and no significant obligations remained. Following thelaunch of a third party generic competitor to Periostat in May 2005 andcommencing with the second quarter of 2005, we began recognizing Periostatsales revenue based on product sales to end-users. As of September 30, 2007, wehave a liability of $571,000 for potential Periostat product returns in accruedexpenses on the Consolidated Balance Sheet for estimated returns prior to thechange to a prescription based revenue recognition model.

 

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

 

The following chartdetails the activity in the revenue related reserves discussed above during thenine months ended September 30, 2007 and 2006:

 

28

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| **Nine Months Ended September 30, 2006   (dollars in thousands)** | ** ** | **Balance   December 31,   2005** | ** ** | **Current Provision   Related to Sales   During the Nine   Months Ended   September 30, 2006** | ** ** | **Actual Returns or   Credits Issued During   the Nine Months   Ended September 30,   2006** | ** ** | **Balance   September 30,   2006** | ** ** |
|-----------------------------------------------------------------------------------------------------------|------------|--------------------------------------------------|------------|------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|----------------------------------------------------------------------------------------------------------------------------------------------------------|------------|---------------------------------------------------|------------|
| Accounts receivable allowances:                                                                           |       |                                             |       |                                                                                                                                                       |       |                                                                                                                                                     |       |                                              |       |
| Chargebacks                                                                                               |       | $                                                | 78         |                                                                                                                                                       | $          | 1,345                                                                                                                                                    |       | $                                                 | (1,369     | ) | $ | 54 |   |
| Cash discounts                                                                                            |       | 26                                               |       | 349                                                                                                                                                        |       | (227                                                                                                                                                     | )          | 148                                               |       |
| Total                                                                                                     |       | $                                                | 104        |                                                                                                                                                       | $          | 1,694                                                                                                                                                    |       | $                                                 | (1,596     | ) | $ | 202 |   |
|                                                                                                      |       |                                             |       |                                                                                                                                                       |       |                                                                                                                                                     |       |                                              |       |
| Accounts payable/Accrued expenses:                                                                        |       |                                             |       |                                                                                                                                                       |       |                                                                                                                                                     |       |                                              |       |
| Product returns (excluding Periostat)                                                                     |       | 98                                               |       | 293                                                                                                                                                        |       | (151                                                                                                                                                     | )          | 240                                               |       |
| Government rebates                                                                                        |       | 158                                              |       | 328                                                                                                                                                        |       | (339                                                                                                                                                     | )          | 147                                               |       |
| Wholesale distribution fees                                                                               |       | 80                                               |       | 414                                                                                                                                                        |       | (189                                                                                                                                                     | )          | 305                                               |       |
| Total                                                                                                     |       | $                                                | 336        |                                                                                                                                                       | $          | 1,035                                                                                                                                                    |       | $                                                 | (679       | ) | $ | 692 |   |
|                                                                                                      |       |                                             |       |                                                                                                                                                       |       |                                                                                                                                                     |       |                                              |       |
| **Nine Months Ended September 30,  2007   (dollars in thousands)**                                        | ** ** | **Balance   December 31,   2006**                | ** ** | **Current Provision   Related to Sales   During the Nine   Months Ended   September 30, 2007**                                                             | ** ** | **Actual Returns or   Credits Issued    During the Nine   Months Ended   September 30, 2007**                                                       | ** ** | **Balance   September 30,   2007**           | ** ** |
| Accounts receivable allowances:                                                                           |       |                                             |       |                                                                                                                                                       |       |                                                                                                                                                     |       |                                              |       |
| Chargebacks                                                                                               |       | $                                                | 73         |                                                                                                                                                       | $          | 974                                                                                                                                                      |       | $                                                 | (958       | ) | $ | 89 |   |
| Cash discounts                                                                                            |       | 114                                              |       | 824                                                                                                                                                        |       | (721                                                                                                                                                     | )          | 217                                               |       |
| Total                                                                                                     |       | $                                                | 187        |                                                                                                                                                       | $          | 1,798                                                                                                                                                    |       | $                                                 | (1,679     | ) | $ | 306 |   |
|                                                                                                      |       |                                             |       |                                                                                                                                                       |       |                                                                                                                                                     |       |                                              |       |
| Accounts payable/Accrued expenses:                                                                        |       |                                             |       |                                                                                                                                                       |       |                                                                                                                                                     |       |                                              |       |
| Patient rebates                                                                                           |       | $                                                | 78         |                                                                                                                                                       | $          | 1,513                                                                                                                                                    |       | $                                                 | (1,156     | ) | $ | 435 |   |
| Product returns (excluding Periostat)                                                                     |       | 384                                              |       | 865                                                                                                                                                        |       | (331                                                                                                                                                     | )          | 918                                               |       |
| Government rebates                                                                                        |       | 80                                               |       | 242                                                                                                                                                        |       | (193                                                                                                                                                     | )          | 129                                               |       |
| Managed care rebates                                                                                      |       | —                                           |       | 452                                                                                                                                                        |       | (172                                                                                                                                                     | )          | 280                                               |       |
| Wholesale distribution fees                                                                               |       | 296                                              |       | 1,218                                                                                                                                                      |       | (1,113                                                                                                                                                   | )          | 401                                               |       |
| Total                                                                                                     |       | $                                                | 838        |                                                                                                                                                       | $          | 4,290                                                                                                                                                    |       | $                                                 | (2,965     | ) | $ | 2,163 |   |

