** **

**UNITED STATES**

**SECURITIES AND EXCHANGE COMMISSION**

**Washington, DC 20549**

** **

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**FORM 10-Q**

** **

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

 

**For the quarterly periodended September 30, 2006**

** **

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

 

**CommissionFile Number 0-28308**

 

**CollaGenex Pharmaceuticals, Inc.**

(Exact Name ofRegistrant as Specified in Its Charter)

 

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

 

**(215) 579-7388**

(Registrant’s Telephone Number, Including Area Code)

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

| **Class**                    | ** ** | **Number  of Shares** |
|------------------------------|------------|-----------------------|
| Common Stock  $.01 par value |       | 17,615,659            |

 

 

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**COLLAGENEX PHARMACEUTICALS, INC.TABLE OF CONTENTS**
|                                     | ** ** | **Page**                                                                                                            |
|-------------------------------------|------------|---------------------------------------------------------------------------------------------------------------------|
| ** **                          | ** ** | ** **                                                                                                          |
| PART  I. FINANCIAL INFORMATION |       |                                                                                                                |
|                                |       |                                                                                                                |   |   |
|                                | Item 1.    | Financial Statements (unaudited)                                                                                    |   | 1 |
|                                |       |                                                                                                                |   |   |
|                                |       | Condensed Consolidated Balance Sheets as of September  30, 2006 and December 31, 2005 (unaudited)                   |   | 2 |
|                                |       |                                                                                                                |   |   |
|                                |       | Condensed Consolidated Statements of Operations for  the Three Months Ended September 30, 2006 and 2005 (unaudited) |   | 3 |
|                                |       |                                                                                                                |   |   |
|                                |       | Condensed Consolidated Statements of Operations for  the Nine Months Ended September 30, 2006 and 2005 (unaudited)  |   | 4 |
|                                |       |                                                                                                                |   |   |
|                                |       | Condensed Consolidated Statements of Cash Flows for  the Nine Months Ended September 30, 2006 and 2005 (unaudited)  |   | 5 |
|                                |       |                                                                                                                |   |   |
|                                |       | Notes to Condensed Consolidated Financial Statements  (unaudited)                                                   |   | 6 |
|                                |       |                                                                                                                |   |   |
|                                | Item 2.    | Management’s Discussion and Analysis of Financial  Condition and Results of Operations                         |   | 19 |
|                                |       |                                                                                                                |   |   |
|                                |       | Results of Operations                                                                                               |   | 21 |
|                                |       |                                                                                                                |   |   |
|                                |       | Liquidity and Capital Resources                                                                                     |   | 28 |
|                                |       |                                                                                                                |   |   |
|                                | Item 3.    | Quantitative and Qualitative Disclosures About Market  Risk                                                         |   | 34 |
|                                |       |                                                                                                                |   |   |
|                                | Item 4.    | Controls and Procedures                                                                                             |   | 35 |
|                                |       |                                                                                                                |   |   |
| PART  II. OTHER INFORMATION    |       | 36                                                                                                                  |
|                                |       |                                                                                                                |   |   |
|                                | Item 1A.   | Risk Factors                                                                                                        |   | 36 |
|                                |       |                                                                                                                |   |   |
|                                | Item 6.    | Exhibits                                                                                                            |   | 47 |
|                                |       |                                                                                                                |   |   |
| SIGNATURES                          |       | 48                                                                                                                  |

 

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

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

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

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

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

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

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

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

**CollaGenex International, Ltd. -European Community Trademarks:**

PeriocyclineTM, RestoradermTM, and Periostat-MRTM.

 

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

i

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**PART I.   FINANCIAL INFORMATION**

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

1

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**COLLAGENEXPHARMACEUTICALS, INC.AND SUBSIDIARIES**

CondensedConsolidated Balance Sheets

September 30, 2006 andDecember 31, 2005

(dollars in thousands,except share data)(unaudited)

