##### Table of Contents

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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, DC 20549



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FORM 10-Q



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QUARTERLY REPORT PURSUANT TO SECTION
13 OR 15(d) OF

THE SECURITIES EXCHANGE ACT OF 1934



For the quarterly period ended June 30, 2004

Commission File Number 0-28308



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CollaGenex Pharmaceuticals, Inc.

(Exact Name of Registrant as Specified in Its Charter)



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



(215) 579-7388

(Registrants Telephone Number, Including Area Code)



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Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was
required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    Yes:  x    No: ̈



Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange
Act).    Yes:  x    No: ̈



Indicate the number of shares outstanding of each of the
Registrants classes of Common Stock as of July 30, 2004:



|                            |  |                 
|--------------------------- |  | ----------------
|Class                       |  | Number of Shares
|Common Stock $.01 par value |  | 14,368,527      



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##### Table of Contents

COLLAGENEX PHARMACEUTICALS, INC.



TABLE OF
CONTENTS



|                              |  |         |  |                                                                                                               |  |     
|----------------------------- |  | ------- |  | ------------------------------------------------------------------------------------------------------------- |  | ----
|                              |  |         |  |                                                                                                               |  | Page
|PART I.
FINANCIAL INFORMATION |  | 1      
|                              |  |         | 
|                              |  | Item 1. |  | Financial Statements (unaudited)                                                                              |  | 1   
|                              |  |         | 
|                              |  |         |  | Condensed Consolidated Balance Sheets as of June 30, 2004 and December 31, 2003 (unaudited)                   |  | 2   
|                              |  |         | 
|                              |  |         |  | Condensed Consolidated Statements of Operations for the Three Months Ended June 30, 2004 and 2003 (unaudited) |  | 3   
|                              |  |         | 
|                              |  |         |  | Condensed Consolidated Statements of Operations for the Six Months Ended June 30, 2004 and 2003 (unaudited)   |  | 4   
|                              |  |         | 
|                              |  |         |  | Condensed Consolidated Statements of Cash Flows for the Six Months Ended June 30, 2004 and 2003 (unaudited)   |  | 5   
|                              |  |         | 
|                              |  |         |  | Notes to Condensed Consolidated Financial Statements (unaudited)                                              |  | 6   
|                              |  |         | 
|                              |  | Item 2. |  | Managements Discussion and Analysis of Financial Condition and Results of Operations                         |  | 13  
|                              |  |         | 
|                              |  |         |  | Results of Operations                                                                                         |  | 16  
|                              |  |         | 
|                              |  |         |  | Liquidity and Capital Resources                                                                               |  | 24  
|                              |  |         | 
|                              |  |         |  | Additional Risks That May Affect Results                                                                      |  | 29  
|                              |  |         | 
|                              |  | Item 3. |  | Quantitative and Qualitative Disclosures About Market Risk                                                    |  | 36  
|                              |  |         | 
|                              |  | Item 4. |  | Controls and Procedures                                                                                       |  | 36  
|                              | 
|PART II.
OTHER INFORMATION    |  | 38     
|                              |  |         | 
|                              |  | Item 1. |  | Legal Proceedings                                                                                             |  | 38  
|                              |  |         | 
|                              |  | Item 2. |  | Changes in Securities, Use of Proceeds and Issuer Purchases of Equity Securities                              |  | 39  
|                              |  |         | 
|                              |  | Item 3. |  | Defaults Upon Senior Securities                                                                               |  | 39  
|                              |  |         | 
|                              |  | Item 4. |  | Submission of Matters to a Vote of Security Holders                                                           |  | 39  
|                              |  |         | 
|                              |  | Item 5. |  | Other Information                                                                                             |  | 40  
|                              |  |         | 
|                              |  | Item 6. |  | Exhibits and Reports on Form 8-K                                                                              |  | 42  
|                              | 
|SIGNATURES                    |  | 43     



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##### Table of Contents

PART I. FINANCIAL INFORMATION



Item 1. Financial Statements (unaudited).



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##### Table of Contents

COLLAGENEX PHARMACEUTICALS, INC.

AND SUBSIDIARIES



Condensed Consolidated Balance Sheets

June 30, 2004 and December 31, 2003

(dollars
in thousands, except share data)



|                                                                                                                                                                                                                                                                                                                                                                                                 |  |               |         |   |                  |   |         |  
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------ |  | ------------- | ------- | - | ---------------- | - | ------- | -
|                                                                                                                                                                                                                                                                                                                                                                                                 |  | June 30, 2004 |         |   | December 31,2003 |  
|                                                                                                                                                                                                                                                                                                                                                                                                 |  | (unaudited)   |         |   |                  |  
|Assets                                                                                                                                                                                                                                                                                                                                                                                           |  |               |         |   |                  |   |         |  
|Current assets:                                                                                                                                                                                                                                                                                                                                                                                  |  |               |         |   |                  |   |         |  
|Cash and cash equivalents                                                                                                                                                                                                                                                                                                                                                                        |  | $             | 30,655  |   |                  | $ | 32,670  |  
|Accounts receivable, net of allowances of $361 and $481 at June 30, 2004 and December 31, 2003, respectively                                                                                                                                                                                                                                                                                     |  |               | 8,335   |   |                  |   | 5,786   |  
|Inventories                                                                                                                                                                                                                                                                                                                                                                                      |  |               | 1,309   |   |                  |   | 1,672   |  
|Prepaid expenses and other current assets                                                                                                                                                                                                                                                                                                                                                        |  |               | 2,804   |   |                  |   | 1,732   |  
|                                                                                                                                                                                                                                                                                                                                                                                                 |  |               |         |   |                  |   |         |  
|Total current assets                                                                                                                                                                                                                                                                                                                                                                             |  |               | 43,103  |   |                  |   | 41,860  |  
|                                                                                                                                                                                                                                                                                                                                                                                                 |  |              
|Equipment and leasehold improvements, net                                                                                                                                                                                                                                                                                                                                                        |  |               | 549     |   |                  |   | 496     |  
|Deferred license fees                                                                                                                                                                                                                                                                                                                                                                            |  |               | 1,458   |   |                  |   | 1,749   |  
|Other assets                                                                                                                                                                                                                                                                                                                                                                                     |  |               | 42      |   |                  |   | 27      |  
|                                                                                                                                                                                                                                                                                                                                                                                                 |  |               |         |   |                  |   |         |  
|Total assets                                                                                                                                                                                                                                                                                                                                                                                     |  | $             | 45,152  |   |                  | $ | 44,132  |  
|                                                                                                                                                                                                                                                                                                                                                                                                 |  |               |         |   |                  |   |         |  
|Liabilities and Stockholders Equity                                                                                                                                                                                                                                                                                                                                                             |  |               |         |   |                  |   |         |  
|Current liabilities:                                                                                                                                                                                                                                                                                                                                                                             |  |               |         |   |                  |   |         |  
|Accounts payable                                                                                                                                                                                                                                                                                                                                                                                 |  | $             | 2,591   |   |                  | $ | 3,699   |  
|Accrued expenses                                                                                                                                                                                                                                                                                                                                                                                 |  |               | 4,124   |   |                  |   | 5,351   |  
|Preferred dividends payable                                                                                                                                                                                                                                                                                                                                                                      |  |               |        |   |                  |   | 800     |  
|                                                                                                                                                                                                                                                                                                                                                                                                 |  |               |         |   |                  |   |         |  
|Total current liabilities                                                                                                                                                                                                                                                                                                                                                                        |  |               | 6,715   |   |                  |   | 9,850   |  
|                                                                                                                                                                                                                                                                                                                                                                                                 |  |               |         |   |                  |   |         |  
|Deferred revenue                                                                                                                                                                                                                                                                                                                                                                                 |  |               | 310     |   |                  |   | 326     |  
|                                                                                                                                                                                                                                                                                                                                                                                                 |  |               |         |   |                  |   |         |  
|Commitments and Contingencies                                                                                                                                                                                                                                                                                                                                                                    |  |               |         |   |                  |   |         |  
|Stockholders equity:                                                                                                                                                                                                                                                                                                                                                                            |  |               |         |   |                  |   |         |  
|Preferred stock, $0.01 par value, 5,000,000 shares authorized; 200,000 shares of Series D cumulative convertible preferred stock issued and
outstanding at June 30, 2004 and December 31, 2003 (liquidation value of $20,800); 150,000 shares of Series A participating preferred stock, $0.01 par value, designated and no shares issued and outstanding at June 30, 2004 and December 31,
2003 |  |               | 2       |   |                  |   | 2       |  
|Common stock, $0.01 par value; 25,000,000 shares authorized, 14,356,027 and 13,842,200 shares issued and outstanding at June 30, 2004 and
December 31, 2003, respectively                                                                                                                                                                                                                        |  |               | 144     |   |                  |   | 138     |  
|Additional paid in capital                                                                                                                                                                                                                                                                                                                                                                       |  |               | 105,870 |   |                  |   | 103,670 |  
|Accumulated deficit                                                                                                                                                                                                                                                                                                                                                                              |  |               | (67,889 | ) |                  |   | (69,854 | )
|                                                                                                                                                                                                                                                                                                                                                                                                 |  |               |         |   |                  |   |         |  
|Total stockholders equity                                                                                                                                                                                                                                                                                                                                                                       |  |               | 38,127  |   |                  |   | 33,956  |  
|                                                                                                                                                                                                                                                                                                                                                                                                 |  |               |         |   |                  |   |         |  
|Total liabilities and stockholders equity                                                                                                                                                                                                                                                                                                                                                       |  | $             | 45,152  |   |                  | $ | 44,132  |  
|                                                                                                                                                                                                                                                                                                                                                                                                 |  |               |         |   |                  |   |         |  



See accompanying notes
to unaudited condensed consolidated financial statements.



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##### Table of Contents

COLLAGENEX PHARMACEUTICALS, INC.

AND SUBSIDIARIES



Condensed Consolidated Statements of Operations

For the Three Months Ended June 30, 2004 and 2003

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

(unaudited)



|                                                                                                        |  |                             |            |      |   |            |  
|------------------------------------------------------------------------------------------------------- |  | --------------------------- | ---------- | ---- | - | ---------- | -
|                                                                                                        |  | Three Months Ended June 30, |           
|                                                                                                        |  | 2004                        |            | 2003 |  
|Revenues:                                                                                               |  |                             |            |      |   |            |  
|Net product sales                                                                                       |  | $                           | 14,372     |      | $ | 11,750     |  
|Contract revenues                                                                                       |  |                             | 60         |      |   | 503        |  
|License revenues                                                                                        |  |                             | 13         |      |   | 433        |  
|                                                                                                        |  |                             |            |      |   |            |  
|Total revenues                                                                                          |  |                             | 14,445     |      |   | 12,686     |  
|                                                                                                        |  |                             |            |      |   |            |  
|Operating expenses:                                                                                     |  |                             |            |      |   |            |  
|Cost of product sales                                                                                   |  |                             | 2,052      |      |   | 1,738      |  
|Research and development                                                                                |  |                             | 2,457      |      |   | 1,654      |  
|Selling, general and administrative  other                                                             |  |                             | 7,530      |      |   | 7,718      |  
|Selling, general and administrative  restructuring (note 8)                                            |  |                             | 480        |      |   |           |  
|                                                                                                        |  |                             |            |      |   |            |  
|Total operating expenses                                                                                |  |                             | 12,519     |      |   | 11,110     |  
|                                                                                                        |  |                             |            |      |   |            |  
|Operating income                                                                                        |  |                             | 1,926      |      |   | 1,576      |  
|                                                                                                        |  |                            
|Other income (expense):                                                                                 |  |                             |            |      |   |            |  
|Interest income                                                                                         |  |                             | 69         |      |   | 25         |  
|Other income (expense)                                                                                  |  |                             | 3          |      |   | (4         | )
|                                                                                                        |  |                             |            |      |   |            |  
|Net income                                                                                              |  |                             | 1,998      |      |   | 1,597      |  
|Preferred stock dividend                                                                                |  |                             | 400        |      |   | 400        |  
|                                                                                                        |  |                             |            |      |   |            |  
|Net income allocable to common stockholders                                                             |  | $                           | 1,598      |      | $ | 1,197      |  
|                                                                                                        |  |                             |            |      |   |            |  
|Net income per basic share allocable to common stockholders                                             |  | $                           | 0.11       |      | $ | 0.10       |  
|                                                                                                        |  |                             |            |      |   |            |  
|Weighted average shares used in computing net income per basic share allocable to common stockholders   |  |                             | 14,310,289 |      |   | 11,427,420 |  
|                                                                                                        |  |                             |            |      |   |            |  
|Net income per diluted share allocable to common stockholders                                           |  | $                           | 0.11       |      | $ | 0.10       |  
|                                                                                                        |  |                             |            |      |   |            |  
|Weighted average shares used in computing net income per diluted share allocable to common stockholders |  |                             | 14,741,845 |      |   | 12,369,971 |  
|                                                                                                        |  |                             |            |      |   |            |  



See accompanying notes
to unaudited condensed consolidated financial statements.



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##### Table of Contents

COLLAGENEX PHARMACEUTICALS, INC.