 

The returns provision for all Periostat outstandinginventories in the trade channel was $571,000 at September 30, 2007 and$688,000 at September 30, 2006. The provision (for all outstanding tradeinventory), was established due to the inability to estimate Periostat returnsupon the launch of a generic product in 2005. Quarterly, we evaluate theadequacy of the provision based on changes reported to us by the wholesaler andadjust our estimate accordingly.

 

***Contract and License Revenues***

*** ***

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

 

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

 

29

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

 

On December 18, 2006, we executed a License and SupplyAgreement with MediGene AG that became effective on January 1, 2007.  Under this agreement, MediGene has the rightto manufacture, register, market and sell Oracea in the European Union, certaincontiguous countries and Russia. MediGene may exercise its right to manufactureOracea at any time during the term of the agreement, upon twelve months noticeto us. During the nine months ended September 30, 2007, we classified the upfront non-refundable fee of $5.0 million as non-current deferred licensingrevenue. We plan to begin  amortizingthis deferred revenue to revenue over the term of the agreement once EUapproval for Oracea has been approved . Additionally, we may be entitled to anadditional $7.5 million in milestone payments upon the achievement of certainannual sales thresholds achieved by MediGene. In addition, we will receive anagreed upon transfer price and a royalty of 12% of annual net sales up to $10.0million and 15% of annual net sales in excess of $10.0 million in the specifiedterritories. Our application for European marketing authorization for Oracea was recently referred CHMP. Referral tothe CHMP may be a lengthy process and we cannot predict when, or if, this bodywill approve our application.

 

***Grant Revenues***

*** ***

During 2005, we received a grant from the NationalInstitutes of Health, or NIH, to fund additional research by us and ourcollaborators on the anti-inflammatory effects of incyclinide.  We expense such research expenditures as theyare incurred and recognize grant revenue when earned for the portion of theexpenditures that are reimbursable by the NIH. We recognized $60,000 and $211,000 in grant revenues for the three andnine months ended September 30, 2007 and $211,000 and $377,000 in grantrevenues for the three and nine months ended September 30, 2006.

 

***Deferred Taxes***

*** ***

In assessing the realizability of deferred tax assets,we consider the likelihood that part or all of the deferred tax assets will notbe realized.  This assessment requiressignificant judgment and estimates. The ultimate realization of the deferredtax assets is dependent upon the generation of future taxable income during theperiod in which those temporary differences become deductible. We consider ourhistory of losses, scheduled reversal of deferred tax assets and liabilities,deferred tax planning strategies, if any, and projected future taxable incomeover the periods in which the deferred tax asset items are deductible. The TaxReform Act of 1986 contains provisions that may limit the net operating lossand research and experimentation credit carryforwards available to be used inany given year upon the occurrence of certain events, including significantchanges in ownership interest. We have incurred a net loss for the years endedDecember 31, 2006 and 2005, and uncertainty regarding our future profitabilityhas prevented us from reaching the “more likely than not” conclusion requiredunder the applicable literature to recognize deferred tax assets on ourConsolidated Balance Sheet. Accordingly, the net deferred tax assets are fullyoffset by a valuation allowance at September 30, 2007 and December 31,2006.