 
| ** **                                                                                                                                                                                                                                                                                      | ** ** | **September 30,  2006** | ** ** | **December 31,  2005** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------------|------------|-----------------------------|------------|
| **Assets**                                                                                                                                                                                                                                                                                      |       |                         |       |                        |       |
| Current assets:                                                                                                                                                                                                                                                                                 |       |                         |       |                        |       |
| Cash and cash  equivalents                                                                                                                                                                                                                                                                      |       | $                            | 9,600      |                        | $          | 26,219 |   |
| Short-term  investments                                                                                                                                                                                                                                                                         |       | 16,290                       |       | 18,206                      |       |
| Accounts  receivable, net of allowances of $202 and $104 at September 30, 2006 and December  31, 2005, respectively                                                                                                                                                                             |       | 7,712                        |       | 1,428                       |       |
| Inventories                                                                                                                                                                                                                                                                                     |       | 1,350                        |       | 630                         |       |
| Prepaid expenses  and other current assets                                                                                                                                                                                                                                                      |       | 2,333                        |       | 1,564                       |       |
| Total current  assets                                                                                                                                                                                                                                                                           |       | 37,285                       |       | 48,047                      |       |
| Equipment and leasehold  improvements, net                                                                                                                                                                                                                                                      |       | 963                          |       | 539                         |       |
| Intangible assets, net.                                                                                                                                                                                                                                                                         |       | 1,979                        |       | 536                         |       |
| Other assets                                                                                                                                                                                                                                                                                    |       | 41                           |       | 43                          |       |
| Total assets                                                                                                                                                                                                                                                                                    |       | $                            | 40,268     |                        | $          | 49,165 |   |
|                                                                                                                                                                                                                                                                                            |       |                         |       |                        |       |
| **Liabilities  and Stockholders’ Equity**                                                                                                                                                                                                                                                  | ** ** | ** **                   | ** ** | ** **                  | ** ** |
| Current liabilities:                                                                                                                                                                                                                                                                            |       |                         |       |                        |       |
| Accounts payable                                                                                                                                                                                                                                                                                |       | $                            | 6,753      |                        | $          | 5,411 |   |
| Accrued expenses                                                                                                                                                                                                                                                                                |       | 7,446                        |       | 5,966                       |       |
| Current portion  of deferred revenue                                                                                                                                                                                                                                                            |       | 2,733                        |       | 58                          |       |
| Accrued equity  financing costs                                                                                                                                                                                                                                                                 |       | —                       |       | 1,069                       |       |
| Preferred  dividends payable                                                                                                                                                                                                                                                                    |       | —                       |       | 900                         |       |
| Total current  liabilities                                                                                                                                                                                                                                                                      |       | 16,932                       |       | 13,404                      |       |
| Other non-current  liabilities                                                                                                                                                                                                                                                                  |       | 279                          |       | 93                          |       |
|                                                                                                                                                                                                                                                                                            |       |                         |       |                        |       |
| Commitments and  contingencies (Notes: 6, 7 and 9)                                                                                                                                                                                                                                              |       |                         |       |                        |       |
|                                                                                                                                                                                                                                                                                            |       |                         |       |                        |       |
| Stockholders’ equity:                                                                                                                                                                                                                                                                      |       |                         |       |                        |       |
|                                                                                                                                                                                                                                                                                            |       |                         |       |                        |       |
| Preferred stock,  $0.01 par value, 5,000,000 shares authorized; 200,000 shares of Series D-1  Cumulative Convertible Preferred Stock issued and outstanding at September  30, 2006 and December 31, 2005 (liquidation value of $20,000 at September 30,  2006 and $20,900 at December 31, 2005) |       | 2                            |       | 2                           |       |
|                                                                                                                                                                                                                                                                                            |       |                         |       |                        |       |
| 150,000  shares of Series A Participating Preferred Stock, designated and no shares  issued and outstanding at September 30, 2006 and December 31, 2005                                                                                                                                         |       | —                       |       | —                      |       |
|                                                                                                                                                                                                                                                                                            |       |                         |       |                        |       |
| Common stock,  $0.01 par value; 75,000,000 and 25,000,000 shares authorized, 17,604,109 and  16,054,797 shares issued and outstanding at September 30, 2006 and December  31, 2005, respectively                                                                                                |       | 176                          |       | 161                         |       |
|                                                                                                                                                                                                                                                                                            |       |                         |       |                        |       |
| Additional  paid-in capital                                                                                                                                                                                                                                                                     |       | 141,556                      |       | 124,647                     |       |
| Accumulated  other comprehensive loss                                                                                                                                                                                                                                                           |       | (7                           | )          | (4                          | )          |
| Accumulated  deficit                                                                                                                                                                                                                                                                            |       | (118,670                     | )          | (89,138                     | )          |
| Total  stockholders’ equity                                                                                                                                                                                                                                                                |       | 23,057                       |       | 35,668                      |       |
| Total liabilities and  stockholders’ equity                                                                                                                                                                                                                                                |       | $                            | 40,268     |                        | $          | 49,165 |   |

 

See accompanying notes tounaudited condensed consolidated financial statements.

2

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**COLLAGENEX PHARMACEUTICALS, INC.**

**AND SUBSIDIARIES**

 

Condensed Consolidated Statements of Operations

Forthe Three Months Ended September 30, 2006 and 2005

(amountsin thousands, except share and per share data)(unaudited)

 
| ** **                                                                                                       | ** ** | **Three Months Ended September 30,** | ** ** |
|------------------------------------------------------------------------------------------------------------------|------------|----------------------------------------------------------|------------|
| ** **                                                                                                       | ** ** | **2006**                                                 | ** ** | **2005** | ** ** |
|                                                                                                             |       |                                                     |       |   |   |
| Revenues:                                                                                                        |       |                                                     |       |   |   |
| Net product  sales                                                                                               |       | $                                                        | 4,991      |   | $ | 4,298 |   |
| Contract and  license revenues                                                                                   |       | 431                                                      |       | 202 |   |
| Grant revenues                                                                                                   |       | 211                                                      |       | — |   |
| Total revenues                                                                                                   |       | 5,633                                                    |       | 4,500 |   |
|                                                                                                             |       |                                                     |       |   |   |
| Operating expenses:                                                                                              |       |                                                     |       |   |   |
| Cost of product  sales                                                                                           |       | 1,326                                                    |       | 852 |   |
| Research and  development                                                                                        |       | 3,991                                                    |       | 3,942 |   |
| Selling, general  and administrative                                                                             |       | 10,594                                                   |       | 4,918 |   |
| Total operating  expenses                                                                                        |       | 15,911                                                   |       | 9,712 |   |
| Operating loss                                                                                                   |       | (10,278                                                  | )          | (5,212 | ) |
|                                                                                                             |       |                                                     |       |   |   |
| Other income (expense):                                                                                          |       |                                                     |       |   |   |
| Interest income                                                                                                  |       | 403                                                      |       | 288 |   |
| Net loss                                                                                                         |       | (9,875                                                   | )          | (4,924 | ) |
| Preferred stock  dividend                                                                                        |       | 500                                                      |       | 454 |   |
| Net loss allocable to  common stockholders                                                                       |       | $                                                        | (10,375    | ) | $ | (5,378 | ) |
| Net loss per basic and  diluted share allocable to common stockholders                                           |       | $                                                        | (0.59      | ) | $ | (0.37 | ) |
| Weighted average shares used in computing net loss per basic and  diluted share allocable to common stockholders |       | 17,541,225                                               |       | 14,455,233 |   |

 

See accompanying notes tounaudited condensed consolidated financial statements.