AND SUBSIDIARIES



Condensed Consolidated Statements of Operations

For the Six Months Ended June 30, 2004 and 2003

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

(unaudited)



|                                                                                                        |  |                           |            |      |   |            |  
|------------------------------------------------------------------------------------------------------- |  | ------------------------- | ---------- | ---- | - | ---------- | -
|                                                                                                        |  | Six Months Ended June 30, |           
|                                                                                                        |  | 2004                      |            | 2003 |  
|Revenues:                                                                                               |  |                           |            |      |   |            |  
|Net product sales                                                                                       |  | $                         | 27,700     |      | $ | 23,120     |  
|Contract revenues                                                                                       |  |                           | 120        |      |   | 1,053      |  
|License revenues                                                                                        |  |                           | 31         |      |   | 670        |  
|                                                                                                        |  |                           |            |      |   |            |  
|Total revenues                                                                                          |  |                           | 27,851     |      |   | 24,843     |  
|                                                                                                        |  |                           |            |      |   |            |  
|Operating expenses:                                                                                     |  |                           |            |      |   |            |  
|Cost of product sales                                                                                   |  |                           | 4,053      |      |   | 3,652      |  
|Research and development                                                                                |  |                           | 3,845      |      |   | 2,621      |  
|Selling, general and administrative  other                                                             |  |                           | 15,648     |      |   | 15,791     |  
|Selling, general and administrative  restructuring                                                     |  |                           | 480        |      |   |           |  
|Selling, general and administrative  legal settlement (note 7)                                         |  |                           | 2,000      |      |   |           |  
|                                                                                                        |  |                           |            |      |   |            |  
|Total operating expenses                                                                                |  |                           | 26,026     |      |   | 22,064     |  
|                                                                                                        |  |                           |            |      |   |            |  
|Operating income                                                                                        |  |                           | 1,825      |      |   | 2,779      |  
|                                                                                                        |  |                          
|Other income (expense):                                                                                 |  |                           |            |      |   |            |  
|Interest income                                                                                         |  |                           | 140        |      |   | 56         |  
|Other expense                                                                                           |  |                           |           |      |   | (10        | )
|                                                                                                        |  |                           |            |      |   |            |  
|Net income                                                                                              |  |                           | 1,965      |      |   | 2,825      |  
|Preferred stock dividend                                                                                |  |                           | 800        |      |   | 800        |  
|                                                                                                        |  |                           |            |      |   |            |  
|Net income allocable to common stockholders                                                             |  | $                         | 1,165      |      | $ | 2,025      |  
|                                                                                                        |  |                           |            |      |   |            |  
|Net income per basic share allocable to common stockholders                                             |  | $                         | 0.08       |      | $ | 0.18       |  
|                                                                                                        |  |                           |            |      |   |            |  
|Weighted average shares used in computing net income per basic share allocable to common stockholders   |  |                           | 14,140,509 |      |   | 11,410,914 |  
|                                                                                                        |  |                           |            |      |   |            |  
|Net income per diluted share allocable to common stockholders                                           |  | $                         | 0.08       |      | $ | 0.17       |  
|                                                                                                        |  |                           |            |      |   |            |  
|Weighted average shares used in computing net income per diluted share allocable to common stockholders |  |                           | 14,668,578 |      |   | 12,252,893 |  
|                                                                                                        |  |                           |            |      |   |            |  



See accompanying notes
to unaudited condensed consolidated financial statements.



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##### Table of Contents

COLLAGENEX PHARMACEUTICALS, INC.

AND SUBSIDIARIES



Condensed Consolidated Statements of Cash Flows

For the Six Months Ended June 30, 2004 and 2003

(dollars in thousands)

(unaudited)



|                                                                                            |  |                           |        |   |      |   |        |  
|------------------------------------------------------------------------------------------- |  | ------------------------- | ------ | - | ---- | - | ------ | -
|                                                                                            |  | Six Months Ended June 30, |       
|                                                                                            |  | 2004                      |        |   | 2003 |  
|Cash flows from operating activities:                                                       |  |                           |        |   |      |   |        |  
|Net income                                                                                  |  | $                         | 1,965  |   |      | $ | 2,825  |  
|Adjustments to reconcile net income to net cash (used in) provided by operating activities: |  |                           |        |   |      |   |        |  
|Non-cash compensation expense                                                               |  |                           |       |   |      |   | 251    |  
|Depreciation and amortization expense                                                       |  |                           | 463    |   |      |   | 445    |  
|Accounts receivable provisions                                                              |  |                           | (120   | ) |      |   | 344    |  
|Changes in operating assets and liabilities:                                                |  |                           |        |   |      |   |        |  
|Accounts receivable                                                                         |  |                           | (2,429 | ) |      |   | 113    |  
|Inventories                                                                                 |  |                           | 363    |   |      |   | (274   | )
|Prepaid expenses and other assets                                                           |  |                           | (1,087 | ) |      |   | (365   | )
|Accounts payable                                                                            |  |                           | (1,108 | ) |      |   | (315   | )
|Accrued expenses                                                                            |  |                           | (1,227 | ) |      |   | (244   | )
|Deferred revenue                                                                            |  |                           | (16    | ) |      |   | (219   | )
|                                                                                            |  |                           |        |   |      |   |        |  
|Net cash (used in) provided by operating activities                                         |  |                           | (3,196 | ) |      |   | 2,561  |  
|                                                                                            |  |                           |        |   |      |   |        |  
|Cash flows from investing activities:                                                       |  |                           |        |   |      |   |        |  
|Capital expenditures                                                                        |  |                           | (225   | ) |      |   | (224   | )
|Payment for Altana License                                                                  |  |                           |       |   |      |   | (900   | )
|                                                                                            |  |                           |        |   |      |   |        |  
|Net cash used in investing activities                                                       |  |                           | (225   | ) |      |   | (1,124 | )
|                                                                                            |  |                           |        |   |      |   |        |  
|Cash flows from financing activities:                                                       |  |                           |        |   |      |   |        |  
|Net proceeds from issuance of common stock                                                  |  |                           | 2,206  |   |      |   | 706    |  
|Payment of preferred dividends                                                              |  |                           | (800   | ) |      |   | (800   | )
|                                                                                            |  |                           |        |   |      |   |        |  
|Net cash provided by (used in) financing activities                                         |  |                           | 1,406  |   |      |   | (94    | )
|                                                                                            |  |                           |        |   |      |   |        |  
|Net (decrease) increase in cash and cash equivalents                                        |  |                           | (2,015 | ) |      |   | 1,343  |  
|Cash and cash equivalents at beginning of period                                            |  |                           | 32,670 |   |      |   | 10,112 |  
|                                                                                            |  |                           |        |   |      |   |        |  
|Cash and cash equivalents at end of period                                                  |  | $                         | 30,655 |   |      | $ | 11,455 |  
|                                                                                            |  |                           |        |   |      |   |        |  



See accompanying notes
to unaudited condensed consolidated financial statements.



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##### Table of Contents

COLLAGENEX PHARMACEUTICALS, INC.

AND SUBSIDIARIES



NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

June 30, 2004 and 2003

(dollars in
thousands, except per share data)

(Unaudited)



Note 1  Basis of Presentation



The unaudited condensed consolidated financial statements included herein have been prepared by the Company, pursuant to the rules and regulations of the
Securities and Exchange Commission and in accordance with accounting principles generally accepted in the United States of America. Certain information and footnote disclosures normally included in the annual consolidated financial statements
prepared in accordance with accounting principles generally accepted in the United States of America have been condensed or omitted pursuant to such rules and regulations. These unaudited condensed consolidated financial statements should be read in
conjunction with the Companys 2003 audited consolidated financial statements and footnotes included in its Annual Report on Form 10-K for the year ended December 31, 2003.



The accompanying unaudited condensed consolidated financial statements include the results of the Company and its
wholly-owned subsidiaries. All intercompany accounts and transactions have been eliminated in consolidation.



Certain amounts in the 2003 consolidated financial statements have been reclassified to conform to the 2004 presentation.



In the opinion of the Companys management, the accompanying unaudited
condensed consolidated financial statements have been prepared on a basis substantially consistent with the audited consolidated financial statements for the year ended December 31, 2003 and contain adjustments, all of which are of a normal
recurring nature, necessary to present fairly the Companys consolidated financial position at June 30, 2004, the results of operations for the three and six months ended June 30, 2004 and 2003, and the cash flows for the six months ended June
30, 2004 and 2003. Interim results are not necessarily indicative of results anticipated for the full fiscal year.



Statement of Financial Accounting Standards (SFAS) No. 123 (SFAS 123), Accounting for Stock-Based Compensation, encourages but
does not require companies to record compensation cost for stock-based employee and director compensation plans at fair value. Accordingly, the Company has elected to account for stock-based compensation under Accounting Principles Board
(APB) Opinion No. 25, Accounting for Stock Issued to Employees, and related interpretations, and compensation cost for stock options issued to employees and directors is measured as the excess, if any, of the market price of
the Companys stock at the date both the number of shares and price per share are known (measurement date) over the exercise price. Such amounts are amortized on a straight-line basis over the respective vesting periods of the option grants.
Transactions with nonemployees (if any) in which goods or services are the consideration received for the issuance of equity instruments are accounted for on a fair value basis in accordance with SFAS 123 and related interpretations.



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##### Table of Contents

As set forth below, the pro forma disclosures of net income (loss) allocable to common stockholders and
income (loss) per share allocable to common stockholders are as if the Company had adopted the fair value based method of accounting in accordance with SFAS No. 123, as amended by SFAS No. 148, which assumes the fair value based method of accounting
had been adopted:



|                                                                                                        |  |                             |       |   |                           |   |        |      |  |   |        |   |  |   |        |  
|------------------------------------------------------------------------------------------------------- |  | --------------------------- | ----- | - | ------------------------- | - | ------ | ---- |  | - | ------ | - |  | - | ------ | -
|                                                                                                        |  | Three Months Ended June 30, |       |   | Six Months Ended June 30, |  
|                                                                                                        |  | 2004                        |       |   | 2003                      |   |        | 2004 |  |   | 2003   |  
|Net income allocable to common stockholders:                                                            |  |                             |       |   |                           |   |        |      |  |   |        |   |  |   |        |  
|As reported                                                                                             |  | $                           | 1,598 |   |                           | $ | 1,197  |      |  | $ | 1,165  |   |  | $ | 2,025  |  
|Add: Stock-based employee compensation expenses included in net income allocable to common stockholders |  |                             |      |   |                           |   |       |      |  |   |       |   |  |   | 251    |  
|Less: Stock-based employee compensation under fair value based method                                   |  |                             | (897  | ) |                           |   | (1,343 | )    |  |   | (1,923 | ) |  |   | (2,537 | )
|                                                                                                        |  |                             |       |   |                           |   |        |      |  |   |        |   |  |   |        |  
|Pro forma net income (loss)                                                                             |  | $                           | 701   |   |                           | $ | (146   | )    |  | $ | (758   | ) |  | $ | (261   | )
|                                                                                                        |  |                             |       |   |                           |   |        |      |  |   |        |   |  |   |        |  
|Basic net income (loss) per share allocable to common stockholders:                                     |  |                             |       |   |                           |   |        |      |  |   |        |   |  |   |        |  
|As reported                                                                                             |  | $                           | 0.11  |   |                           | $ | 0.10   |      |  | $ | 0.08   |   |  | $ | 0.18   |  
|                                                                                                        |  |                             |       |   |                           |   |        |      |  |   |        |   |  |   |        |  
|Pro forma net income (loss)                                                                             |  | $                           | 0.05  |   |                           | $ | (0.01  | )    |  | $ | (0.05  | ) |  | $ | (0.02  | )
|                                                                                                        |  |                             |       |   |                           |   |        |      |  |   |        |   |  |   |        |  
|Diluted net income (loss) per share allocable to common stockholders:                                   |  |                             |       |   |                           |   |        |      |  |   |        |   |  |   |        |  
|As reported                                                                                             |  | $                           | 0.11  |   |                           | $ | 0.10   |      |  | $ | 0.08   |   |  | $ | 0.17   |  
|                                                                                                        |  |                             |       |   |                           |   |        |      |  |   |        |   |  |   |        |  
|Pro forma net income (loss)                                                                             |  | $                           | 0.05  |   |                           | $ | (0.01  | )    |  | $ | (0.05  | ) |  | $ | (0.02  | )
|                                                                                                        |  |                             |       |   |                           |   |        |      |  |   |        |   |  |   |        |  



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Note 2  Inventories



Inventories at June 30, 2004 and December 31, 2003 consist of the following:



|                |  |      |       |      |   |      
|--------------- |  | ---- | ----- | ---- | - | -----
|                |  | 2004 |       | 2003
|Raw materials   |  | $    | 33    |      | $ | 396  
|Work-in-process |  |      | 453   |      |   | 52   
|Finished goods  |  |      | 823   |      |   | 1,224
|                |  |      |       |      |   |      
|                |  | $    | 1,309 |      | $ | 1,672
|                |  |      |       |      |   |      



Note 3  Line of Credit



On June 7, 2004, the Company entered into a Loan
Modification Agreement with Silicon Valley Bank to renew its revolving credit facility, as modified by such agreement, which had expired on March 15, 2004. The credit facility expires on May 31, 2006. Pursuant to the terms of the credit facility,
the Company may borrow up to the lesser of $5,000 or 80% of eligible accounts receivable, as defined under the credit facility. The amount available to the Company is reduced by any outstanding letters of credit which may be issued under the credit
facility in amounts totaling up to $2,000. As the Company pays down amounts under any letter of credit, the amount available to it under the credit facility increases. As of June 30, 2004, the Company had an outstanding letter of credit
approximating $544 that served as collateral for certain inventory purchase commitments of the Company. The Company is not obligated to draw amounts and any borrowings shall bear interest, payable monthly, at the current prime rate. Without the
consent of Silicon Valley Bank, the Company, among other things, shall not: (i) merge or consolidate with another entity; (ii) acquire assets outside the ordinary course of business; or (iii) pay or declare any cash dividends on the Companys
common stock.The Company must maintain a minimum tangible net worth, as defined, of at least $28,000, subject to certain upward adjustments, as a result of profitable operations or additional debt or equity financings. In addition, the
Company must maintain a quick ratio of at least 2 to 1. In addition, the Company has secured its obligations under the credit facility through the granting of a security interest in favor of the bank with respect to all of the Companys assets.
As of June 30, 2004, the Company had no borrowings outstanding against the credit facility.



Note 4  Commitments and Contingencies



On August 24, 2001, the Company signed an exclusive License Agreement (the Atrix License Agreement) with Atrix Laboratories, Inc. to market Atrixs proprietary dental products, Atridox®, Atrisorb® FreeFlow and Atrisorb®-D, to the United States dental market. Pursuant to the terms of the Atrix License
Agreement, the Company is required to make certain annual minimum expenditures for the lesser of $4,000 or 30% of the Companys contribution margin, as defined in the agreement, relating to a specific Atrix product that the Company markets and
the lesser of $2,000 or 30% of the Companys contribution margin, as defined in the agreement, relating to another Atrix product that the Company markets. The Company spent $863 during the year ended December 31, 2003 which, in the aggregate,
exceeded the spending requirements for each of the provisions in the Agreement. During the six month periods ending June 30, 2004 and June 30, 2003, the Company spent in the aggregate $480 and $468, respectively, related to each provision in the
Agreement.