 

***Intangible Assets***

*** ***

***Acquired productrights and Oracea milestone fees are stated at cost, amortized over the shorterof the estimated useful life of the products or the contract term under whichsuch rights have been licensed, using the straight-line method.  Amortization of acquired product rights andOracea milestone fees are charged to cost of product sales.***

*** ***

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

 

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

 

30

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***Inventories***

*** ***

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

 

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

 

***Research and Development***

*** ***

Research and product development costs are expensed asincurred.  Research and developmentexpenses consist primarily of personnel costs and funds paid to third partiesfor the provision of services and materials for drug development, manufacturingand formulation enhancements, clinical trials (including post FDA-approval,clinical trials), statistical analysis and report writing and regulatorycompliance costs, including governmental filing fees.

 

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

 

Costs to acquire in-process research and developmentprojects and technologies which have not achieved technical feasibility at thedate of acquisition are expensed as research and development expense asincurred.  We expensed $2.2 million ofin-process research and development for the nine months ended September 30,2007 and $300,000 for the nine months ended September 30, 2006.

 

***Stock-Based Compensation***

*** ***

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

 

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

 

***Accounting Change***

*** ***

On January 1, 2007, we adopted the FinancialAccounting Standards Board, or FASB Interpretation No. 48, *Accountingfor Uncertainty in Income Taxes,* or FIN 48. FIN 48 clarifies theaccounting for uncertainty in income taxes recognized in an enterprise’sfinancial statements in accordance with SFAS No. 109, *Accountingfor Income Taxes*. FIN 48 prescribes a recognition threshold andmeasurement for financial statement recognition and measurement of a taxposition reported or expected to be reported on a tax return. FIN 48 alsoprovides guidance on derecognition, classification, interest and penalties,accounting in interim periods, disclosure, and transition. Prior to theadoption of FIN 48, our policy was to recognize tax benefits of uncertain taxpositions only if it was “probable” that the position would be sustained. FIN48 requires application of a “more likely than not” threshold to therecognition and derecogntion of tax positions. As a result of the adoption ofFIN 48, retained earning increased in the amount of $945,000 and accruedexpenses decreased by the same amount as of January 1, 2007. 

 

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***Recently Issued Accounting Pronouncements***

*** ***

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

 

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

 

In June 2007, the Emerging Issues Task Force (“EITF”)reached a final consensus on EITF Issue No. 07-3, “Accounting for NonrefundableAdvance Payments for Goods or Services to Be Used in Future Research andDevelopment Activities” (“EITF 07-3”). EITF 07-3 is effective for fiscal yearsbeginning after December 15, 2007.  EITF07-3 requires that non-refundable advance payments for future research anddevelopment activities should be capitalized until the goods have beendelivered or related services have been performed.  Adoption is on a prospective basis and couldimpact the timing of expense recognition for agreements entered into afterDecember 31, 2007.  We do not expect theadoption of EITF 07-3 to have a significant impact on our consolidatedfinancial statements.

 

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

** **

We had cash and cash equivalents and short-terminvestments at September 30, 2007 which are exposed to the impact of interestrate changes and our interest income fluctuates as interest rates change.  Due to the short-term nature of ourinvestments in money market funds, the carrying values of our cash equivalentsapproximate their fair value at September 30, 2007. Our short-term investmentsin commercial paper, certificates of deposit and government notes are carriedat fair value.

 

**Item 4.**                          Controls and Procedures.

** **

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

 

No change in our internal control over financialreporting (as defined in Rules 13a-15(f) and 15d-15(f) under the ExchangeAct) occurred during the fiscal quarter ended September 30, 2007 that hasmaterially affected, or is reasonably likely to materially affect, our internalcontrol over financial reporting.

 

**PART II.  OTHERINFORMATION**

** **

**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 statements regarding future events and our futureresults are based on current expectations, estimates, forecasts, andprojections and the beliefs and assumptions of our management including, withoutlimitation, our expectations regarding revenues, results of operations,selling, general and administrative expenses, research and developmentexpenses, the sufficiency of our cash for future operations, and the success ofour preclinical, clinical and development programs and our dermatologyfranchise.  Forward-looking statementsmay be identified by the use of forward-looking terminology such as “believe,” “couldincrease the likelihood,” “hope,” “target,” “project,” “goals,” “potential,”*

 