3

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**COLLAGENEX PHARMACEUTICALS, INC.**

**AND SUBSIDIARIES**

Condensed Consolidated Statements of Operations

Forthe Nine Months Ended September 30, 2006 and 2005

(amountsin thousands, except share and per share data)(unaudited)

 
| ** **                                                                                                       | ** ** | **Nine Months Ended September 30,** | ** ** |
|------------------------------------------------------------------------------------------------------------------|------------|---------------------------------------------------------|------------|
| ** **                                                                                                       | ** ** | **2006**                                                | ** ** | **2005** | ** ** |
|                                                                                                             |       |                                                    |       |   |   |
| Revenues:                                                                                                        |       |                                                    |       |   |   |
| Net product  sales                                                                                               |       | $                                                       | 11,686     |   | $ | 23,006 |   |
| Contract and  license revenues                                                                                   |       | 1,084                                                   |       | 446 |   |
| Grant revenues                                                                                                   |       | 377                                                     |       | — |   |
| Total revenues                                                                                                   |       | 13,147                                                  |       | 23,452 |   |
|                                                                                                             |       |                                                    |       |   |   |
| Operating expenses:                                                                                              |       |                                                    |       |   |   |
| Cost of product  sales                                                                                           |       | 3,311                                                   |       | 5,017 |   |
| Research and  development                                                                                        |       | 10,587                                                  |       | 11,237 |   |
| Selling, general  and administrative                                                                             |       | 29,291                                                  |       | 19,175 |   |
| Restructuring  charge                                                                                            | ** ** | **—**                                              |       | 1,184 |   |
| Total operating  expenses                                                                                        |       | 43,189                                                  |       | 36,613 |   |
| Operating loss                                                                                                   |       | (30,042                                                 | )          | (13,161 | ) |
|                                                                                                             |       |                                                    |       |   |   |
| Other income (expense):                                                                                          |       |                                                    |       |   |   |
| Interest income                                                                                                  |       | 1,438                                                   |       | 763 |   |
| Net loss                                                                                                         |       | (28,604                                                 | )          | (12,398 | ) |
| Preferred stock  dividend                                                                                        |       | 1,428                                                   |       | 1,282 |   |
| Net loss allocable to  common stockholders                                                                       |       | $                                                       | (30,032    | ) | $ | (13,680 | ) |
| Net loss per basic and  diluted share allocable to common stockholders                                           |       | $                                                       | (1.72      | ) | $ | (0.95 | ) |
| Weighted average shares used in computing net loss per basic and  diluted share allocable to common stockholders |       | 17,460,749                                              |       | 14,425,038 |   |

 

See accompanying notes tounaudited condensed consolidated financial statements.

4

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**COLLAGENEX PHARMACEUTICALS, INC.**

**AND SUBSIDIARIES**

Condensed Consolidated Statements of Cash Flows

Forthe Nine Months Ended September 30, 2006 and 2005

(dollarsin thousands)

(unaudited)