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On February 11, 2002, the Company executed a Co-operation, Development and Licensing Agreement pursuant
to which the Company was granted an exclusive, sublicenseable, transferable license with respect to the Restoraderm topical drug delivery system which the Company intends to develop for dermatological applications. Pursuant to the terms of such agreement, upon the
occurrence of certain events, the Company will be required to pay certain future consulting, royalty and milestone payments in the aggregate amount of up to approximately $3,150. The Company paid $76 under this Agreement during the six months ended
June 30, 2004 and has paid an aggregate of $1,006 through June 30, 2004. The term of such agreement is for the life of any patent that may be issued to the Company for the first product the Company develops utilizing such technology, or, if such a
patent fails to issue, seven years.



As of June 30,
2004, the Company has an obligation to purchase $544 of inventory from the Companys third-party manufacturer of Periostat over the next twelve months.



On June 10, 2002, the Company executed a Development and Licensing Agreement with Shire Laboratories, Inc. pursuant to which the Company was granted an
exclusive worldwide license (including the right to sublicense) to develop, make, have made, use, supply, export, import, register and sell products for the treatment of various inflammatory disorders using Shires technology. In addition,
under the agreement, certain product development functions shall be performed for the Company. Also under the agreement, the Company is committed to payments of up to $5,200 in the aggregate for the indications for which it currently seeks approval.
The payments may be made in cash or at the Companys option, a combination of cash and the Companys common stock, upon the achievement of certain clinical and regulatory milestones. Pursuant to the terms of such agreement, the Company
shall also pay a percentage of certain net sales of products, if any, utilizing any part of the technology. The Company may terminate the agreement upon sixty days notice.



Note 5  Stock Compensation Charge



During March 2003, the Company executed an agreement with Brian M. Gallagher, Ph.D., the Companys former chairman, chief executive officer and
president, pursuant to which Dr. Gallagher was compensated for, among other things, his services during a transition period and to recognize his historical contributions to the Company. As a result of this agreement, the Company recognized a
non-cash compensation charge relating to certain modifications of Dr. Gallaghers stock option agreements of approximately $251 during the six months ended June 30, 2003. The Company also entered into a consulting agreement with Dr. Gallagher
pursuant to which he is providing consulting services to the Company for a period of 24 months, commencing in December 2003.



Note 6  Termination of Co-Promotion/License Agreements



On March 14, 2003, the Company terminated its license agreement with Roche S.P.A. As a result of the termination of the agreement, during the first
quarter of 2003, the Company accelerated the recognition of $222 of unamortized deferred revenue related to the $400 up-front payment received in 1996.



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Pursuant to a Co-Promotion Agreement the Company executed with Merck & Co., Inc. in September 1999,
the Company received the exclusive right to co-promote Vioxx®, a prescription strength non-steroidal anti-inflammatory drug that was approved by the United States Food and Drug Administration (the FDA) on May 20, 1999. The agreement provided for certain payments by
Merck to the Company upon sales of Vioxx to the dental community. On September 23, 2002, the Company executed an amendment, extension and restatement of the Co-Promotion Agreement with Merck with respect to Vioxx. In accordance with that amendment,
extension and restatement, the Companys agreement with Merck automatically expired on December 31, 2003. The Company will continue to earn nominal residual contract revenues through 2005 from the expired agreement with Merck. During the three
and six months ended June 30, 2004, the Company recorded $60 and $120, respectively, in residual contract revenues.



In March 2003, the Company executed co-promotion agreements with Sirius Laboratories, Inc. pursuant to which the Company jointly marketed Sirius
Laboratories AVAR product line and
Pandel® to dermatologists in the United States.
These agreements were mutually terminated on December 31, 2003. The Company has not received any revenue during the six months ended June 30, 2004 and does not expect to receive contract revenues from Sirius Laboratories AVAR thereafter.



On October 1, 2002, the Company entered into a Product
Detailing Agreement with Novartis Consumer Health, Inc. pursuant to which the Company co-promoted Denavir® to target dentists in the United States and received detailing fees and performance incentives from Novartis Consumer Health, Inc. The agreement with Novartis to co-promote Denavir
expired on September 30, 2003, and the Company and Novartis decided not to renew the arrangement with respect to Denavir. The Company has not received any revenue during the six months ended June 30, 2004 and does not expect to receive contract
revenues from Novartis with respect to Denavir thereafter.



Note 7 
Mutual Settlement



In July 2003, the Company sued United
Research Laboratories, Inc./Mutual Pharmaceutical Company, Inc. (Mutual) in the United States District Court for the Eastern District of New York, alleging that Mutuals announced launch of a generic version of Periostat® would infringe the Companys patents directed to
the use of Periostat for the treatment of adult periodontitis. The Companys complaint also alleged that Mutual infringed the Companys patent rights by its offering to sell its generic drug and by submitting an Abbreviated New Drug
Application (ANDA) with the FDA, seeking FDA approval to market a generic tablet version of Periostat. The Companys compliant also alleged that Mutuals offer to sell its generic version of Periostat prior to receiving FDA
approval constituted unfair competition under Section 43(a) of the Lanham (Trademark) Act.



In a separate action in the United States District Court for the District of Columbia, the Company sought and, on July 22, 2003, was granted a preliminary injunction preventing the FDA from approving generic versions
of Periostat, including Mutuals version. Mutual intervened in that case.



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In July 2003, Mutual commenced an action against the Company in the United States District Court for the
Eastern District of Pennsylvania. Mutual alleged that the Company had engaged in an effort to monopolize the market for low-dose doxycycline products.



On April 8, 2004, the Company announced that it had settled all pending litigation between the Company and Mutual.



In connection with the settlement, the Company and Mutual entered into a
License and Supply Agreement pursuant to which Mutual received a license to sell a branded version of Periostat. Under this agreement, the Company will be the sole supplier of this product to Mutual, subject to certain conditions. The product will
be sold to Mutual at prices below the Companys average manufacturers price for Periostat through May 15, 2007 or the earlier termination of such supply arrangements under certain circumstances. In addition, the Company agreed not to
grant any license to sell Periostat in generic form to any third party during the supply term.



In the settlement, Mutual agreed and confessed to judgment that the Companys Periostat patents are valid and would be infringed by the commercial manufacture, use, sale, importation or offer for sale of the
generic version of Periostat for which Mutual submitted its ANDA. Mutual consented to a judgment enjoining Mutual and any party acting in concert with Mutual from infringing the Companys patents by making and selling a generic version of
Periostat until the Companys patents expire or are declared invalid or unenforceable by a court of competent jurisdiction from which decision no appeal has been taken or all appeals have been exhausted. Under the terms of the License and
Supply Agreement, Mutual would be granted a license under the patents if a third-party, generic version of Periostat is launched and remains on the market for a certain period of time, or if the Company materially breaches its obligations under the
agreement. Finally, Mutual agreed to withdraw from the FDA case in the District of Columbia.



The Company paid to Mutual $2,000, which represented a portion of the anticipated fees and expenses that the Company will save as a result of the settlement of the pending actions with Mutual. This charge was recorded
in the first quarter of 2004. Under the Companys license agreement with the Research Foundation of the State University of New York (SUNY) covering Periostat, the Company is entitled to deduct costs incurred to defend its patents,
including this payment, from current and future royalties due to SUNY on net sales of Periostat and Mutuals branded version of Periostat. In April 2004, the Company recorded net product sales of $4,689 associated with the initial stocking
shipment to Mutual pursuant to the License and Supply Agreement. The revenues associated with this transaction included a one-time discount from the price Mutual is contractually obligated to pay for their branded version of Periostat on all
subsequent orders. At June 30, 2004, the revenues associated with the initial stocking sale are reflected in the Companys accounts receivable balance. The outstanding receivable from Mutual is due and payable in various installments commencing
on August 20, 2004 through October 20, 2004.



During the three
months ended March 31, 2004 and June 30, 2004, the Company incurred $2,493 (which includes the $2,000 Mutual settlement) and $365, respectively in legal defense,



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litigation and settlement costs, $952 of which in the aggregate was deducted from royalties payable to SUNY during such
periods. Such cumulative legal costs exceeded the amount of the royalties payable to SUNY as of June 30, 2004. As of June 30, 2004, the Company has $3,514 in previously recognized legal expenses available to offset future royalties earned by SUNY,
if any.



Note 8  Sales Force Restructuring



On April 22, 2004, the Company announced the restructuring of the
Companys pharmaceutical sales organization into dedicated dental and dermatology sales forces. The restructuring is intended to increase the Companys sales focus on high-prescribing dentists and dermatologists while reducing the
Companys cost base. Prior to the reorganization, virtually all of the Companys 115-person pharmaceutical sales force called on both dentists and dermatologists to market the Companys portfolio of dental and dermatology products.
After the restructuring, the Company has a 56-person dental sales force calling on a highly targeted group of 10,000 high prescribing dentists and a 33-person dermatology sales force calling on the 5,600 dermatologists who are the highest
prescribers of acne, rosacea and dermatitis products. The Company incurred a $480 charge for such restructuring costs during the quarter ended June 30, 2004. As of June 30, 2004, approximately $320 of these restructuring costs had been paid by the
Company.



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Item 2. Managements Discussion and Analysis of Financial Condition and Results of Operations.



Overview



CollaGenex Pharmaceuticals, Inc. and subsidiaries is a specialty pharmaceutical company currently focused on providing innovative medical therapies to the
dental and dermatology markets. Our first product, Periostat®, is an orally administered, prescription pharmaceutical product that was approved by the United States Food and Drug Administration (the FDA) in September 1998 and is the first and only pharmaceutical to
treat adult periodontitis by inhibiting the enzymes that destroy periodontal support tissues.



We are marketing Periostat and other pharmaceutical products to the dental and dermatology communities through our own dedicated professional sales force of approximately 90 sales representatives and managers.
Pursuant to an exclusive License and Marketing Agreement with Atrix Laboratories, Inc., we began, in October 2001, to actively market Atrixs proprietary dental products, Atridox® and Atrisorb FreeFlow®, and, in February 2002, Atrisorb-D®, to the United States dental market (the Atrix Products). In May 2002, we
executed a sublicense agreement with Altana Inc. to, among other things, market and distribute, in the United States and Puerto Rico, Pandel®, a mid-potency topical corticosteroid product developed by Altana Inc. We distribute Periostat and Pandel through drug wholesalers and large retail
chains in the United States. Periostat is also sold through wholesalers and direct to dentists in the United Kingdom through our wholly-owned subsidiary, CollaGenex International Ltd., and by distributors and licensees in certain other overseas
markets. The Atrix Products are distributed through specialty distributors who sell these products directly to dental practitioners in the United States and Puerto Rico.



We also continue to implement our plans to expand into the dermatology market, including conducting ongoing studies focused
on the safety and efficacy of Periostat for the treatment of rosacea and the formulation of our product development candidates based on our transdermal drug delivery technology called Restoraderm. In addition, we are actively seeking additional product licensing opportunities to
augment our near-term offerings to the dental and dermatology markets.



Although we achieved net income of $2.0 million for the six months ended June 30, 2004 and net income of $6.4 million and $902,000 for the years ended December 31, 2003 and December 31, 2002, respectively, we have incurred losses in each
other year since inception and have an accumulated deficit of $67.9 million at June 30, 2004.



Statements contained or incorporated by reference in this Quarterly Report on Form 10-Q that are not based on historical fact are forward-looking statements within the meaning of the Private Securities
Litigation Reform Act of 1995, Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. These forward-looking statements regarding future events and our future results are based on
current expectations, estimates, forecasts, and projections and the beliefs and assumptions of our management including, without limitation, our expectations regarding results of operations, selling, general and administrative expenses, research and
development expenses and the



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sufficiency of our cash for future operations. Forward-looking statements may be identified by the use of forward-looking
terminology such as may, will, expect, estimate, anticipate, continue, or similar terms, variations of such terms or the negative of those terms. This Form 10-Q contains
forward-looking statements that involve risks and uncertainties. Our business of selling, marketing and developing pharmaceutical products is subject to a number of significant risks, including risks relating to the implementation of
CollaGenexs sales and marketing plans for Periostat and other products that we market, risks associated with our arrangement with United Research Laboratories, Inc./Mutual Pharmaceutical Company, Inc. (Mutual), risks inherent in
research and development activities, risks associated with enforcement of our intellectual property rights, risks that the FDA will approve products that will compete with and limit the market for Periostat, risks relating to our litigation with the
FDA, risks associated with conducting business in a highly regulated environment and uncertainty relating to clinical trials of products under development. CollaGenexs success depends to a large degree upon the market acceptance of Periostat
by periodontists, dental practitioners, other health care providers, patients and insurance companies and the success of our dermatology product candidates. There can be no assurance that CollaGenexs product candidates (other than the
FDAs approval of Periostat for marketing in the United States, the United Kingdom Medicines and Healthcare Products Regulatory Agencys approval of Periostat for marketing in the United Kingdom and Periostats marketing approval in
Austria, Finland, Switzerland, Ireland, Israel, Italy, Luxembourg, the Netherlands, Portugal and Canada) will be approved by any regulatory authority for marketing in any jurisdiction or, if approved, that any such products will be successfully
commercialized by CollaGenex. In addition, there can be no assurance that CollaGenex will successfully promote Pandel, Atridox, Atrisorb-FreeFlow or Atrisorb-D. As a result of such risks, those risks set forth in the section entitled
Additional Risks That May Affect Results and others expressed from time to time in CollaGenexs filings with the Securities and Exchange Commission, CollaGenexs actual results may differ materially from the results discussed
in or implied by the forward-looking statements contained herein. We undertake no obligation to update or revise any forward-looking statements, whether as a result of new information, future events or otherwise.