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*“predict,”“might,” “expect,” “intend,” “is planned,” “should,” “will enable,” “would beexpected,” “look forward,” “may provide,” “would,” “may,” “could,” “will,” “expect,”“estimate,” “anticipate,” “continue,” or similar terms, variations of suchterms or the negative of those terms.*

 

*Wecannot assure investors that our assumptions and expectations will prove tohave been correct.  Important factorscould cause our actual results to differ materially from those indicated orimplied by forward-looking statements. Such factors that could cause or contribute to such differences includethose factors discussed below.  Weundertake no intention or obligation to update or revise any forward-lookingstatements, whether as a result of new information, future events orotherwise.  If any of the following risksactually occur, our business, financial condition, results of operations orliquidity would likely suffer.*

 

The following discussion includes six revised risk factors (“We aredepending heavily on the commercial success of Oracea.  If we are unable to commercialize Oraceasuccessfully our business will be materially harmed”, “If we are not able toobtain and enforce patent protection for Oracea or our other discoveries, ourability to commercialize Oracea and our product candidates successfully will beharmed and we may not be able to operate our business profitably”, “We cannotassure you that our pursuit of business in the dermatology market will besuccessful”, “If we are not able to obtain required regulatory approvals, wewill not be able to commercialize our product candidates, and our ability togenerate revenue will be materially impaired”, “We may be unable to raiseadditional capital if needed, which would force us to delay, reduce oreliminate our product development programs and commercialization efforts” and “Wecannot assure you that our clinical trials will be completed in a timely manneror will meet agreed upon end-points”) and two new risk factors (“If third-partypayors do not adequately reimburse customers for any of our approved products,they might not be purchased or used, and our revenues and profits will notdevelop or increase” and “If we are unable to establish, maintain and rely onnew collaborative relationships, then we may not be able to successfullydevelop and commercialize our technologies”) that reflect developmentssubsequent to the discussion of risk factors included in our most recent AnnualReport on Form 10-K.

 

***We are depending heavily on the commercial success ofOracea.  If we are unable to commercialize Oracea successfully ourbusiness will be materially harmed.***

 

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

 

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

 

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

 

Market exclusivity is, however, not available to drugsthat contain an active ingredient that has already been approved as anantibiotic and marketed prior to 1998. On January 19, 2005, the United States District Court for the Districtof Columbia upheld the FDA’s application of this principle to Periostat anddetermined that Periostat was not entitled to market exclusivity because itsactive ingredient, doxycycline, had previously been approved as anantibiotic.  Because Oracea also containsdoxycycline as its active ingredient, it will also not be entitled to marketexclusivity.

 

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

 

With limited or no market exclusivity it could be moredifficult for us to prevent competitors from seeking approval for copies of ourproprietary products, and in such a case the value of such products would bematerially adversely affected.  Withoutmarket exclusivity, generic versions of our products could quickly gain marketentry if they meet regulatory

 

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approval criteria.  Thus, despite the FDA’s May 2006 approval ofOracea, because it will not be entitled to market exclusivity, third partiesmay enter the market which would materially harm our business.

 

***If we are not able to obtain and enforce patent protectionfor Oracea or our other discoveries, our ability to commercialize Oracea andour product candidates successfully will be harmed and we may not be able tooperate our business profitably.***

 

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

 

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

 

Our strategy depends on our ability to identify ourdiscoveries rapidly and to seek patent protection for them.  This process is expensive and time consuming,and we may not be able to file and prosecute all necessary or desirable patentapplications at a reasonable cost or in a timely manner.  Despite our efforts to protect our proprietaryrights, unauthorized parties may be able to obtain and use information that weregard as proprietary.  The issuance of apatent does not guarantee that it is valid or enforceable, so even if we obtainpatents, they may not be valid or enforceable against third parties.  In addition, the issuance of a patent doesnot guarantee that we have the right to practice the patented invention.  Third parties may have blocking patents thatcould be used to prevent us from marketing our own patented product and practicingour own patented technology.

 

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

 

A number of our pending patent applications arerelated and include claims that are intended to cover Oracea.  However, our issued patents relating toOracea, and if issued, our other patents relating Oracea and COL-118, may notcontain claims sufficiently broad to protect us against third parties withsimilar products, or provide us with any competitive advantage.  Moreover, once issued, any of our patents maybe challenged, narrowed, invalidated or circumvented.  In addition, the patent rights in ourproducts that derive from claims under method of use patents may be hard toassert or enforce if medical professionals prescribe or dispense similar(including generic), though non-approved, products for indications covered byour patents.  If our patents are invalidated or otherwise limited, othercompanies will be better able to develop products and technologies that competewith ours, which could adversely affect our competitive business position,business prospects and financial condition.