 
| ** **                                                                       | ** ** | **Nine Months Ended September 30,** | ** ** |
|----------------------------------------------------------------------------------|------------|---------------------------------------------------------|------------|
| ** **                                                                       | ** ** | **2006**                                                | ** ** | **2005** | ** ** |
| Cash flows from operating  activities:                                           |       |                                                    |       |   |   |
| Net loss                                                                         |       | $                                                       | (28,604    | ) | $ | (12,398 | ) |
| Adjustments to  reconcile net loss to net cash used in operating activities:     |       |                                                    |       |   |   |
| Stock-based  compensation                                                        |       | 2,528                                                   |       | — |   |
| Write-down of  inventory                                                         |       | 250                                                     |       | 979 |   |
| Write-down of  fixed assets                                                      |       | —                                                  |       | 96 |   |
| Depreciation and  amortization expense                                           |       | 453                                                     |       | 661 |   |
| Accounts  receivable provisions                                                  |       | 98                                                      |       | (79 | ) |
| Charge for  in-process research and development                                  |       | 300                                                     |       | — |   |
| Changes in  operating assets and liabilities:                                    |       |                                                    |       |   |   |
| Accounts  receivable                                                             |       | (6,382                                                  | )          | 5,204 |   |
| Inventories                                                                      |       | (970                                                    | )          | 1,053 |   |
| Prepaid expenses  and other assets                                               |       | (769                                                    | )          | 302 |   |
| Accounts payable                                                                 |       | 672                                                     |       | 85 |   |
| Accrued expenses                                                                 |       | 1,292                                                   |       | 1,904 |   |
| Deferred revenue                                                                 |       | 2,675                                                   |       | — |   |
| Other  non-current liabilities                                                   |       | 4                                                       |       | (104 | ) |
| Net cash used in  operating activities                                           |       | (28,453                                                 | )          | (2,297 | ) |
|                                                                             |       |                                                    |       |   |   |
| Cash flows from  investing activities:                                           |       |                                                    |       |   |   |
| Capital  expenditures                                                            |       | (386                                                    | )          | (319 | ) |
| Purchase of  in-process research and development                                 |       | (200                                                    | )          | (150 | ) |
| Payment of  Oracea milestone fees                                                |       | (1,000                                                  | )          | — |   |
| Purchase of  short-term investments                                              |       | (27,155                                                 | )          | (25,768 | ) |
| Sales of short-term  investments                                                 |       | 29,074                                                  |       | 30,559 |   |
| Net cash  provided by investing activities                                       |       | 333                                                     |       | 4,322 |   |
|                                                                             |       |                                                    |       |   |   |
| Cash flows from  financing activities:                                           |       |                                                    |       |   |   |
| Net proceeds  from issuance of common stock                                      |       | 11,594                                                  |       | — |   |
| Net proceeds  from the exercise of stock options                                 |       | 1,734                                                   |       | 397 |   |
| Payment of  preferred dividends                                                  |       | (1,827                                                  | )          | (1,628 | ) |
| Net cash  provided by (used in) financing activities                             |       | 11,501                                                  |       | (1,231 | ) |
| Net (decrease)  increase in cash and cash equivalents                            |       | (16,619                                                 | )          | 794 |   |
| Cash and cash  equivalents at beginning of period                                |       | 26,219                                                  |       | 11,889 |   |
| Cash and cash  equivalents at end of period                                      |       | $                                                       | 9,600      |   | $ | 12,683 |   |
| Supplemental disclosure  of non-cash investing activities:                       |       |                                                    |       |   |   |
| Accounts payable  balance related to capitalized product development fees        |       | $                                                       | 670        |   | $ | — |   |
| Accrued liability for  in-process research and development                       |       | $                                                       | 100        |   | $ | — |   |
| Liability (current and non-current) for equipment purchased under  capital lease |       | $                                                       | 264        |   | $ | — |   |

 

See accompanying notes tounaudited condensed consolidated financial statements.

5

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**COLLAGENEXPHARMACEUTICALS, INC.AND SUBSIDIARIES**

**NOTES TO CONDENSED CONSOLIDATEDFINANCIAL STATEMENTSSeptember 30, 2006 and 2005(dollars in thousands, except per share data)(Unaudited)**

**Note 1 — Basis ofPresentation**

The unaudited condensed consolidated financialstatements included herein have been prepared by CollaGenex Pharmaceuticals,Inc. and subsidiaries, or the Company, pursuant to the rules and regulations ofthe Securities and Exchange Commission and in accordance with accountingprinciples generally accepted in the United States of America.  Certain information and footnote disclosuresnormally included in the annual consolidated financial statements prepared inaccordance with accounting principles generally accepted in the United Statesof America, or U.S. GAAP, have been condensed or omitted pursuant to such rulesand the regulations of the Securities and Exchange Commission.  These unaudited condensed consolidatedfinancial statements should be read in conjunction with the Company’s 2005 auditedconsolidated financial statements and footnotes included in its Annual Reporton Form 10-K for the year ended December 31, 2005.

The accompanying unaudited condensed consolidatedfinancial statements include the results of the Company and its subsidiaries.  All intercompany accounts and transactionshave been eliminated in consolidation.

Certain amounts in the 2005 consolidated financialstatements have been reclassified to conform to the 2006 presentation.

In the opinion of the Company’s management, theaccompanying unaudited condensed consolidated financial statements have beenprepared on a basis substantially consistent with the audited consolidatedfinancial statements for the year ended December 31, 2005 and containadjustments, all of which are of a normal, recurring nature necessary topresent fairly the Company’s consolidated financial position at September 30,2006, the results of operations for the three and nine months ended September30, 2006 and 2005, and the cash flows for the nine months ended September 30,2006 and 2005.  Interim results are notnecessarily indicative of results anticipated for the full fiscal year.

The preparation of consolidated financial statementsin conformity with U.S. GAAP requires management to make estimates and assumptionsthat affect the amounts reported in the consolidated financial statements andaccompanying notes.  Actual results coulddiffer from those estimates.

***Net Product Sales***

The Company historically recognized revenues forproduct sales upon shipment to wholesale customers, net of estimated returnsand estimates for chargebacks, applicable wholesale distribution fees andrebates provided that collection was probable and no significant obligationsremained.  Following the launch of athird party generic competitor to Periostat® in May 2005 and commencing withthe second quarter of 2005, the Company began recognizing 

6

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Periostat sales revenue based on product sales toend-users, which are estimated using prescription dispensing data generated byan independent prescription tracking service, as well as on-hand inventoryestimates in the distribution channel. The launch of generic competition to Periostat resulted in increasedproduct returns from the wholesale and retail channels.  As of September 30, 2006, the Company has aliability of $688 for potential Periostat product returns in accrued expenseson the Condensed Consolidated Balance Sheet.

For new product launches, including the OraceaTM launchin July 2006, the Company’s policy is to recognize revenue on a netprescription value basis using dispensing data generated by an independentprescription tracking service until trade channel inventories are reduced totargeted stocking levels and the Company has sufficient data to determineproduct acceptance in the marketplace which will enable the Company to estimateproduct returns based on historical data of similar products.  Net prescription value is calculated bydeducting estimates for chargebacks, wholesale distribution fees, patientrebates, government rebates and any other launch discounts offered from theapplicable gross sales value.  Wheninventories have been reduced to targeted wholesale and retail levels and theCompany has the ability to estimate product returns, the Company will recognizeproduct sales upon shipment, net of discounts, returns and allowances.  As of September 30, 2006, the Companydeferred $2,652 of Oracea revenues as a result of recognizing Oracea revenueson a net prescription basis during the third quarter of 2006.