Periostat®, Metastat®, Dermostat®, Nephrostat®, Osteostat®, Arthrostat®,
Rheumastat®, Corneostat®, Gingistat®, IMPACS, PS20®, The Whole Mouth Treatment®, Restoraderm, Dentaplex®, Lytra,
Periostat-MR and Xerostat are United States trademarks of CollaGenex
Pharmaceuticals, Inc. Periostat®, Nephrostat®, Optistat®, Xerostat® and IMPACS are European Community trademarks of CollaGenex Pharmaceuticals, Inc. Periostat®, Nephrostat®, Optistat®, Xerostat®, IMPACS®,
Dentaplex®, Restoraderm, Periocycline®, Periostatus® and Periostat-SR® are United Kingdom trademarks of our wholly-owned subsidiary, CollaGenex International Ltd. CollaGenex®, PS20®, Dermastat®, Periostan®, C Logo® and The Whole Mouth Treatment Logo® are European Community and United Kingdom trademarks of CollaGenex International Ltd. Periocycline, Restoraderm, Periostat-SR and Lytra are
European Community Trademarks of CollaGenex International Ltd. All other trade names, trademarks or service marks appearing in this Quarterly Report are the property of their respective owners and are not property of CollaGenex Pharmaceuticals, Inc.
or any of our subsidiaries.



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Critical Accounting Policies and Estimates



Managements discussion and analysis of its financial position and
results of operations are based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these financial statements requires
management to make judgments and estimates that affect the reported amounts of assets, liabilities, revenues and expenses and related disclosure of contingent assets and liabilities. Management believes the critical accounting policies and areas
that require the most significant judgments and estimates to be used in the preparation of the consolidated financial statements pertain to revenue recognition, stock compensation and deferred taxes.



Revenue Recognition



We recognize product sales revenue upon shipment, net of estimated returns,
provided that collection is determined to be probable and no significant obligations remain. Certain sales revenue from our customers is subject to agreements allowing limited rights of return, rebates and price protection. Accordingly, we reduce
such revenue recognized for estimated future returns, rebates and price protection at the time the related revenue is recorded. The estimates for returns are adjusted periodically based upon historical rates of returns, inventory levels in the
distribution channel and other related factors. While management believes it can make reliable estimates for these matters, unsold products in these distribution channels may be exposed to expiration. Accordingly, it is possible that these estimates
will change in the future or that the actual amounts could vary materially from our estimates and that the amounts of such changes could impact our results of operations, financial condition and our business. Our contract revenues are fee-based
arrangements where revenue is earned as prescriptions are filled. Accordingly, since we never take title to the product being promoted, no significant obligations exist beyond the point that revenue is recognized.



Since our inception, a portion of our revenue has been generated from license
and distribution agreements for our products. We recognize nonrefundable signing or license fees that are not dependent on future performance under these agreements as revenue when received or over the term of the arrangement if we have continuing
performance obligations. Any amounts deferred are amortized to revenue over the expected performance period of each underlying agreement. The expected performance period is based on managements best estimate and is subject to change based on
current market conditions. Deferred revenue represents the portion of up front license payments received that has not been earned. Milestone revenue from licensing arrangements is recognized upon completion of the milestone event or requirement if
it represents the achievement of a significant step in the research, development or regulatory process.



Stock-Based Compensation



It is our policy to apply Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees, and related interpretations to
account for our stock option grants rather than Statement of Financial Accounting Standards No. 123, Accounting for Stock-Based Compensation. As such, compensation expense is recorded on fixed stock option grants only if



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the current market value of the underlying stock exceeds the exercise price of the option at the date of grant and is
recognized on a straight-line basis over the vesting period. Had we applied SFAS No. 123, which requires recording stock option grants at their fair value, our net income (loss) would have varied from the reported net income (loss) as we would have
recorded additional expenses in each period.



Deferred Taxes



In assessing the realizability of deferred tax assets, we
consider whether it is more likely than not that some portion or all of the deferred tax assets will not be realized. This assessment requires significant judgment and estimates. The ultimate realization of the deferred tax assets is dependent upon
the generation of future taxable income during the period in which those temporary differences become deductible. We consider our history of losses, scheduled reversal of deferred tax assets and liabilities and projected future taxable income over
the periods in which the deferred tax asset items are deductible. The Tax Reform Act of 1986 contains provisions that may limit the net operating loss (NOL) and research and experimentation credit carryforwards available to be used in any given year
upon the occurrence of certain events, including significant changes in ownership interest. The rules providing for the definition of an ownership change are complex.



Results of Operations



Three
Months Ended June 30, 2004 Compared to Three Months Ended June 30, 2003



Revenues



|                                |  |      |        |        |       |    |      |   |       
|------------------------------- |  | ---- | ------ | ------ | ----- | -- | ---- | - | ------
|Revenues (dollars in thousands) |  | 2004 |        | Change |       |    | 2003
|Net Product Sales               |  | $    | 14,372 |        | 22.3  | %  |      | $ | 11,750
|Contract Revenues               |  |      | 60     |        | (88.1 | )% |      |   | 503   
|License Revenues                |  |      | 13     |        | (97.0 | )% |      |   | 433   
|                                |  |      |        |        |       |    |      |   |       
|Total                           |  | $    | 14,445 |        | 13.9  | %  |      | $ | 12,686



Total revenues during
the three months ended June 30, 2004 were approximately $14.4 million, representing a 13.9% increase over total revenues of approximately $12.7 million during the three months ended June 30, 2003. Such 2004 revenues included approximately $14.4
million in net product sales of Periostat, Mutuals branded version of Periostat, Pandel and the Atrix Products, $60,000 in contract revenues, which were derived from residual contract revenues from our expired agreement with Merck & Co.,
Inc. for Vioxx®, and $13,000 of international
licensing revenues for Periostat. Net product sales increased approximately $2.6 million, or 22.3%, to approximately $14.4 million during the three months ended June 30, 2004 compared to approximately $11.8 million during the three months ended June
30, 2003. Net product sales during the three months ended June 30, 2004 included an initial stocking sale to Mutual of approximately $4.7 million, which reflects a significant promotional discount from the price that Mutual is contractually
obligated to pay for their branded version of Periostat on all subsequent orders. As a result of the initial stocking sale to Mutual, the Company does not anticipate material sales to Mutual before the fourth quarter of 2004. During the three months



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ended June 30, 2004, prescriptions filled by Mutuals branded version of Periostat represented approximately 15.9%
of total combined prescriptions for Periostat and the branded version of Periostat.



Contract revenues for the three months ended June 30, 2004 decreased 88.1% to $60,000 from $503,000 during the three months ended June 30, 2003, primarily due to the expiration and/or mutual termination of our
co-promotion agreements with Merck, Novartis and Sirius Laboratories during 2003. Such 2004 revenue related to residual contract revenue from our expired agreement with Merck for Vioxx.



We recorded $13,000 and $8,000 in licensing revenues for the three months ended June 30, 2004 and June 30, 2003,
respectively, that was attributable to our recognition of previously received up-front license fees recognized for various agreements that were deferred and are being recognized as licensing revenue over the expected performance period of the
agreements. We recorded licensing revenues of $425,000 during the three months ended June 30, 2003 that represented milestone fees received from foreign licensing partners upon the achievement of certain milestones.



Cost of Product Sales



|                                             |  |      |       |   |        |      |   |      |   |       |  
|-------------------------------------------- |  | ---- | ----- | - | ------ | ---- | - | ---- | - | ----- | -
|Cost of Product Sales (dollars in thousands) |  | 2004 |       |   | Change |      |   | 2003 |  
|Cost of Product Sales                        |  | $    | 2,052 |   |        | 18.1 | % |      | $ | 1,738 |  
|Percent of Net Product Sales                 |  |      | 14.3  | % |        | N/A  |   |      |   | 14.8  | %



Cost of product sales
includes product packaging, third-party royalties, amortization of product licensing fees, and the costs associated with the manufacturing, storage and stability of Periostat, Mutuals branded version of Periostat, Pandel and the Atrix
Products.



Cost of product sales were approximately $2.1
million, or 14.3% of net product sales during the three months ended June 30, 2004, compared to approximately $1.7 million, or 14.8% of net product sales during the three months ended June 30, 2003. As a percentage of net product sales, cost of net
product sales decreased slightly compared to the three months ended June 30, 2003, due to Periostat price increases and product mix, offset in part by the promotional discount on Mutuals branded version of Periostat as part of an initial
stocking order.



Research and Development



|                                                |  |      |       |        |      |   |      |   |      
|----------------------------------------------- |  | ---- | ----- | ------ | ---- | - | ---- | - | -----
|Research and Development (dollars in thousands) |  | 2004 |       | Change |      |   | 2003
|Research and development                        |  | $    | 2,457 |        | 48.5 | % |      | $ | 1,654



Research and
development expenses consist primarily of funds paid to third parties for the provision of services and materials for drug development, including milestone fees, manufacturing and formulation enhancements, clinical trials, statistical analysis and
report writing and regulatory compliance costs.



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Research and development expenses increased $803,000, or 48.5%, to approximately $2.5 million during the
three months ended June 30, 2004 from approximately $1.7 million during the three months ended June 30, 2003.



Development projects conducted during the three months ended June 30, 2004 included our continuing clinical and manufacturing development work for
Col-101, our once daily, modified formulation of doxycycline, 40 mg, which is also known as Periostat MR, and formulation and stability testing for several potential products utilizing our licensed Restoraderm technology, which totaled approximately
$154,000 and approximately $74,000, respectively. If all of the potential products for which we currently seek approval are successful, the estimated additional formulation development expenses and milestones fees at this time could be as much as
approximately $8.7 million.



Clinical projects totaling
approximately $1.7 million were conducted during the three months ended June 30, 2004 and primarily included a Phase III study to evaluate Col-101 for the treatment of adult periodontitis, which totaled approximately $335,000, and two separate Phase
III studies related to Col-101 for the treatment of rosacea which totaled approximately $1.0 million. Clinical projects conducted also included the initiation of a Phase II study associated with our licensed Restoraderm technology, which totaled
approximately $180,000, and several Phase IV studies related to Periostat in various applications, which totaled approximately $146,000. The estimated additional clinical development costs at this time could include as much as $5.7 million in costs
associated with the clinical development of Col-101 for the treatment of adult periodontitis and for the treatment of rosacea. At this time, it is premature to estimate the future costs associated with the clinical development of our licensed
Restoraderm technology.



Other research and development
expenses incurred during the three months ended June 30, 2004 included approximately $29,000 in regulatory consulting and legal and filing fees under the Mutual Recognition Procedure in Europe, approximately $69,000 for various regulatory costs,
including annual FDA filing fees and regulatory expenses in the United States, and approximately $3,000 in manufacturing development costs for Metastat® and the IMPACS compounds. Direct salaries and
other personnel expenses incurred during the three months ended June 30, 2004 were approximately $259,000. Additionally, during such period we incurred approximately $151,000 in consulting, clinical monitoring and other office expenses.



Development projects conducted during the three months ended
June 30, 2003 included our continuing formulation development work for Col-101 and formulation and stability testing for several potential products utilizing our licensed Restoraderm technology, which totaled approximately $462,000 and approximately
$535,000, respectively.



Clinical projects totaling
approximately $252,000 were conducted during the three months ended June 30, 2003 and included several Phase IV studies for Periostat in various dental indications and continued clinical development work relating to Periostat in dermatological
indications, including a Phase III trial in 150 patients to evaluate Periostat for the treatment of rosacea.



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Other research and development expenses incurred during the three months ended June 30, 2003 included
approximately $42,000 in regulatory consulting and legal and filing fees under the Mutual Recognition Procedure in Europe and approximately $137,000 for various regulatory costs, including annual FDA filing fees, legal and regulatory expenses in the
United States. Direct salaries and other personnel expenses incurred during the three months ended June 30, 2003 were approximately $131,000. Additionally, during such period we incurred approximately $95,000 in consulting, clinical monitoring and
other office expenses.



Selling, General and Administrative



|                                                           |  |      |       |        |      |    |      |   |      
|---------------------------------------------------------- |  | ---- | ----- | ------ | ---- | -- | ---- | - | -----
|Selling, General and Administrative (dollars in thousands) |  | 2004 |       | Change |      |    | 2003
|Selling, General and Administrative  other                |  | $    | 7,530 |        | (2.4 | )% |      | $ | 7,718
|Selling, General and Administrative  restructuring        |  |      | 480   |        | N/A  |    |      |   |     
|                                                           |  |      |       |        |      |    |      |   |      
|Subtotal                                                   |  | $    | 8,010 |        | 3.8  | %  |      | $ | 7,718



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



Selling, general and administrative  other expenses decreased 2.4% to
approximately $7.5 million during the three months ended June 30, 2004 from approximately $7.7 million during the three months ended June 30, 2003.



Significant components of selling, general and administrative  other expenses incurred during the three months ended June 30, 2004 included
approximately $3.8 million in direct selling and sales training expenses, approximately $2.1 million in marketing expenses (including advertising and promotion expenditures for Periostat, the Atrix Products and Pandel) and approximately $1.6 million
in general and administrative expenses, which include business development, finance, legal and corporate activities. Significant components of selling, general and administrative  other expenses incurred during the three months ended June 30,
2003 included approximately $3.8 million in direct selling and sales training expenses, approximately $2.0 million in marketing expenses (including advertising and promotion expenditures for Periostat, the Atrix Products and co-promotion expenses
relating to Vioxx and AVAR) and approximately $1.9 million in general and administrative expenses, which include business development, finance and corporate activities. The decrease in selling, general and administrative  other expenses during
the three months ended June 30, 2004 compared to the three months ended June 30, 2003 is primarily a function of decreased legal costs, which is the result of the benefit for the current period SUNY royalty expense exceeding the current period
patent litigation costs recoverable from SUNY, as a result of the April 2004 Mutual settlement, offset in part by increased employee costs.



Selling, general and administrative  restructuring during the three months ended June 30, 2004 consisted of $480,000 that resulted from a
restructuring charge related to the reorganization of our sales organization into dedicated dental and dermatology sales forces.



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##### Table of Contents

Other Income/Expense



|                                            |  |      |    |        |       |    |      |   |   
|------------------------------------------- |  | ---- | -- | ------ | ----- | -- | ---- | - | --
|Other Income/Expense (dollars in thousands) |  | 2004 |    | Change |       |    | 2003
|Interest income                             |  | $    | 69 |        | 176.0 | %  |      | $ | 25
|Other income (expense)                      |  | $    | 3  |        | (25.0 | )% |      | $ | 4 



Interest income
increased to $69,000 for the three months ended June 30, 2004 compared to $25,000 for the three months ended June 30, 2003. This increase was due to higher average investment balances in 2004.