 

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

 

We continue to implement our plans to expand into thedermatology market. In May 2006, the FDA approved Oracea for the treatment ofrosacea in adults, and in July 2006, we launched Oracea in the UnitedStates.  While we have

 

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begun to generate revenuefrom Oracea sales in connection with the product’s July 2006 trade-launch, itis premature to determine the future success and growth, if any, of the Oraceaproduct brand.  We continue to seekadditional product licensing opportunities to enhance our near-term offeringsto the dermatology market. Even if we succeed in our efforts to identify andlicense additional products, it is not possible to guarantee that in licensedproducts will continue indefinitely to be available to us.  For instance, on February 1, 2007 we receivedwritten notice of termination of our agreement with Altana Inc., which providesfor the termination of our rights in Pandel effective November 1, 2007.

 

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

 

At the same time, new product development is alengthy, complex and uncertain process that will require significant attentionand resources from management.  A productcandidate can fail at any stage of the development process due to, among otherthings, efficacy or safety concerns, the inability to obtain necessaryregulatory approvals, the difficulty or excessive cost to manufacture and/orthe infringement of patents or intellectual property rights of others.  For instance, on September 26, 2007 and onNovember 6, 2007, we announced that we discontinued all development work onincyclinide for rosacea and acne indications, respectively.

 

Furthermore, the sales of new products may prove to bedisappointing and fail to reach anticipated levels.  We therefore cannot assure you that we willbe successful in our pursuit of business in the dermatology market, or that wecan sustain any business in which we achieve initial success.

 

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

 

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

 

Failure to obtain regulatory approval for a productcandidate will prevent us from commercializing the product candidate.  Other than Oracea and Periostat, we have notreceived regulatory approval to market any of our product candidates in anyjurisdiction.  We have only limitedexperience in filing and prosecuting the applications necessary to gainregulatory approvals.  Securing FDA andother comparable authority approval, requires the submission of extensivepreclinical and clinical data, information about product manufacturingprocesses and inspection of facilities and supporting information to the FDAand other comparable authorities  foreach therapeutic indication to establish the product candidate’s safety andefficacy.  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 of obtaining regulatory approvals isexpensive, often takes many years, if approval is obtained at all, and can varysubstantially based upon, among other things, the type, complexity and noveltyof the product candidates involved. Changes in the regulatory approval policy during the development period,changes in or the enactment of additional statutes or regulations, or changesin regulatory review for each submitted product application, may cause delaysin the approval or rejection of an application.

 

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

 

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reach a unanimousdecision concerning our application for European marketing authorization for Oracea and this application wasrecently referred to the CHMP. Referral to the CHMP may be a lengthy processand we cannot predict when, or if this body will approve our application.

 

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

 

***If we lose our sole supplier of doxycycline or ourmanufacturer of Oracea, our sales of Oracea will be interrupted, halted or lessprofitable.***

 

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

 

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

 

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

 

***If the federal regulatory status of Alcortin or Novacortchanges, we may be unable to continue to market one or both of these products.***

 

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

 

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*** ***

***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, our products and product candidates and ourmanufacturers are subject to extensive regulatory requirements.  Failureto comply with these requirements could subject us to administrative andjudicial sanctions.***

 

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

 

•                  restrictions on such products,manufacturers or manufacturing processes;

 

•                  warning letters;

 

•                  withdrawal of the products from themarket;

 

•                  refusal to approve pendingapplications or supplements to approved applications that we submit;

 

•                  recall;

 

•                  fines;

 

•                  suspension or withdrawal ofregulatory approvals;

 

•                  refusal to permit the import orexport of our products;

 

•                  product seizure; and

 

•                  injunctions or the imposition ofcivil or criminal penalties.