As described above, the Company records salesdiscounts, allowances and returns upon recognizing product sales. The Companyonly accepts returns of damaged or expired products. The return allowance, whenestimatable, is based on an analysis of the historical returns of the productand the Company considers current end user demand and wholesale and retailinventory levels. If product returns are not estimatable, the Company defersrevenue recognition for all outstanding product in the wholesale and retailchannel that is subject to return. Chargebacks, wholesale distribution fees and rebates are based on ananalysis of the applicable agreements and historical experience. In addition,the Company also considers the volume and price of the product in the channel,trends in wholesaler and retailer inventory levels, conditions that mightaffect end-user demand (such as generic competition) and other relevantfactors.

During the third quarter of 2006, the Company launchedOracea to the U.S. dermatology community. As part of such launch, the Company introduced a patient rebate programfor Oracea prescriptions.  The rebatecard was included in marketing materials that the Company’s salesrepresentatives gave to dermatologists, and only patients presenting thecomputer-coded card to their pharmacists were entitled to receive therebate.  In accordance with EmergingIssues Task Force, Issue No. 01-09, *“Accounting forConsideration Given by a Vendor to a Customer,”* the Company hasaccounted for these patient rebates as a reduction of net product sales on theCompany’s Condensed Consolidated Statements of Operations for the three andnine month periods ended September 30, 2006.

***ContractRevenue***

Pursuant to the Company’s Promotion and CooperationAgreement, or the Promotion Agreement, with Primus Pharmaceuticals, Inc., orPrimus, contract revenues for AlcortinTM, a prescription topical antifungalsteroid combination, and NovacortTM,a prescription topical steroid and anesthetic, are fee-based arrangements wherecontract revenue is earned as prescriptions are filled and recognized as apercentage of the gross profit earned by Primus.  The Company does not take title to theinventory sold by Primus under the Promotion Agreement.

7

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***Grant Revenues***

During the fourth quarter of 2005, the Companyreceived notice that a grant had been approved by the National Institutes ofHealth, or NIH, to fund additional research by the Company and itscollaborators on the potent anti-inflammatory effects of incyclinide.  The Company expenses such researchexpenditures as they are incurred and recognizes grant revenue when earned forthe portion of the expenditures that are reimbursable by the NIH.  The Company recognized $211 and $377 in grantrevenues during the three and nine months ended September 30, 2006.

***Pre-LaunchManufacturing Costs***

The Company classifies costs relating to themanufacture of product inventory and samples in advance of a new product launchas research and development expense until the product is approved by the Foodand Drug Administration, or FDA. Following FDA approval, the Company’s policyis to capitalize any inventory costs that were not previously recognized asR&D expense.

***Share-BasedCompensation***

As part of the Company’s adoption of Statement ofFinancial Accounting Standards (SFAS) No. 123 (revised 2004), *Share-Based Payment,*or SFAS No. 123R, asof January 1, 2006, the Company has recognized the fair value ofshare-based compensation awards in the Company’s consolidated financialstatements using the modified prospective method. The Company applies theBlack-Scholes option pricing model to determine the fair value of stock optionson the date of grant and estimates key assumptions that are important elementsin the model, such as the expected stock-price volatility and expected stockoption life. The Company’s estimates of these important assumptions andexpected forfeiture rates are based on historical data and judgment regardingmarket trends and factors.

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

The Company considers all highly liquid investmentswith an original maturity of three months or less at the date of acquisition tobe cash equivalents.  Cash equivalentinvestments are held at amortized cost, which approximates fair value.  All short-term investments have originalmaturity dates of between three months and one year.  The Company’s short-term investments areprimarily composed of commercial paper and government notes.  At September 30, 2006, all of the Company’sshort-term investments, carried at fair value, were classified asavailable-for-sale with unrealized gains and losses included as a separatecomponent of stockholders’ equity.  Theaccumulated net unrealized loss on short-term investments was $7 and $4 atSeptember 30, 2006 and December 31, 2005, respectively.

***RecentlyIssued Accounting Pronouncements***

***In September2006, the Securities and Exchange Commission issued Staff Accounting Bulletin(SAB) No. 108, “Considering the Effects of Prior Year Misstatements when QuantifyingFinancial Misstatements in Current Year Financial Statements,” which expressesthe Staff’s views regarding the process of quantifying financial statementmisstatements. Registrants are required to quantify the impact of correctingall misstatements, including both the carryover and reversing effects of prioryear misstatements, on the current year financial statements. The techniquesmost commonly used in practice to accumulate and quantify misstatements aregenerally referred to as***

8

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the “rollover” (current year income statementperspective) and “iron curtain” (year-end balance perspective) approaches. Thefinancial statements would require adjustment when either approach results inquantifying a misstatement that is material, after considering all relevantquantitative and qualitative factors. SAB No. 108 is effective for annualfinancial statements covering the first fiscal year ending after November 15,2006. The Company does not expect this guidance to have a material effect onthe Company’s financial condition, results of operations and cash flows.