Preferred Stock Dividend



Preferred stock dividends included in net income allocable to common
stockholders were $400,000 during each of the three months ended June 30, 2004 and June 30, 2003. Such preferred stock dividends were paid in cash and are the result of our obligations in connection with the issuance of our Series D preferred stock
in May 1999.



Six Months Ended June 30, 2004 Compared to Six
Months Ended June 30, 2003



Revenues



|                                |  |      |        |        |       |    |      |   |       
|------------------------------- |  | ---- | ------ | ------ | ----- | -- | ---- | - | ------
|Revenues (dollars in thousands) |  | 2004 |        | Change |       |    | 2003
|Net Product Sales               |  | $    | 27,700 |        | 19.8  | %  |      | $ | 23,120
|Contract Revenues               |  |      | 120    |        | (88.6 | )% |      |   | 1,053 
|License Revenues                |  |      | 31     |        | (95.4 | )% |      |   | 670   
|                                |  |      |        |        |       |    |      |   |       
|Total                           |  | $    | 27,851 |        | 12.1  | %  |      | $ | 24,843



Total revenues during
the six months ended June 30, 2004 were approximately $27.9 million, representing a 12.1% increase over total revenues of approximately $24.8 million during the six months ended June 30, 2003. Such 2004 revenues included approximately $27.7 million
in net product sales of Periostat, Mutuals branded version of Periostat, Pandel and the Atrix Products, $120,000 in contract revenues, which were derived from residual contract revenues from our expired agreement with Merck for Vioxx, and
$31,000 of international licensing revenues for Periostat. Net product sales increased approximately $4.6 million, or 19.8%, to approximately $27.7 million during the six months ended June 30, 2004 compared to approximately $23.1 million during the
six months ended June 30, 2003. Net product sales during the six months ended June 30, 2004 included an initial stocking sale to Mutual of approximately $4.7 million, which reflects a significant promotional discount from the price that Mutual is
contractually obligated to pay for their branded version of Periostat on all subsequent orders. As a result of the initial stocking sale to Mutual, the Company does not anticipate material sales to Mutual before the fourth quarter of 2004. During
the six months ended June 30, 2004 (beginning in April in connection with the delivery of the initial stocking sale to Mutual), prescriptions filled by Mutuals branded version of Periostat represented approximately 15.9% of total combined
prescriptions for Periostat and the branded version of Periostat.



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##### Table of Contents

Contract revenues for the six months ended June 30, 2004 decreased 88.6% to $120,000 from approximately
$1.1 million during the six months ended June 30, 2003, primarily due to the expiration and/or mutual termination of our co-promotion agreements with Merck, Novartis and Sirius Laboratories during 2003. Such 2004 revenue related to residual contract
revenue from our expired agreement with Merck for Vioxx.



We
recorded $31,000 and $23,000 in licensing revenues for the six months ended June 30, 2004 and June 30, 2003, respectively, that was attributable to our recognition of previously received up-front license fees recognized for various agreements that
were deferred and are being recognized as licensing revenue over the expected performance period of the agreements. We recorded licensing revenues of $222,000 during the six months ended June 30, 2003 that represent previously deferred foreign
up-front licensing fees where the recognition of revenue was accelerated in connection with certain licensing agreements that were mutually terminated during such period. Additionally, during the six months ended June 30, 2003, we recognized
$425,000 in license milestone fees received from foreign licensing partners upon the achievement of certain milestones.



Cost of Product Sales



|                                             |  |      |       |   |        |      |   |      |   |       |  
|-------------------------------------------- |  | ---- | ----- | - | ------ | ---- | - | ---- | - | ----- | -
|Cost of Product Sales (dollars in thousands) |  | 2004 |       |   | Change |      |   | 2003 |  
|Cost of Product Sales                        |  | $    | 4,053 |   |        | 11.0 | % |      | $ | 3,652 |  
|Percent of Net Product Sales                 |  |      | 14.6  | % |        | N/A  |   |      |   | 15.8  | %



Cost of product sales
includes product packaging, third-party royalties, amortization of product licensing fees, and the costs associated with the manufacturing, storage and stability of Periostat, Mutuals branded version of Periostat, Pandel and the Atrix
Products.



Cost of product sales were approximately $4.1
million, or 14.6% of net product sales during the six months ended June 30, 2004, compared to approximately $3.7 million, or 15.8% of net product sales during the six months ended June 30, 2003. As a percentage of net product sales, cost of net
product sales decreased slightly compared to the six months ended June 30, 2003, due to Periostat price increases and product mix, offset in part by the promotional discount on the branded version of Periostat sold to Mutual in the second quarter of
2004 as part of an initial stocking order.



Research and Development



|                                                |  |      |       |        |      |   |      |   |      
|----------------------------------------------- |  | ---- | ----- | ------ | ---- | - | ---- | - | -----
|Research and Development (dollars in thousands) |  | 2004 |       | Change |      |   | 2003
|Research and development                        |  | $    | 3,845 |        | 46.7 | % |      | $ | 2,621



Research and
development expenses consist primarily of funds paid to third parties for the provision of services and materials for drug development, including milestone fees, manufacturing and formulation enhancements, clinical trials, statistical analysis and
report writing and regulatory compliance costs.



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##### Table of Contents

Research and development expenses increased approximately $1.2 million, or 46.7%, to approximately $3.8
million during the six months ended June 30, 2004 from approximately $2.6 million during the six months ended June 30, 2003.



Development projects conducted during the six months ended June 30, 2004 included our continuing clinical and manufacturing development work for Col-101,
our once daily, modified formulation of doxycycline, 40 mg, which is also known as Periostat MR, and formulation and stability testing for several potential products utilizing our licensed Restoraderm technology, which totaled approximately $225,000 and approximately $119,000,
respectively. If all of the potential products that we currently seek approval are successful, the estimated additional formulation development expenses and milestones fees at this time could be as much as approximately $8.7 million.



Clinical projects totaling approximately $2.5 million were conducted during
the six months ended June 30, 2004 and primarily included a Phase III trial in 134 patients to evaluate the 20 mg current commercial formulation of Periostat for the treatment of rosacea, which totaled approximately $418,000, and a separate Phase
III study to evaluate Col-101 for the treatment of adult periodontitis, which totaled approximately $583,000. Additional clinical projects conducted included two separate Phase III studies related to Col-101 for the treatment of rosacea, which
totaled approximately $1.1 million, the initiation of a Phase II study associated with our licensed Restoraderm technology, which totaled approximately $182,000, and several Phase IV studies related to Periostat in various applications, which
totaled approximately $183,000. The estimated additional clinical development costs at this time could include as much as $5.7 million in costs associated with the clinical development of Col-101 for the treatment of adult periodontitis and for the
treatment of rosacea. At this time, it is premature to estimate the future costs associated with the clinical development of our licensed Restoraderm technology.



Other research and development expenses incurred during the six months ended June 30, 2004 included approximately $62,000 in
regulatory consulting and legal and filing fees under the Mutual Recognition Procedure in Europe, approximately $157,000 for various regulatory costs, including annual FDA filing fees and regulatory expenses in the United States, and approximately
$53,000 in manufacturing development costs for Metastat and the IMPACS compounds. Direct salaries and other personnel expenses incurred during the six months ended June 30, 2004 were approximately $516,000. Additionally, during such period we
incurred approximately $260,000 in consulting, clinical monitoring and other office expenses.



Development projects conducted during the six months ended June 30, 2003 included our continuing formulation development work for Col-101 and formulation
and stability testing for several potential products utilizing our licensed Restoraderm technology, which totaled approximately $782,000 and approximately $584,000, respectively.



Clinical projects totaling approximately $500,000 were conducted during the six months ended June 30, 2003 and included
several Phase IV studies for Periostat in various dental indications and continued clinical development work relating to Periostat in dermatological indications, including a Phase III trial in 150 patients to evaluate Periostat for the treatment of
rosacea.



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Other research and development expenses incurred during the six months ended June 30, 2003 included
approximately $53,000 in regulatory consulting and legal and filing fees under the Mutual Recognition Procedure in Europe and approximately $243,000 for various regulatory costs, including annual FDA filing fees, legal and regulatory expenses in the
United States. Direct salaries and other personnel expenses incurred during the six months ended June 30, 2003 were approximately $271,000. Additionally, during such period we incurred approximately $188,000 in consulting, clinical monitoring and
other office expenses.



Selling, General and Administrative



|                                                           |  |      |        |        |       |   |      |   |       
|---------------------------------------------------------- |  | ---- | ------ | ------ | ----- | - | ---- | - | ------
|Selling, General and Administrative (dollars in thousands) |  | 2004 |        | Change |       |   | 2003
|Selling, General and Administrative  other                |  | $    | 15,648 |        | 0.9   | % |      | $ | 15,791
|Selling, General and Administrative  restructuring        |  | $    | 480    |        | 100.0 | % |      | $ |      
|Selling, General and Administrative  legal settlement     |  |      | 2,000  |        | N/A   |   |      |   |      
|                                                           |  |      |        |        |       |   |      |   |       
|Subtotal                                                   |  | $    | 18,128 |        | 14.8  | % |      | $ | 15,791
|                                                           |  |      |        |        |       |   |      |   |       



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



Selling, general and administrative  other expenses decreased 0.9% to
approximately $15.6 million during the six months ended June 30, 2004 from approximately $15.8 million during the six months ended June 30, 2003.



Significant components of selling, general and administrative  other expenses incurred during the six months ended June 30, 2004 included
approximately $8.2 million in direct selling and sales training expenses, approximately $4.1 million in marketing expenses (including advertising and promotion expenditures for Periostat, the Atrix Products and Pandel) and approximately $3.3 million
in general and administrative expenses, which include business development, finance, legal and corporate activities. Significant components of selling, general and administrative  other expenses incurred during the six months ended June 30,
2003 included approximately $7.9 million in direct selling and sales training expenses, approximately $4.0 million in marketing expenses (including advertising and promotion expenditures for Periostat, the Atrix Products and Pandel and co-promotion
expenses relating to Vioxx and AVAR), approximately $3.6 million in general and administrative expenses, which include business development, finance and corporate activities and $251,000 related to the modifications of certain stock options. The
decrease in selling, general and administrative  other expenses during the six months ended June 30, 2004 compared to the six months ended June 30, 2003 is primarily a function of decreased legal costs, which is the result of the benefit for
the current period SUNY royalty expense exceeding the current period patent litigation costs recoverable from SUNY, as a result of the April 2004 Mutual settlement.



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Selling, general and administrative  restructuring during the six months ended June 30, 2004
consisted of $480,000 that resulted from a restructuring charge related to the reorganization of our sales organization into dedicated dental and dermatology sales forces.



Selling, general and administrative  legal settlement during the six months ended June 30, 2004 consisted of $2.0
million which resulted from the payment to Mutual in connection with the settlement of all outstanding litigation between us and Mutual.



Other Income/Expense



|                                            |  |      |     |        |       |   |      |   |   
|------------------------------------------- |  | ---- | --- | ------ | ----- | - | ---- | - | --
|Other Income/Expense (dollars in thousands) |  | 2004 |     | Change |       |   | 2003
|Interest income                             |  | $    | 140 |        | 150.0 | % |      | $ | 56
|Other expense                               |  | $    |    |        | 100   | % |      | $ | 10



Interest income
increased to $140,000 for the six months ended June 30, 2004 compared to $56,000 for the six months ended June 30, 2003. This increase was due to higher average investment balances in 2004.



Preferred Stock Dividend



Preferred stock dividends included in net income allocable to common
stockholders were $800,000 during each of the six months ended June 30, 2004 and June 30, 2003. Such preferred stock dividends were paid in cash and are the result of our obligations in connection with the issuance of our Series D preferred stock in
May 1999.



Liquidity and Capital Resources



On October 3, 2003, we announced that we had entered into agreements for the sale of 2,000,000 shares of our common stock registered under a registration statement on Form S-3 to certain institutional investors, at a per share purchase
price of $10.00 for aggregate gross proceeds of $20.0 million, which generated net proceeds to us of approximately $18.7 million, after the payment of placement agent fees and related expenses.



Our Series D preferred stock is convertible at any time into shares of our
common stock at a current conversion price of $9.89 per share, which conversion price reflects a decrease from the initial conversion price of $11.00 per share as a result of certain subsequent equity issuances by us. Such conversion price is not
subject to reset except in the event that we should fail to declare and pay dividends when due or we should issue new equity securities or convertible securities at a price per share or having a conversion price per share lower than the then
applicable conversion price of the Series D preferred stock. The holders of the Series D preferred stock are entitled to dividends payable in cash at a rate of 8.0% per annum, which are declared and paid every six months. Beginning on the sixth
anniversary of the date of the original issuance of the Series D preferred stock (May 12, 1999), dividends payable will increase by 1% per annum if the Series D preferred stock has not then been converted or redeemed.



All or a portion of the shares of Series D preferred stock shall, at our
option (as determined by our board of directors), automatically be converted into fully paid, registered and



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##### Table of Contents

non-assessable shares of common stock, if the following two conditions are met: (i) the last sale price, or, in case no
such sale takes place on such day, the average of the closing bid and asked prices on the Nasdaq National Market is at least 200% of the conversion price then in effect (as of June 30, 2004, such conversion price was $9.89 per share) for forty
consecutive trading days; and (ii) a shelf registration statement is in effect for the shares of common stock to be issued upon conversion of the Series D preferred stock. Without written approval of a majority of the holders of record of the Series
D preferred stock, we, among other things, shall not: (i) declare or pay any dividend or distribution on any shares of our capital stock other than dividends on the Series D preferred stock; (ii) make any loans, incur any indebtedness or guarantee
any indebtedness, advance capital contributions to, or investments in any person, issue or sell any securities or warrants or other rights to acquire our debt securities, except that we may incur such indebtedness in any amount not to exceed $10.0
million in the aggregate outstanding at any time for working capital requirements in the ordinary course of business; or (iii) make research and development expenditures in excess of $7.0 million in any continuous twelve month period, unless we have
reported positive net income for four consecutive quarters immediately prior to such twelve month period.