 

***We may be unable to raiseadditional capital if 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 additional fundingto meet these additional expenses and may be unable to raise capital whenneeded or on attractive terms, which would force us to delay, reduce oreliminate our research and development programs and commercializationactivities.  If we generate revenues and incurexpenses at our anticipated levels, we anticipate that our current cash, cashequivalents and short-term investments at September 30, 2007 will be sufficientto fund our operations through 2008.  However, our forecast of the periodof time through which our financial resources will be adequate to support ouroperations involves risks and uncertainties, and actual results could varymaterially.  Our future funding requirements will depend on many factors,including:

 

•                  the cost of commercialization activities, including product marketing andsales;

 

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

 

•                  the success of our dermatologyfranchise;

 

•                  the success of our prosecution of ourpatent applications related to the SansRosa technology and the use of COL-118for the treatment of erythema associated with rosacea;

 

•                  receipt and maintenance of marketingapprovals from the FDA and similar foreign regulatory authorities for ourproduct candidates;

 

•                  the success of our preclinical,clinical and development programs;

 

•                  revenues and profits from sales ofOracea and our other product candidates;

 

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•                  the terms and conditions of ourSeries D-1 Stock;

 

•                  our ability to continue to meet thecovenant requirements under our amended revolving credit facility with SVB;

 

•                  the costs involved in preparing,filing, prosecuting, maintaining and enforcing patent claims and otherpatent-related costs, including potential litigation costs and the results ofsuch litigation;

 

•                  the extent to which we acquire orinvest in businesses, products and technologies;

 

•                  the success of our application forEuropean Union marketing authorization for Oracea and in turn the success ofMediGene AG, our foreign marketing partner for Oracea, in commercializingOracea in the European Union;

 

•                  the costs involved in obtaining andmaintaining regulatory approvals and clearances required to market and sell ourproducts; and

 

•                  the receptivity of the capitalmarkets to any future financings.

 

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

 

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

 

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

 

For instance, on May 2, 2007, we learned that onepatient had experienced apparent significant photo-toxicity, a known sideeffect of tetracyclines, while participating in the 40 mg cohort of ourPhase II dose ranging trial of incyclinide. We suspended enrollment of all new patients in this study as aresult.  On May 7, 2007, we learned ofanother patient who had experienced apparent photo-toxicity and we announcedthat we had discontinued treatment of all enrolled patients.

 

On September 26, 2007, we announced results of a PhaseII dose-finding study designed to evaluate the safety and determine thetherapeutic range of incyclinide for the treatment of rosacea.  The study demonstrated that incyclinide waswell tolerated with most adverse events being mild to moderate.  However, the patients administeredincyclinide did not demonstrate greater reduction in inflammatory lesions thanthe patients on placebo at any time point during the study and we discontinuedall development work on incyclinide for a rosacea indication.

 

On November 6, 2007, we announced that  following a detailed cost, benefit and riskanalysis in the fourth quarter of 2007, we had decided to discontinue alldevelopment work on incyclinide for an acne indication in order to focus ourresources and energies on those projects in our pipeline  that we believe have the greatest potential.

 

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

 

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

 

•                  interim results of preclinical orclinical studies do not necessarily predict their final results, and results inearly studies might not be seen in later studies;

 

•                  potential products that appearpromising at early stages of development may ultimately fail for a number ofreasons, including the possibility that the products may be ineffective, lesseffective than products of our competitors or cause harmful side effects;

 

•                  any preclinical or clinical test mayfail to produce results satisfactory to the FDA or foreign regulatoryauthorities;

 

•                  preclinical and clinical data can beinterpreted in different ways, which could delay, limit or prevent regulatoryapproval;

 

•                  we may not be able to manufacture theinvestigational or commercial product in sufficient quantity or quality or atacceptable cost;

 

•                  negative or inconclusive results froma preclinical study or clinical trial or adverse medical events during aclinical trial could cause a preclinical study or clinical trial to be repeatedor a program to be terminated, even if other studies or trials relating to theprogram are successful;

 

•                  the FDA can place a hold on aclinical trial if, among other reasons, it finds that patients enrolled in thetrial are or would be exposed to an unreasonable and significant risk ofillness or injury;

 

•                  we may encounter delays or rejectionsbased on changes in regulatory agency policies during the period in which wedevelop a drug or the period required for review of any application forregulatory agency approval; and

 

•                  our clinical trials may notdemonstrate the safety and efficacy needed for our products to receiveregulatory approval.