In June 2006, the Financial Accounting StandardsBoard, or the FASB, issued Interpretation No. 48, “*Accounting for Uncertainty in Income Taxes**3⁄4An Interpretation of FASB Statement No. 109*,”(“FIN No. 48”).  FIN No. 48 clarifies the accounting foruncertainty in income taxes recognized in an enterprise’s financial statementsin accordance with FASB Statement No. 109, “*Accounting for Income Taxes*.”  FIN No. 48 alsoprescribes a recognition threshold and measurement attribute for the financialstatement recognition and measurement of a tax position taken or expected to betaken in a tax return that results in a tax benefit.  Additionally,FIN No. 48 provides guidance on de-recognition, income statementclassification of interest and penalties, accounting in interim periods,disclosure, and transition.  This interpretation is effective for fiscalyears beginning after December 15, 2006.   The Company is currently evaluating theeffect that the application of FIN No. 48 will have on its consolidatedresults of operations and financial condition, but given its current netoperating losses and operating loss carryforwards, does not expect asignificant effect on its results of operations or financial condition as aresult of adopting FIN No. 48.

In November 2005, the FASB issued FASB Staff PositionSFAS 123(R)-3, *Transition Election Relatedto Accounting for the Tax Effects of Share-based Payment Awards*, orSFAS No. 123(R)-3, that provides an elective alternative transition method ofcalculating the pool of excess tax benefits available to absorb taxdeficiencies recognized subsequent to the adoption of SFAS No. 123R to themethod otherwise required by paragraph 81 of SFAS No. 123R.  The Company may take up to one year from theeffective date of the FSP to evaluate its available alternatives and make itsone-time election.  The Company iscurrently evaluating the alternative methods in connection with its adoption ofSFAS No. 123(R)-3.

**Note 2 — Concentrationof Credit and Other Risks**

The Company invests its excess cash in money marketfunds with major U.S. financial institutions, commercial paper, certificates ofdeposit and government notes, based on investment guidelines designed toprotect the safety and liquidity of these investments.

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

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

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| ** **        | ** ** | **Percentage of  Net Product Sales  Nine Months Ended  September 30,** | ** ** |
|-------------------|------------|------------------------------------------------------------------------------------------------------|------------|
| **Customer**      | ** ** | **2006**                                                                                             | ** ** | **2005** | ** ** |
| Cardinal Health   |       | 46                                                                                                   | %          | 35 | % |
| McKesson          |       | 29                                                                                                   | %          | 24 | % |
| AmerisourceBergen |       | 13                                                                                                   | %          | 12 | % |
| URL/Mutual        |       | —                                                                                               |       | 24 | % |

* *
| ** **      | ** ** | **Percentage of  Gross Trade Accounts  Receivable  Balance at   September 30,** | ** ** |
|-----------------|------------|---------------------------------------------------------------------------------------------------------------|------------|
| **Customer**    | ** ** | **2006**                                                                                                      | ** ** | **2005** | ** ** |
| Cardinal Health |       | 44                                                                                                            | %          | 50 | % |
| McKesson        |       | 33                                                                                                            | %          | 20 | % |
| URL/Mutual      |       | —                                                                                                        |       | 19 | % |

 

During the three months ended September 30, 2006, Oraceaaccounted for approximately 40% of the Company’s total revenues.  During the three months ended September 30,2005, Periostat and Mutual’s branded version of Periostat accounted forapproximately 63% of the Company’s total revenues.

**Note 3 — Share-BasedCompensation**

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

Prior to January 1, 2006, the Company accountedfor stock-based employee compensation, including stock options, using themethod prescribed in Accounting Principles Board (APB) Opinion No. 25, “*Accounting for Stock Issued to Employees*”and related Interpretations.  Under APBOpinion No. 25, no compensation cost was recognized for stock options withan exercise price equal to the fair market value of the Company’s common stockon the date of grant, and a disclosure was made regarding the pro forma effecton net earnings (loss) assuming compensation cost had been recognized inaccordance with SFAS No. 123, “*Accountingfor Stock-Based Compensation*.”

The following table illustrates the effect on net lossand basic and diluted net loss per common share if the Company had applied thefair value recognition provisions of SFAS No. 123 to stock-based employeecompensation during the three and nine month periods ended September 30, 2005(option forfeitures are accounted for as they occurred and no amounts ofcompensation expense have been capitalized into inventory or other assets, butinstead are considered period expenses in the pro forma amounts):

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| ***In thousands, except per share data***                                           | ** ** | **Nine Months  Ended  September 30, 2005** | ** ** | **Three Months  Ended  September 30, 2005** | ** ** |
|--------------------------------------------------------------------------------------------------------------|------------|-----------------------------------------------------------|------------|------------------------------------------------------------|------------|
| Net loss allocable to  common stockholders - as reported                                                     |       | $                                                         | (13,680    | )                                                          | $          | (5,378 | ) |
| Add: Stock-based  compensation included in the determination of net loss as reported                         |       | —                                                    |       | —                                                     |       |
| Deduct: Total  stock-based compensation  expense determined under the fair value method  for all grants |       | (2,578                                                    | )          | (848                                                       | )          |
| Net loss allocable to  common stockholders - pro forma                                                       |       | $                                                         | (16,258    | )                                                          | $          | (6,226 | ) |
| Basic and diluted net  loss per share                                                                        |       |                                                      |       |                                                       |       |
| As reported                                                                                                  |       | $                                                         | (0.95      | )                                                          | $          | (0.37 | ) |
| Pro forma                                                                                                    |       | $                                                         | (1.13      | )                                                          | $          | (0.43 | ) |

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(1)             Amountshave not been taxed as a result of the Company’s net operating losscarry-forwards and full valuation allowance.