On June 7, 2004, we entered into a Loan Modification Agreement with Silicon Valley Bank to renew our revolving credit facility, which had expired on March
15, 2004. The credit facility, as modified by such Agreement, expires on May 31, 2006. Pursuant to the terms of the credit facility, we may borrow up to the lesser of $5.0 million or 80% of eligible accounts receivable, as defined under the credit
facility. The amount available to us is reduced by any outstanding letters of credit which may be issued under the credit facility in amounts totaling up to $2.0 million. As we pay down amounts under any letter of credit, the amount available to us
under the credit facility increases. As of June 30, 2004, we had an outstanding letter of credit approximating $544,000 that served as collateral for certain inventory purchase commitments. We are not obligated to draw amounts and any borrowings
shall bear interest, payable monthly, at the current prime rate.Without the consent of Silicon Valley Bank, we, among other things, shall not: (i) merge or consolidate with another entity; (ii) acquire assets outside the ordinary course of
business; or (iii) pay or declare any cash dividends on our common stock.We must maintain a minimum tangible net worth, as defined, of at least $28.0 million, subject to certain upward adjustments, as a result of profitable operations or
additional debt or equity financings. In addition, we must maintain a quick ratio of at least 2 to 1. We secured our obligations under the credit facility through the granting of a security interest in favor of the bank with respect to all of our
corporate assets. As of June 30, 2004, we had no borrowings outstanding against the credit facility.



On August 24, 2001, we signed a License and Marketing Agreement with Atrix Laboratories, Inc. to market Atrixs proprietary dental products, Atridox,
Atrisorb FreeFlow and Atrisorb-D, to the United States dental market. Pursuant to the terms of this agreement, we are required to make certain annual minimum expenditures for the lesser of $4.0 million or 30% of our contribution margin, as defined
in the agreement, relating to a specific Atrix product that we market and the lesser of $2.0 million or 30% of our contribution margin, as defined in the agreement, relating to another Atrix product that we market. We spent $863,000 in 2003, which,
in the aggregate, exceeded the spending requirements for each of the provisions in the agreement. During the six month periods ended June 30, 2004 and June 30, 2003, we spent in the aggregate $480,000 and $468,000, respectively, related to each
provision in the agreement.



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During 2003, our co-promotional agreements with Merck, Novartis and Sirius, generated approximately $3.1
million in revenue and approximately $1.6 million in positive cash-flows. As of December 31, 2003, all of these agreements either expired or were mutually terminated. We do not expect any future revenues or cash in-flows from Merck, Novartis and
Sirius, other than nominal residual contract revenues through 2005 from our expired agreement with Merck for Vioxx.



On February 11, 2002, we executed a Co-operation, Development and Licensing Agreement pursuant to which we were granted an exclusive, sublicenseable,
transferable license with respect to the Restoraderm topical drug delivery system which we intend to develop for dermatological applications. Pursuant to the terms of such agreement, upon the occurrence of certain events, we will be required to pay
certain future consulting, royalty and milestone payments in the aggregate amount of up to approximately $3.2 million. We paid $76,000 under this agreement during the six months ended June 30, 2004 and have paid an aggregate of $1.0 million through
June 30, 2004. The term of such agreement is for the life of any patent that may be issued to us for the first product we develop utilizing such technology, or, if such a patent fails to issue, seven years.



At June 30, 2004, we had cash and cash equivalents of approximately $30.7
million, a decrease of $2.0 million from the approximately $32.7 million balance at December 31, 2003. This decrease was primarily attributable to an increase in accounts receivable relating to the payment terms of our initial stocking sale to
Mutual and a decrease in accounts payable and accrued expenses, all of which offset and exceeded the net income earned during the first six months of 2004. The outstanding receivable from Mutual is due in various installments commencing on August
20, 2004 through October 20, 2004. In accordance with investment guidelines approved by our Board of Directors, cash balances in excess of those required to fund operations have been invested in money market funds. Our working capital at June 30,
2004 was $36.4 million, an increase of $4.4 million from $32.0 million at December 31, 2003. This increase was primarily attributable to an increase in accounts receivable relating to the payment terms of our initial stocking sale to Mutual, a
decrease in accounts payable and accrued expenses and the cash proceeds from the exercise of stock options and warrants. During the six months ended June 30, 2004, we invested $225,000 in capital expenditures and paid $800,000 in cash dividends to
the holders of our Series D preferred stock.



We currently
believe that projected sales of our United States marketed products in combination with contract and license revenues and working capital at June 30, 2004, will allow us to fund our operations, capital expenditures and preferred stock dividend
requirements for at least the next twelve months. At this time, however, we cannot accurately predict the effect of certain developments on future product sales such as the degree of market acceptance of our products and technology, our arrangement
with Mutual, competition, the effectiveness of our sales and marketing efforts and the outcome of our research and development to demonstrate the utility of Periostat in indications beyond those already included in the FDA approved label. We expect
to significantly increase our investment in research and development during the remainder of 2004.



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



| |  | Revenues and profits from sales of Periostat and other products and contracted services;
| | - | ----------------------------------------------------------------------------------------



| |  | The success of our dermatology franchise;
| | - | -----------------------------------------



| |  | The success of our pre-clinical, clinical and development programs;
| | - | -------------------------------------------------------------------



| |  | Our ability to meet the covenant requirements under our revolving credit facility with Silicon Valley Bank;
| | - | -----------------------------------------------------------------------------------------------------------



| |  | The receptivity of the capital markets to future financings;
| | - | ------------------------------------------------------------



| |  | Our ability to enter into additional strategic collaborations and to maintain existing and new collaborations and the success of such collaborations;
| | - | -----------------------------------------------------------------------------------------------------------------------------------------------------



| |  | The effect of our arrangement with Mutual; and
| | - | ----------------------------------------------



| |  | The outcome and consequences of our litigation with the FDA.
| | - | ------------------------------------------------------------



Contractual Obligations



Our major outstanding contractual obligations relate to cash dividends on our outstanding Series D preferred stock, operating leases for our office space
and contractual commitments with our marketing partners for certain selling and promotional expenses associated with the products we are currently detailing. Additionally, we also expect to make certain inventory purchases from our contract
manufacturer of Periostat, guaranteed by our irrevocable letter of credit with Silicon Valley Bank.



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##### Table of Contents

Below is a table which presents our contractual obligations and commercial commitments as of June 30,
2004:



|                                           |  |                        |            |     |                                  |   |           |              |  |   |              |     |  |               |           |     |  |   |         |    
|------------------------------------------ |  | ---------------------- | ---------- | --- | -------------------------------- | - | --------- | ------------ |  | - | ------------ | --- |  | ------------- | --------- | --- |  | - | ------- | ---
|                                           |  | Payments Due by Period |           
|Contractual Obligations                    |  | Total                  |            |     | Six MonthsendingDecember 31,2004 |   |           | 2005 and2006 |  |   | 2007 and2008 |     |  | 2009 andafter |          
|Operating Leases(1)                        |  | $                      | 2,271,000  |     |                                  | $ | 273,000   |              |  | $ | 1,108,000    |     |  | $             | 694,000   |     |  | $ | 196,000 |    
|Unconditional Purchase Obligations         |  | $                      | 544,000    | (2) |                                  | $ | 544,000   |              |  |   |             |     |  |               |          |     |  |   |        |    
|Co-Promotional Commitments                 |  |                        |            | (3) |                                  |   |           | (3)          |  |   |              | (3) |  |               |           | (3) |  |   |         | (3)
|Cash Dividends on Series D Preferred Stock |  | $                      | 8,898,000  | (4) |                                  | $ | 800,000   | (4)          |  | $ | 3,649,000    | (4) |  | $             | 4,449,000 | (4) |  |   |         | (4)
|Consulting Payments                        |  | $                      | 520,000    | (5) |                                  | $ | 216,000   | (5)          |  | $ | 304,000      | (5) |  |               |          |     |  |   |        |    
|Total Contractual Obligations              |  | $                      | 12,233,000 |     |                                  | $ | 1,833,000 |              |  | $ | 5,061,000    |     |  | $             | 5,143,000 |     |  | $ | 196,000 |    

---

|(1) | Such amounts primarily include minimum rental payments for our office lease in Newtown, Pennsylvania, as well as payments for sales force computer leases.
|--- | ----------------------------------------------------------------------------------------------------------------------------------------------------------

|(2) | Such amounts represent a minimum purchase order commitment with our third-party manufacturer of Periostat. This commitment relates to the twelve-month period commencing on March 31,
2004.
|--- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(3) | We are required to make certain annual minimum expenditures for advertising and promotional activities amounting to: (i) the lesser of $4.0 million or 30% of our contribution margin
(as defined in the agreement) relating to a specific Atrix product that we market, and (ii) the lesser of $2.0 million or 30% of our contribution margin (as defined in the agreement) relating to another Atrix product that we market. See further
information regarding the Atrix License and Marketing Agreement under the heading Liquidity and Capital Resources.
|--- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(4) | Pursuant to the terms of our Series D Cumulative Convertible preferred stock and unless earlier converted pursuant to its terms, the holders of the Series D preferred stock are
entitled to dividends payable in cash at a rate of 8.0% per annum, which are declared and paid every six months. Beginning on the sixth anniversary of the date of the original issuance of the Series D preferred stock (May 12, 1999), dividends
payable will increase by 1% per annum if the Series D preferred stock has not then been converted or redeemed.
|--- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(5) | Such amount represents consulting payments to be made to Brian M. Gallagher, our former chief executive officer and president in connection with his separation from the Company and
pursuant to the terms of a consulting agreement executed March 18, 2003.
|--- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



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In May 1999, we entered into a lease agreement relating to our office space in Newtown, Pennsylvania. The
lease has an initial term of ten years. Rent is expected to be approximately $334,000 per year.



On February 11, 2002, we executed a Co-operation, Development and Licensing Agreement pursuant to which we were granted an exclusive, sublicenseable,
transferable license with respect to the Restoraderm topical drug delivery system which we intend to develop for dermatological applications. Pursuant to the terms of such agreement, upon the occurrence of certain events, we will be required to pay
certain future consulting, royalty and milestone payments in the aggregate amount of up to $3.2 million. The term of such agreement is for the life of any patent that may be issued to us for the first product we develop utilizing such technology,
or, if such a patent fails to issue, seven years. We paid $76,000 under this agreement during the six months ended June 30, 2004 and have paid an aggregate of $1.0 million through June 30, 2004.



On June 10, 2002, we executed a Development and Licensing Agreement with
Shire Laboratories, Inc. pursuant to which we were granted an exclusive worldwide technology license (including the right to sublicense) to develop, make, have made, use, supply, export, import, register and sell products for the treatment of
various inflammatory disorders. In addition, under the agreement, certain product development functions shall be performed for us. Pursuant to the terms of such agreement, we will pay to Shire a percentage of certain net sales of products, if any,
utilizing any part of Shires technology. Also under the agreement, we have committed to payments in cash, or, at our option, a combination of cash and our common stock, upon the achievement of certain clinical and regulatory milestones in the
event we pursue certain applications of the technology. For the two indications for which we currently seek regulatory approval, we estimate the total expenses will be $2.7 million and $2.5 million, respectively. These fees become payable to Shire
in varying amounts for each indication upon the filing of an NDA with the FDA, the FDA or other regulatory approvals, and upon the commercial launch of a licensed product for such indication in the United States. We expect these payments to be made
in 2005 and 2006 if our clinical trails for these indications are successful.



Additional Risks That May Affect Results



Important factors could cause our actual results to differ materially from those indicated or implied by forward-looking statements contained or incorporated by reference in this Quarterly Report on Form 10-Q. Factors that could cause or
contribute to such differences include those factors discussed below. If any of the following risks actually occur, our business, financial condition or results of operations would likely suffer.



We Rely on Periostat and Mutuals Branded Version of Periostat for
Most of Our Revenue. Sales of Mutuals Branded Version of Periostat Could Affect Our Sales Patterns and Profitability.



During the six months ended June 30, 2004 and for the years ended 2003 and 2002, Periostat and Mutuals branded version of Periostat (with respect to
the sixth months ended June 30, 2004), accounted for approximately 90%, 82% and 82% of our total net revenues, respectively. Although we currently derive additional revenue from marketing and/or selling



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other products (Atridox, Atrisorb FreeFlow, Atrisorb-D and Pandel) and from licensing fees from foreign marketing
partners, our revenue and profitability in the near future will depend on our ability to successfully market and sell Periostat and Mutuals branded version of Periostat.



Although we recently settled our litigation with West-ward Pharmaceutical Corporation and Mutual, other companies may have
submitted applications for approval of generic versions of Periostat. We have filed suits to enforce our patent rights and to compel the FDA to award patent and exclusivity protections that would prevent a generic drug application from being
approved. On July 23, 2003, we announced that the United States District Court for the District of Columbia had granted a preliminary injunction temporarily restraining the FDA from approving any Abbreviated New Drug Applications (ANDAs)
submitted for any generic version of Periostat. Until the Court has made a final ruling on our complaint, the FDA cannot approve any ANDAs for a generic version of Periostat. Although the Courts ruling on this issue is not expected to occur
until early 2005, the Court could make a final ruling at any time. If the Court decides in favor of the FDA, the FDA could begin to approve generic drugs immediately thereafter.



We cannot be sure that one or more generic versions of Periostat will not be approved and marketed. If one or more generic
versions of Periostat are approved and marketed, our combined revenues from Periostat and Mutuals branded version of Periostat, would significantly decrease, and as result, our business, financial condition, cash flows and results of
operations would be materially adversely affected.



In
addition, in connection with our settlement with Mutual, we are the sole supplier to Mutual of a branded version of Periostat, subject to certain conditions, at prices below our average manufacturers price through May 2007, or the earlier
termination of such supply arrangements due to certain circumstances. During the second quarter of 2004, we shipped an initial stocking order of product to Mutual that included a one-time promotional allowance. We expect that this initial amount of
stocking maintained by Mutual will affect our sales and profitability for the third and fourth quarter of 2004. Although future sales of Periostat and sales of the branded version of Periostat to Mutual, beyond the initial stocking order, are
expected to generate gross margins in the range of 88% to 90%, our overall revenues of Periostat and the branded version of Periostat could decline significantly, which could materially harm our business.



We May Not Be Able to Maintain Profitability.