 

If we are required to conduct additional clinicaltrials or other studies beyond those that we currently contemplate, if we areunable to successfully complete our clinical trials or other studies or if theresults of these trials or studies are not positive or are only modestlypositive, we may be delayed in obtaining marketing approval, we may not be ableto obtain marketing approval or we may obtain approval for indications that arenot as broad as intended.  Our productdevelopment costs will also increase if we experience delays in testing orapprovals.  Significant clinical trialdelays could allow our competitors to bring products to market before we do andimpair our ability to commercialize our products or potential products.  If any of this occurs, our business will bematerially harmed.

 

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

 

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

 

As a result of patent infringement claims, or in orderto avoid potential claims, we or our collaborators may choose or be required toseek a license from the third party and be required to pay license fees orroyalties or both.  These licenses maynot be available on acceptable terms, or at all.  Even if we or our collaborators were able toobtain a license, the rights

 

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may be nonexclusive,which could result in our competitors gaining access to the same intellectualproperty.  Ultimately, we could beprevented from commercializing a product, or be forced to cease some aspect ofour business operations, if, as a result of actual or threatened patentinfringement claims, we or our collaborators are unable to enter into licenseson acceptable terms.  This could harm ourbusiness significantly.

 

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

 

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

 

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

*** ***

***If third-party payors do notadequately reimburse customers for any of our approved products, they might notbe purchased or used, and our revenues and profits will not develop orincrease.***

 

Our revenues and profits will depend heavily upon theavailability of adequate reimbursement for the use of our approved productcandidates from governmental and other third-party payors, both in the UnitedStates and in foreign markets. Reimbursement by a third-party payor may dependupon a number of factors, including the third-party payor’s determination thatuse of a product is:

 

•                  a covered benefit under its healthplan;

 

•                  safe, effective and medicallynecessary;

 

•                  appropriate for the specific patient;

 

•                  cost-effective; and

 

•                  neither experimental norinvestigational.

 

Obtaining reimbursement approval for a product fromeach government or other third-party payor is a time-consuming and costlyprocess that could require us to provide supporting scientific, clinical andcost-effectiveness data for the use of our products to each payor. We may notbe able to provide data sufficient to gain acceptance with respect toreimbursement.

 

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Evenwhen a payor determines that a product is eligible for reimbursement, the payormay impose coverage limitations that preclude payment for some uses that areapproved by the FDA or comparable authority. Moreover, eligibility for coveragedoes not imply that any product will be reimbursed in all cases or at a ratethat allows us to make a profit or even cover our costs. Interim payments fornew products, if applicable, may also not be sufficient to cover our costs andmay not be made permanent. Reimbursement rates may vary according to the use ofthe product and the clinical setting in which it is used, may be based onpayments allowed for lower-cost products that are already reimbursed, may beincorporated into existing payments for other products or services, and mayreflect budgetary constraints and/or imperfections in Medicare, Medicaid orother data used to calculate these rates. Net prices for products may bereduced by mandatory discounts or rebates required by government health careprograms or by any future relaxation of laws that restrict imports of certainmedical products from countries where they may be sold at lower prices than inthe United States.

 

There have been, and we expect that there willcontinue to be, federal and state proposals to constrain expenditures formedical products and services, which may affect payments for our products. TheCenters for Medicare and Medicaid Services, or CMS, frequently change productdescriptors, coverage policies, product and service codes, paymentmethodologies and reimbursement values. Third-party payors often followMedicare coverage policy and payment limitations in setting their ownreimbursement rates, and both CMS and other third-party payors may havesufficient market power to demand significant price reductions. Due in part toactions by third-party payors, the health care industry is experiencing a trendtoward containing or reducing costs through various means, including loweringreimbursement rates, limiting therapeutic class coverage and negotiatingreduced payment schedules with service providers for drug products.

 

Our inability to promptly obtain coverage andprofitable reimbursement rates from government-funded and private payors forour products could have a material adverse effect on our operating results andour overall financial condition.