On December 16, 2004, the FASB issuedSFAS No. 123R, which requires companies to measure and recognizecompensation expense for all stock-based payments at fair value.SFAS No. 123R eliminates accounting for stock-based compensationtransactions using APB Opinion No. 25, and generally requires that suchtransactions be accounted for using prescribed fair-value-based methods.  Effective January 1, 2006, the Companyadopted SFAS No. 123R using the modified prospective method.  Under APB Opinion No. 25, no compensationexpense related to stock option grants was recorded in the consolidatedstatements of operations for the three or nine months ended September 30,2005.  The results for prior periods havenot been restated.  Under the “modifiedprospective” method, compensation costs are recognized for all newly granted ormodified stock-based awards and for the unvested portion of all awards grantedprior to the effective date.

The Company is using the straight-line method torecognize stock-based compensation expense. The amount of stock-based compensation recognized during a period isbased on the value of the awards that vest in that period.  SFAS No. 123R requires forfeitures to beestimated at the time of grant and revised, if necessary, in subsequent periodsif actual forfeitures differ from those estimates.  The term “forfeitures” is distinct from “cancellations”or “expirations” and represents only the unvested portion of the surrenderedoption.  The Company has applied anannual forfeiture rate of 2.8% to all unvested options as of the date of adoptionand for the three and nine months ended September 30, 2006.  This analysis is re-evaluated quarterly andthe forfeiture rate is adjusted as necessary. Ultimately, the actual expense recognized over the vesting period willonly be for those shares that vest.

During the nine months ended September 30, 2006, theCompany recorded $2,528 of stock-based compensation cost.  This amount is composed of $317 related toresearch and development expenses and $2,211 related to selling, general andadministrative expenses.  No amount ofstock-based compensation cost has been capitalized into inventory or otherassets during the nine month period ended September 30, 2006.

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As a result of adopting SFAS No. 123R, the Company’sloss allocable to common stockholders for the three and nine months endedSeptember 30, 2006, respectively, was $858 and $2,528 greater than if theCompany had continued to account for stock-based compensation under APB OpinionNo. 25.  Basic and diluted loss per shareallocable to common stockholders for the three and nine months ended September30, 2006, respectively, would have been $0.54 and $1.58 per share if theCompany had not adopted SFAS No. 123R, compared to reported basic and dilutedloss per share allocable to common stockholders of $0.59 and $1.72 per share.

Since inception, the Company has had four stock-basedcompensation plans.  The Company issuesnew shares of common stock upon the exercise of stock options.  The only active plan at September 30, 2006 isthe 2005 Equity Incentive Plan, or the 2005 Plan.

The 1992 Stock Option Plan, as amended, or the 1992Plan, provided for the granting of incentive and nonqualified options todirectors, employees and consultants to purchase up to 291,000 shares of theCompany’s common stock at an exercise price not less than the fair value on thegrant date. Such options are exercisable for a period of ten years from thegrant date and generally vest over a four-year period. All 291,000 optionsavailable under the 1992 Plan were granted by 1996.

The 1996 Non-Employee Director Stock Option Plan, orthe Non-Employee Director Plan, provided for the granting of stock options tonew non-employee directors to purchase up to 300,000 shares of common stock atan exercise price not less than the fair value on the grant date. Such optionsare exercisable for a period of ten years from the date of grant and generallyvest over a five-year period. The Non-Employee Director Plan expired in March2006.  Unissued shares under theNon-Employee Director Plan were eligible to be reissued into other activeCompany stock-based compensation plans.

The 1996 Stock Option Plan, as amended, or the 1996Plan, provided for the granting of incentive and nonqualified options toemployees and consultants to purchase up to 3,000,000 shares of the Company’scommon stock at an exercise price not less than the fair value on the grantdate. Such options are exercisable for a period of ten years from the grantdate and generally vest over a two-to-five-year period, although vesting foroptions granted to certain Company officers is subject to acceleration undercertain circumstances, as these options are performance-based.  The 1996 Plan expired in March 2006, at whichtime all unissued options were rolled over to the 2005 Plan.

The 2005 Plan provides for the issuance of incentiveand nonqualified options, restricted stock awards, restricted stock units andother stock-based awards, including the grant of stock appreciation rights toemployees, officers, directors, consultants, advisors, and other serviceproviders to purchase shares of the Company’s common stock at a price pershare, for the incentive options, not less than the fair value of a share ofthe Company’s common stock on the grant date. The number of shares of common stock that can be issued pursuant to the2005 Plan is 1,000,000 shares plus the rollover of 476,555 remaining shares ofcommon stock reserved for issuance under the 1996 Plan upon its expiration inMarch 2006.  At September 30, 2006, stockoptions were only available for issuance under the 2005 Plan.  Such options are exercisable for a period often years from the grant date and generally vest over a five-year period.  At September 30, 2006, 890,005 shares ofcommon stock were available to be granted pursuant to outstanding awards underthe 2005 Plan.

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Certain options granted in 2003 are being amortized ata rate that is accelerated versus the contractual vesting period of suchoptions as these options are performance-based and it is anticipated that theperformance criteria will be met prior to straight-line vesting.