From our founding in 1992 through the commercial launch of Periostat in
November, 1998, we had no revenue from sales of our own products. As of June 30, 2004, we have an accumulated deficit of $67.9 million. Our historical losses have resulted primarily from the expenses associated with our pharmaceutical development
program, clinical trials, the regulatory approval process associated with Periostat and sales and marketing activities relating to Periostat. Although we achieved net income of $2.0 million for the six months ended June 30, 2004 and net income of
$6.4 million for the year ended December 31, 2003, we expect to incur significant future expenses, particularly with respect to the sales and marketing of Periostat, new products and continuing clinical and manufacturing development for other
indications and formulations of Periostat, and therefore, we cannot be certain that we will be able to maintain our profitability in the future, if at all.



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Our Competitive Position in the Marketplace Depends on Enforcing and Successfully Defending Our
Intellectual Property Rights.



In order to be
competitive in the pharmaceutical industry, it is important to establish, enforce, and successfully defend patent and trade secret protection for our established and new technologies. We must also avoid liability from infringing the proprietary
rights of others.



Our core technology is licensed from The
Research Foundation of the State University of New York, or SUNY, and other academic and research institutions collaborating with SUNY. Under the license agreement with SUNY, or the SUNY License, we have an exclusive worldwide license to SUNYs
rights in certain patents and patent applications to make and sell products employing tetracyclines to treat certain disease conditions. The SUNY License imposes various payment and reporting obligations on us, and our failure to comply with these
requirements permits SUNY to terminate the SUNY License. If the SUNY License is terminated, we would lose our right to exclude competitors from commercializing similar products, and we could be excluded from marketing the same products if SUNY
licensed the underlying technology to a competitor after terminating the SUNY License.



SUNY owns 30 United States patents and four United States patent applications that are licensed to us. The patents licensed from SUNY expire between 2004 and 2019. Two of the patents are related to Periostat and
expire in 2004 and 2007. Specifically, treatment of a patient in accordance with the package insert of the Periostat product requires the patient to utilize methods covered by the two Periostat patents. And even though the technology covered by
these patents becomes available to competitors as the patents expire, expiration of the first patent does not diminish the protection provided by the second patent.



Since many of our patent rights cover new treatments using tetracyclines, we may be required to bring expensive infringement
actions to enforce our patents and protect our technology. Although federal law prohibits making and selling pharmaceuticals for infringing use, competitors and/or practitioners may provide generic forms of tetracycline for treatment(s) which
infringe our patents, rather than prescribe our Periostat product. Enforcement of patents can be expensive and time consuming.



Although we have settled all pending litigation with Mutual, we cannot be certain that other third parties will not receive FDA approval and introduce a
competitive generic version of Periostat. Any infringement or related action involving any third party will likely result in significant expenditures, even if such actions are settled, require substantial management time and may not be resolved in
our favor.



Our success also depends upon know-how, trade
secrets, and the skills, knowledge and experience of our scientific and technical personnel. To that end, we require all of our employees and, to the extent possible, all consultants, advisors and research collaborators, to enter into
confidentiality agreements prohibiting unauthorized disclosure. With respect to information and chemical compounds we provide for testing to collaborators in academic



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institutions, we cannot guarantee that the institutions will not assert property rights in the results of such tests nor
that a license can be reasonably obtained from such institutions which assert such rights. Failure to obtain the benefit of such testing could adversely affect our commercial position and, consequently, our financial condition.



If We Materially Default on or Breach Our Agreement With Mutual or if a
Generic Version of Periostat is Shipped by a Generic Third-Party Competitor and Remains Available For Sale for a Certain Period of Time, Mutual May Independently Manufacture and Sell a Branded Version of Periostat, and Our Business will be
Materially Harmed.



In connection with our settlement
with Mutual, we entered into a License and Supply Agreement, pursuant to which Mutual received a license to sell a branded version of Periostat. Under this agreement, we will be the sole supplier of this product to Mutual, subject to certain
conditions, at prices below our average manufacturers price through May 15, 2007 or the earlier termination of such supply arrangements under certain circumstances. Upon a material default by us or a breach of our obligations under our
agreement with Mutual or if a generic version of Periostat is shipped by a third-party generic competitor and remains available for sale for a certain period of time, Mutual would be entitled to independently manufacture and sell its own branded
version of Periostat. If Mutual manufactures and sells its own branded version of Periostat, Mutual will be entitled to freely sell its branded product to the market, including to our customers, and we will not receive any revenues from these sales.
If Mutual manufactures and sells its own branded version of Periostat, our revenues could decline significantly and our business will be materially harmed.



If We Lose Our Sole Supplier of Doxycycline Hyclate or Our Current Manufacturer of Periostat, Our Sales of Periostat
and Mutuals branded version of Periostat Will be Interrupted, Halted or Less Profitable.



We rely on a single supplier, Hovione International Limited, or Hovione, for doxycycline, the active ingredient in Periostat and Mutuals branded
version of Periostat. There are relatively few alternative suppliers of doxycycline and Hovione produces the majority of the doxycycline used in the United States. Our current supply agreement with Hovione expires on May 14, 2006 and thereafter
automatically renews for successive two-year periods unless, 90 days prior to the expiration of any such periods, either party gives the other party written notice of termination. In addition, in the event of a default, uncured for 90 days, the
non-defaulting party can terminate the supply agreement effective immediately at the end of such ninety-day period. We rely on Hovione as our sole supplier of doxycycline and have no back-up supplier at this time. If we are unable to procure a
commercial quantity of doxycycline from Hovione on an ongoing basis at a competitive price, or if we cannot find a replacement supplier in a timely manner or with favorable pricing terms, our costs may increase significantly and we may experience
delays in the supply of Periostat and Mutuals branded version of Periostat.



We have entered into an agreement with a contract manufacturer, Pharmaceutical Manufacturing Research Services, Inc., or PMRS, for our tablet formulation for Periostat and Mutuals branded version of Periostat.
Our current arrangement with PMRS has been extended until the earlier of March 30, 2007 or until a generic 20 mg doxycycline hyclate tablet is available on the market. Currently, PMRS is the sole third-party contract manufacturer to supply



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a tablet formulation of Periostat to us, including the branded version of Periostat that we supply to Mutual. Any
inability of PMRS to produce and supply product on agreed upon terms could result in delays in the supply of Periostat and could result in a default in our agreement with Mutual which would permit Mutual to independently manufacture and sell its own
branded version of Periostat. The introduction of a generic 20 mg doxycycline hyclate tablet could leave us without a manufacturer or force us to negotiate a new arrangement, possibly on less favorable terms. We intend to contract with additional
manufacturers for the commercial manufacture of Periostat tablets. We believe, however, that it could take up to one year to successfully transition from PMRS to a new manufacturer.



Our Products are Subject to Extensive Regulation by the FDA.



Drugs and medical devices generally require approval or clearance from the
FDA before they can be marketed in the United States. Periostat and Mutuals branded version of Periostat, Pandel and Atridox have been approved by the FDA as drugs. Atrisorb FreeFlow and Atrisorb-D have been cleared by the FDA as medical
devices. Our drug products under development, however, will have to be approved by the FDA before they can be marketed in the United States. Also, we cannot market our approved products for new indications until the FDA approves the product for that
indication. If the FDA does not approve our products under development or additional indications for marketed products in a timely fashion, or does not approve them at all, our financial condition may be adversely affected.



In addition, drug and medical device products remain subject to comprehensive
regulation by the FDA while they are being marketed. The drug and medical device regulatory schemes differ in detail, but they are essentially similar. The FDA regulates, for example, the safety, manufacturing, labeling, and promotion of both drug
and medical device products. If we or our partners who manufacture our products fail to comply with regulatory requirements, various adverse consequences can result, including recalls, civil penalties, withdrawal of the product from the market
and/or the imposition of civil or criminal sanctions.



We are,
and will increasingly be, subject to a variety of foreign regulatory regimes governing clinical trials and sales of our products. Other than Periostat, which has been approved by the United Kingdom Medicines and Healthcare Products Regulatory Agency
for marketing in the United Kingdom and approved for marketing in Austria, Finland, Switzerland, Ireland, Israel, Italy, Luxembourg, the Netherlands, Portugal and Canada, our products in development have not been approved in any foreign country.
Whether or not FDA approval has been obtained, approval of drug products by the comparable regulatory authorities of foreign countries must be obtained prior to the commencement of marketing of those products in those countries. The approval process
varies from country to country, and other countries may also impose post-approval requirements.



A Small Number of Wholesale Customers, Large Retail Chains, and Mutual Account for the Majority of Our Sales, and the Loss of One of Them, or
Changes in Their Purchasing Patterns, Could Result in Reduced Sales, Thereby Adversely Affecting Our Operating Results.



The majority of our sales are to a small number of wholesale drug distributors and Mutual. For the year ended December 31, 2003, sales to Cardinal Health,
Inc., McKesson



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Corporation and Amerisource-Bergen Corporation, represented approximately 43%, 31% and 20%, respectively, of our
aggregate net product sales. For the six months ended June 30, 2004, sales to Cardinal Health, Inc., McKesson Corporation, Amerisource-Bergen Corporation and Mutual, represented approximately 34%, 25%, 16% and 17%, respectively, of our aggregate net
product sales. Our small number of customers, consolidation in the pharmaceutical wholesale industry or financial difficulties of these customers could result in situations which could temporarily increase returns of our products from our
wholesalers or, as a result of wholesalers and Mutual reducing their respective inventory levels, delay the purchase of our products. In addition, wholesalers and Mutual may increase purchase levels in anticipation of future price increases. This
may cause an unexpected increase in the level of trade inventories normally maintained by wholesalers. Although we have developed a plan to manage trade inventory levels of Periostat and the branded version of Periostat exclusively marketed to
Mutual, this plan may not be effective. If trade inventory levels of Periostat and the branded version of Periostat become too high, or if prescription growth of Periostat and the branded version of Periostat, is lower than expected by the trade,
wholesalers, large retail chains and Mutual could reduce their orders for Periostat, which could result in reduced sales of Periostat and the branded version of Periostat, and adversely affect our operating results.



We Cannot Assure You that Our Pursuit of Business in the Dermatology
Market will be Successful.



During 2003, we began to
implement our plans to expand into the dermatology market. We have completed and announced the preliminary results of a double-blind, placebo-controlled 134-patient Phase III clinical trial to evaluate the safety and efficacy of Periostat to treat
rosacea, we have licensed a new dermal and transdermal drug delivery technology called Restoraderm and we executed a sublicense agreement with Altana Inc. with respect to the marketing and distribution of Pandel. In addition, we continue to actively
seek product licensing opportunities to enhance our near-term offerings to the dermatology market. On April 22, 2004, we announced the restructuring of our pharmaceutical sales organization into dedicated dental and dermatology sales forces. After
the restructuring, we have a 56-person dental sales force calling on a highly targeted group of 10,000 high prescribing dentists and a 33-person dermatology sales force calling on the 5,600 dermatologists who are the highest prescribers of acne,
rosacea and dermatitis products. Our future success will depend on, among other things, our ability to: (i) achieve market acceptance for any current or future dermatological offerings; (ii) hire and retain personnel with experience in the
dermatology market; (iii) execute our business plan with respect to this market segment; and (iv) adapt to technical or regulatory changes once operational. Furthermore, while we have experience in the sales and marketing of dental products, we have
limited experience in this market. This market is very competitive and some of our competitors have substantially greater resources than we have. New product development is a lengthy, complex and uncertain process that will require significant
attention and resources from management. A product candidate can fail at any stage of the development process due to, among other things, efficacy or safety concerns, the inability to obtain necessary regulatory approvals, the difficulty or
excessive cost to manufacture and/or the infringement of patents or intellectual property rights of others. Furthermore, the sales of new products may prove to be disappointing and fail to reach anticipated levels. We therefore cannot assure you
that we will be successful in our pursuit of business in the dermatology market, or that we can sustain any business in which we achieve initial success.



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If Our Products Cause Injuries, We May Incur Significant Expense and Liability.



Our business may be adversely affected by potential product liability
risks inherent in the testing, manufacturing and marketing of Periostat and other products developed by or for us or for which we have licensing or co-promotion rights. We have an aggregate of $10.0 million in product liability insurance for
Periostat and Mutuals branded version of Periostat, our product candidates and products for which we have licensing or co-promotion rights. This level of insurance may not adequately protect us against product liability claims. Insufficient
insurance coverage or the failure to obtain indemnification from third parties for their respective liabilities may expose us to product liability claims and/or recalls and could cause our business, financial condition and results of operations to
decline.



Because Our Executive Officers, Directors and
Affiliated Entities Own Approximately 21.6% of Our Capital Stock, They Could Influence Our Actions in a Manner That Conflicts With Our Interests and the Interests of Our Other Stockholders.



Currently, our executive officers, directors and affiliated entities
together beneficially own approximately 21.6% of the outstanding shares of our common stock or equity securities convertible into common stock. As a result, these stockholders, acting together, or in the case of our preferred stockholders, in
certain instances, as a class, will be able to influence corporate actions requiring stockholder approval, including the election of directors. This concentration of ownership may have the effect of delaying or preventing a change in control,
including transactions in which our stockholders might otherwise receive a premium for their shares over then current market prices.



Our Stock Price is Highly Volatile and, Therefore, the Value of Your Investment May Fluctuate Significantly.