 

***If******we areunable to establish, maintain and rely on new collaborative relationships, thenwe may not be able to successfully develop and commercialize our technologies.***

 

Wecurrently expect that the continued development of our technologies will resultin the initiation of research and development efforts and additional clinicaltrials. We expect that these developments will require us to establish,maintain and rely on new collaborative relationships in order to successfully developand commercialize our technologies. We face significant competition in seekingappropriate collaborators. Collaboration arrangements are complex to negotiateand time consuming to document. We may not be successful in our efforts toestablish additional collaborations or other alternative arrangements, and theterms of any such collaboration or alternative arrangement may not be favorableto us. There is no certainty that:

 

•                  we will be able to enter into suchcollaborations on economically feasible and otherwise acceptable terms andconditions;

 

•                  such collaborations will not requireus to undertake substantial additional obligations or require us to devoteadditional resources beyond those we have identified at present;

 

•                  any of our collaborators will notbreach or terminate their agreements with us or otherwise fail to conduct theiractivities on time, thereby delaying the development or commercialization ofthe technology for which the parties are collaborating;

 

•                  our collaborators will agree to providedus with any rights in the intellectual property generated by suchcollaborations; and

 

•                  the parties will not dispute theownership rights to any technologies developed under such collaborations.

 

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

 

Our IMPACS technology is licensed from SUNY, referredto herein as the SUNY License, and other academic and research institutionscollaborating with SUNY.  Under the SUNYLicense, we have an exclusive worldwide license to SUNY’s rights in certainpatents and patent applications to make and sell products employingtetracyclines to treat certain disease conditions.  The SUNY License imposes various payment andreporting obligations on us, and our failure to comply

 

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with these requirementspermits SUNY to terminate the SUNY License. If the SUNY License is terminated, we would lose our right to excludecompetitors from commercializing similar products, and we could be excludedfrom marketing the same products if SUNY licensed the underlying technology toa competitor after terminating the SUNY License.  The SUNY License is terminable by SUNY on 90days prior notice only upon our failure to make timely payments, reimbursementsor reports, if the failure is not cured by us within 90 days.  The termination of the SUNY License, or thefailure to obtain and maintain patent protection for our technologies, wouldhave a material adverse effect on our business, financial condition, liquidityand results of operations.

 

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

 

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

 

Our insurer has also notified us that our generalproduct liability policy will not cover claims arising from our past sales ofVioxx® to the extent such claims are made after December 31,2004.  This does not affect our rightsunder the Co-Promotion Agreement with Merck, which provides for indemnificationof us by Merck against any claims arising from manufacturing or design defectsin the Vioxx product or for which we, as the seller of the product, may bestrictly liable as a seller of an inherently dangerous product.

 

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

 

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

 

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

 

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

 
| **Quarter Ended** | ** ** | **High** | ** ** | **Low** | ** ** |
|------------------------|------------|----------|------------|---------|------------|
|                   |       |     |       |    |       |
| December 31, 2005      |       | $        | 12.07      |    | $          | 8.50 |   |
|                   |       |     |       |    |       |
| March 31, 2006         |       | $        | 14.80      |    | $          | 11.27 |   |
| June 30, 2006          |       | $        | 14.67      |    | $          | 10.52 |   |
| September 30, 2006     |       | $        | 13.22      |    | $          | 8.52 |   |
| December 31, 2006      |       | $        | 14.65      |    | $          | 11.35 |   |
|                   |       |     |       |    |       |
| March 31, 2007         |       | $        | 15.58      |    | $          | 12.70 |   |
| June 30, 2007          |       | $        | 14.48      |    | $          | 9.91 |   |
| September 30, 2007     |       | $        | 13.49      |    | $          | 8.98 |   |

 

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**Item 5.****        OtherInformation**

 

On November 6, 2007, we announced that we had decidedto discontinue all development work on incyclinide for an acne indication.

 

**Item 6.**           Exhibits.

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

 

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**SIGNATURES**

 

Pursuant to the requirements of the SecuritiesExchange Act of 1934, the registrant has duly caused this report to be signedon its behalf by the undersigned thereunto duly authorized.

 
|                              | CollaGenex  Pharmaceuticals, Inc. |
|------------------------------|-----------------------------------|
|                         |                              |
|                         |                              |
| Date:  November 7, 2007 | By:                               | /s/ Colin W. Stewart |
|                         |                              | Colin W. Stewart |
|                         |                              | President and Chief  Executive Officer |
|                         |                              | (Principal Executive  Officer) |
|                         |                              |   |
|                         |                              |   |
| Date:  November 7, 2007 | By:                               | /s/ Nancy C. Broadbent |
|                         |                              | Nancy C. Broadbent |
|                         |                              | Chief Financial Officer  (Principal |
|                         |                              | Financial and  Accounting Officer) |

 

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