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



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The following table sets forth the high and low closing market price per share for our common stock for
each of the quarters in the period beginning January 1, 2001 through June 30, 2004, as reported on the Nasdaq National Market:



|                   |  |      |       |     |   |      
|------------------ |  | ---- | ----- | --- | - | -----
|Quarter Ended      |  | High |       | Low
|March 31, 2001     |  | $    | 6.00  |     | $ | 4.47 
|June 30, 2001      |  | $    | 8.80  |     | $ | 5.06 
|September 30, 2001 |  | $    | 10.00 |     | $ | 7.25 
|December 31, 2001  |  | $    | 9.50  |     | $ | 7.50 
|March 31, 2002     |  | $    | 12.00 |     | $ | 7.72 
|June 30, 2002      |  | $    | 11.65 |     | $ | 5.75 
|September 30, 2002 |  | $    | 7.34  |     | $ | 4.70 
|December 31, 2002  |  | $    | 9.74  |     | $ | 4.05 
|March 31, 2003     |  | $    | 11.03 |     | $ | 6.66 
|June 30, 2003      |  | $    | 13.27 |     | $ | 8.62 
|September 30, 2003 |  | $    | 15.84 |     | $ | 10.50
|December 31, 2003  |  | $    | 11.82 |     | $ | 8.90 
|March 31, 2004     |  | $    | 14.16 |     | $ | 10.07
|June 30, 2004      |  | $    | 13.21 |     | $ | 8.70 



|Item  3. |  | Quantitative and Qualitative Disclosures About Market Risk.
|-------- |  | -----------------------------------------------------------



We had cash and cash equivalents at June 30, 2004 which are exposed to the impact of interest rate changes and our interest income fluctuates as our
interest rates change. Due to the short-term nature of our investments in money market funds, the carrying values of our cash equivalents approximate their fair value at June 30, 2004.



|Item  4. |  | Controls and Procedures.
|-------- |  | ------------------------



Our management, with the participation of our chief executive officer and chief financial officer, evaluated the effectiveness of our disclosure controls
and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended, or Exchange Act) as of June 30, 2004. In designing and evaluating our disclosure controls and procedures, management recognized that
any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving their objectives and management necessarily applied its judgment in evaluating the cost-benefit relationship of possible
controls and procedures. Based on this evaluation, our chief executive officer and chief financial officer concluded that, as of June 30, 2004, our disclosure controls and procedures were (1) designed to ensure that material information relating to
us, including our consolidated subsidiaries, is made known to our chief executive officer and chief financial officer by others within those entities, particularly during the period in which this report was being prepared and (2) effective, in that
they provide reasonable assurance that information required to be disclosed by us in our reports that we file or submit under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the Securities and
Exchange Commissions rules and forms.



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No change in our internal control over financial reporting (as defined in Rules 13a-15(f) and 15d-15(f)
under the Exchange Act) occurred during the fiscal quarter ended June 30, 2004 that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.



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PART II. OTHER INFORMATION



|Item  1. |  | Legal Proceedings.
|-------- |  | ------------------



United Research Laboratories, Inc./Mutual Pharmaceutical Company, Inc. Litigation



In July 2003, we sued Mutual in the United States District Court for the Eastern District of New York, alleging that Mutual infringed our patents directed
to the use of Periostat for the treatment of adult periodontitis. Our complaint also alleged that Mutual infringed our patent rights by its offering to sell its generic drug and by submitting an ANDA with the FDA, seeking FDA approval to market a
generic tablet version of Periostat.



In a separate action in
the United States District Court for the District of Columbia, we sought and, on July 22, 2003, we were granted a preliminary injunction preventing the FDA from approving generic versions of Periostat, including Mutuals version. Mutual
intervened in that case.



In July 2003, Mutual commenced an
action against us in the United States District Court for the Eastern District of Pennsylvania. Mutual alleged that we had engaged in an effort to monopolize the market for low-dose doxycycline products.



On April 8, 2004, we announced that we had settled all pending litigation
between us and Mutual.



In connection with the settlement, we
and Mutual entered into a License and Supply Agreement pursuant to which Mutual received a license to sell a branded version of Periostat. Under this agreement, we will be the sole supplier of this product to Mutual, subject to certain conditions,
at prices below our average manufacturers price through May 15, 2007 or the earlier termination of such supply arrangements under certain circumstances. In addition, we agreed not to grant any license to sell Periostat in generic form to any
third party during the supply term.



In the settlement, Mutual
agreed and confessed to judgment that our Periostat patents are valid and would be infringed by the commercial manufacture, use, sale, importation or offer for sale of the generic version of Periostat for which Mutual submitted its ANDA. Mutual
consented to a judgment enjoining Mutual and any party acting in concert with Mutual from infringing our patents by making and selling a generic version of Periostat until our patents expire or are declared invalid or unenforceable by a court of
competent jurisdiction from which decision no appeal has been taken or all appeals have been exhausted. Under the terms of the License and Supply Agreement, Mutual would be granted a license under the patents if a third-party, generic version of
Periostat is launched and remains on the market for a certain period of time, or if we materially breach our obligations under the agreement. Finally, Mutual agreed to withdraw from the FDA case in the District of Columbia.



We paid Mutual the amount of $2,000,000, which represented a portion of the
anticipated fees and expenses that we will save as a result of the settlement of the pending actions with Mutual. This charge was recorded in the first quarter of 2004. Under our license agreement with SUNY covering Periostat, we are entitled to
deduct costs incurred to defend its patents, including this payment, from current and future royalties due SUNY on net sales of Periostat and Mutuals branded version of Periostat.



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|Item  2. |  | Changes in Securities, Use of Proceeds and Issuer Purchases of Equity Securities.
|-------- |  | ---------------------------------------------------------------------------------



None.



|Item  3. |  | Defaults upon Senior Securities.
|-------- |  | --------------------------------



None.



|Item  4. |  | Submission of Matters to a Vote of Security Holders.
|-------- |  | ----------------------------------------------------



The Annual Meeting of Stockholders was held on May 25, 2004.



There were present at the Annual Meeting in person or by proxy stockholders holding an aggregate of 12,309,033 shares of Common Stock and 189,000 shares
of Series D Stock, which shares of Series D Stock account for an additional 1,910,385 shares of Common Stock on an as converted to Common Stock basis. The results of the vote taken at such Annual Meeting with respect to the election of the nominees
to be the Common Stock directors were as follows:



|                          |  |                   |  |                 
|------------------------- |  | ----------------- |  | ----------------
|Common Stock Nominees     |  | For               |  | Withheld        
|Colin W. Stewart          |  | 12,115,395 Shares |  | 193,638 Shares  
|Brian M. Gallagher, Ph.D. |  | 12,115,395 Shares |  | 193,638 Shares  
|Peter R. Barnett, D.M.D.  |  | 12,115,395 Shares |  | 193,638 Shares  
|Robert C. Black           |  | 12,115,395 Shares |  | 193,638 Shares  
|James E. Daverman         |  | 12,115,395 Shares |  | 193,638 Shares  
|Robert J. Easton          |  | 11,054,565 Shares |  | 1,254,468 Shares
|W. James OShea           |  | 12,115,395 Shares |  | 193,638 Shares  



The results of the
vote taken at such Annual Meeting with respect to the election of the nominee to be the Series D Director, Stephen A. Kaplan, were as follows: 1,910,385 shares of Series D Stock (on an as converted to Common Stock basis) were voted for the Series D
Stock nominee, with no shares voting against or abstaining.



In
addition, a vote of the stockholders was taken at the Annual Meeting on the proposal to ratify the appointment of KPMG LLP as the independent auditors of the Company for the fiscal year ending December 31, 2004. For the purpose of such vote, the
holders of shares of Common Stock and the holders of Series D Stock (on an as converted to Common Stock basis) voted together as a single class. Of such shares, 14,201,748 shares voted in favor of such proposal, 14,318 shares were voted against such
proposal and 3,350 shares abstained from voting.



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|Item  5. |  | Other Information.
|-------- |  | ------------------



Settlement of Litigation with Mutual



On April 8, 2004, we announced that we had settled all pending litigation between us and Mutual.



In connection with our settlement with Mutual, we entered into a License and Supply Agreement with Mutual, pursuant to which Mutual received a license to
sell a branded version of Periostat. Under this agreement, we will be the sole supplier of this product to Mutual, subject to certain conditions, at prices below our average manufacturers price through May 15, 2007 or the earlier termination
of such supply arrangements due to certain circumstances.



We
paid Mutual $2,000,000, which represented a portion of the anticipated fees and expenses that we will save as a result of the settlement of the pending actions with Mutual. This charge was recorded in the first quarter of 2004. Under our license
agreement with SUNY covering Periostat, we are entitled to deduct costs incurred to defend its patents, including this payment, from current and future royalties due SUNY on net sales of Periostat and Mutuals branded version of Periostat.



Formation of Dedicated Dental and Dermatology Sales
Forces



On April 22, 2004, we announced the
restructuring of our pharmaceutical sales organization into dedicated dental and dermatology sales forces. The restructuring is intended to increase our sales focus on high-prescribing dentists and dermatologists while reducing our cost base. Prior
to the reorganization, virtually all of our 115-person pharmaceutical sales force called on both dentists and dermatologists to market our portfolio of dental and dermatology products. After the restructuring, we have a 56-person dental sales force
calling on a highly targeted group of 10,000 high prescribing dentists and a 33-person dermatology sales force calling on the 5,600 dermatologists who are the highest prescribers of acne, rosacea and dermatitis products.



Renewal of Credit Facility



On June 7, 2004, we entered into a Loan Modification Agreement with Silicon
Valley Bank to renew our revolving credit facility with Silicon Valley Bank, which had expired on March 15, 2004. Pursuant to the terms of the credit facility, we will be permitted to borrow up to the lesser of $5.0 million or 80% of eligible
accounts receivable, as defined under the credit facility. We are not obligated to draw amounts and any borrowings shall bear interest, payable monthly, at the current prime rate. We secured our obligations under the credit facility through the
granting of a security interest in favor of the bank with respect to all of our corporate assets. The credit facility with Silicon Valley Bank, as modified by such Agreement, expires on May 31, 2006.



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Positive Outcome of Phase II Clinical Study



On April 30, 2004, we announced the interim results of a Phase II multicenter, open label and randomized clinical study
evaluating the safety and efficacy of our investigational product, Metastat® (Col-3), for the treatment of HIV-related Kaposis sarcoma.



This Phase II study is conducted under a CRADA between us and the National Cancer Institute. Seventy-five patients were randomized to receive Col-3 at a
dose of either 50 mg or 100 mg per day. The study is still ongoing with 12 patients in the low dose group and 10 patients in the high dose group who have been in the study for more than 2 years.



The interim analysis showed a response rate of 38% in the low dose group and
26% in the high dose group, confirming the tumor activity described previously in the Phase I trial. While the median time to response was comparable in both dose groups, patients in the higher dose group had a markedly prolonged duration of
remission. Also, the study confirmed the previous finding that median levels of circulating MMP-2 (gelatinase A) levels are reduced with higher dosing.



Identification of Application for Generic Form of Periostat



On May 10, 2004, we announced that we had identified an application by IVAX Corporation to list a generic form of Periostat (doxycycline hyclate) 20 mg
tablets on the Illinois Drug Formulary. The application was filed on April 8, 2004 and was listed on the Illinois Drug Formulary on May 7, 2004.



IVAXs generic form of Periostat has not been approved by the FDA. A preliminary injunction was entered on July 22, 2003 by the United States
District Court for the District of Columbia which prevents the FDA from approving any Abbreviated New Drug Applications (ANDAs) for generic versions of Periostat until the Court has finally resolved the issue of whether the FDA should have
classified Periostat as an antibiotic. The Courts ruling on this issue is not expected to occur until early 2005.



Initiation of Two Phase 3 Clinical Trials



On June 15, 2004, we announced that the FDA has cleared the way for the immediate enrollment of patients in two Phase 3 clinical trials of Col-101, our
once daily, modified-release formulation of doxycycline, 40 mg, for the treatment of rosacea. Col-101 is also known as Periostat MR, which is already in Phase 3 clinical testing for the adjunctive treatment of adult periodontitis.



The two double-blinded, placebo-controlled Phase 3 clinical studies will each
enroll up to 264 patients at a total of 22 investigational centers. The studies will evaluate the clinical indices of rosacea, including reductions in inflammatory lesions and erythema, during a 16-week period of administration.



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Results of Clinical Trial Combining Periostat and Atridox



On July 6, 2004, we announced the clinically and statistically significant
results of a six-month, 180 patient clinical trial designed to evaluate the safety and efficacy of Periostat when combined with Atridox and scaling and root planning (SRP), versus SRP alone. All patients entering the trial had eight diseased tooth
sites with periodontal pocket depths of at least 5 mm. At the end of the six month study, patients in the Periostat + Atridox + SRP group showed a 48% mean improvement in clinical attachment level and a 44% mean reduction in periodontal pocket
depths for pockets of 7 mm or greater at baseline, compared to comparable pockets in the patients who had SRP alone. Those deep pockets with baseline depths of 7 mm or greater and treated with combination therapy experienced an average reduction in
pocket depth of more than 2 mm.



The results, showing that the
patients receiving the combination of treatments experienced more than 2 mm improvement in mean attachment gain and pocket depth reduction, were highly statistically significant when compared to SRP alone (p = less than 0.0001 for both parameters).



|Item  6. |  | Exhibits and Reports on Form 8-K.
|-------- |  | ---------------------------------



| | (a) | 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 | Certification Pursuant to 18 U.S.C. Section 1350.
| | -- | -------------------------------------------------



| | (b) | Reports on Form 8-K.
| | --- | --------------------



On April 8, 2004, we filed a Current Report on Form 8-K with the Securities and Exchange Commission relating to the settlement of all outstanding
litigation with United Research Laboratories, Inc./Mutual Pharmaceutical Company, Inc.



On April 27, 2004, we filed a Current Report on Form 8-K with the Securities and Exchange Commission containing a copy of our earnings release for the quarter ended March 31, 2004 (including financial information)
pursuant to Item 12 (Results of Operations and Financial Condition).



On May 11, 2004, we filed a Current Report on Form 8-K with the Securities and Exchange Commission relating to the filing of an application by IVAX Corporation to list a generic form of Periostat (doxycycline hyclate) 20 mg tablets on the
Illinois Drug Formulary.



On June 7, 2004, we filed a Current
Report on Form 8-K with the Securities and Exchange Commission relating to the execution of a Loan Modification Agreement with Silicon Valley Bank.



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SIGNATURES



Pursuant to the
requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.



|                     |  |                                  |  |                                      
|-------------------- |  | -------------------------------- |  | -------------------------------------
|                     |  | CollaGenex Pharmaceuticals, Inc.
|                     |  |                                 
|Date: August 9, 2004 |  | By:                              |  | /s/ Colin W. Stewart                 
|                     |  |                                  |  | Colin W. Stewart                     
|                     |  |                                  |  | President and Chief Executive Officer
|                     |  |                                  |  | (Principal Executive Officer)        
|                     |  |                                 
|Date: August 9, 2004 |  | By:                              |  | /s/ Nancy C. Broadbent               
|                     |  |                                  |  | Nancy C. Broadbent                   
|                     |  |                                  |  | Chief Financial Officer (Principal   
|                     |  |                                  |  | Financial and Accounting Officer)    



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