In May 2006, the Company accelerated the vesting ofcertain options held by a former member of the Company’s Board ofDirectors.  Accordingly, a charge of $92was recorded for the nine month periods ended September 30, 2006 to reflect thefair value of such options on the date of modification.

The following table summarizes activity under allstock option plans for the respective periods:
| ** **                                                           | ** ** | **Nine Months Ended**  | ** ** |
|----------------------------------------------------------------------|------------|----------------------------------|------------|
| ***(In thousands, except per share data)*** | ** ** | **September 30, 2006** | ** ** | **September 30, 2005** | ** ** |
| Weighted-average  fair value of options granted per share            |       | $                                | 7.70       |   | $ | 4.10 |   |
| Intrinsic value of  options exercised                                |       | $                                | 795        |   | $ | 241 |   |

 

At September 30, 2006, the value of the unvestedportion of all outstanding stock-related awards was $7,591 which the Companyexpects to amortize and recognize as compensation expense over theweighted-average service period of approximately 3 years.

The amount of cash received during the nine monthsended September 30, 2006 and 2005 from the exercise of options was $1,734 and$397, respectively.  No related taxbenefit from the exercise of such options was realized as a result of theCompany’s net operating loss carryforwards and full valuation allowance.

The fair values of the options granted during thethree and nine months ended September 30, 2006 and 2005 were determined usingthe Black-Scholes option pricing model, which incorporates various assumptions.The risk-free rate of interest for the average contractual life of the optionis based on U.S. Government Securities Treasury Constant Maturities. Expectedvolatility is based on the historical daily volatility of the Company’s commonstock. The expected life is determined using the short-cut method permittedunder Staff Accounting Bulletin No. 107, *Share-BasedPayment*.  The expecteddividend rate yield is zero because the Company currently does not pay orexpect to pay dividends to common stockholders. The following are the weighted average assumptions used during therespective periods:
| ** **               | ** ** | **Three Months  Ended  September 30,** | ** ** | **Nine Months  Ended  September 30,** | ** ** |
|--------------------------|------------|--------------------------------------------------|------------|-------------------------------------------------|------------|
| ** **               | ** ** | **2006**                                         | ** ** | **2005**                                        | ** ** | **2006** | ** ** | **2005** | ** ** |
| Expected life in  years  |       | 6.50                                             |       | 6.00                                            |       | 6.50 |   | 5.87 |   |
| Risk-free  interest rate |       | 4.77                                             | %          | 4.01                                            | %          | 4.63 | % | 3.99 | % |
| Volatility               |       | 65.0                                             | %          | 75.0                                            | %          | 68.9 | % | 73.5 | % |
| Expected dividend yield  |       | —                                           |       | —                                          |       | — |   | — |   |

 

Stock option activity under all plans during the ninemonths ended September 30, 2006 is as follows:

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| ** **                           | ** ** | **Number of  Shares** | ** ** | **Weighted  Average  Exercise Price  per Share** | ** ** | **Weighted  Average  Remaining  Contractual  Term (years)** | ** ** | **Aggregate  Intrinsic  Value (000’s) (1)** | ** ** |
|--------------------------------------|------------|----------------------------|------------|------------------------------------------------------------|------------|------------------------------------------------------------------|------------|------------------------------------------------------------|------------|
| Balance at  December 31, 2005        |       | 3,305,267                  |       | $                                                          | 9.35       |                                                             |       |                                                       |       |   |
|  Options granted                |       | 508,150                    |       | $                                                          | 11.39      |                                                             |       |                                                       |       |   |
|  Options exercised              |       | (199,312                   | )          | $                                                          | 8.74       |                                                             |       |                                                       |       |   |
|  Options forfeited or cancelled |       | (39,000                    | )          | $                                                          | 9.47       |                                                             |       |                                                       |       |   |
| Balance at  September 30, 2006       |       | 3,575,105                  |       | $                                                          | 9.67       |                                                             | 6.13       |                                                       | $          | 11,869 |   |
| Exercisable at  September 30, 2006   |       | 2,129,477                  |       | $                                                          | 9.90       |                                                             | 4.59       |                                                       | $          | 6,580 |   |

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(1)             Theaggregate intrinsic value on this table was calculated based on the positivedifference between the closing sales price of the Company’s common stock($12.99 per share) on September 29, 2006 and the exercise prices of theunderlying options.

**Note 4 — Inventories**

Inventories at September 30, 2006 andDecember 31, 2005 consist of the following:

|                 | ** ** | **2006** | ** ** | **2005** | ** ** |
|-----------------|------------|----------|------------|----------|------------|
| Raw materials   |       | $        | 448        |     | $          | 77 |   |
| Work in process |       | 288      |       | —   |       |
| Finished goods  |       | 614      |       | 553      |       |
|            |       | $        | 1,350      |     | $          | 630 |   |

 

During the three and nine month periods endedSeptember 30, 2006, the Company recorded charges of $160 and $250 respectively,related to excess inventories.  Duringthe nine months ended September 30, 2005, the Company recorded a charge of $979for the excess inventory of Periostat and Mutual’s branded version of Periostatdue to the anticipated decreased demand following the introduction of a thirdparty generic version of Periostat that occurred in May 2005.

**Note 5 — IntangibleAssets, Net**

Intangible assets, net at September 30, 2006 andDecember 31, 2005 consist of the following:

|                               | ** ** | **2006** | ** ** | **2005** | ** ** |
|-------------------------------|------------|----------|------------|----------|------------|
| Oracea milestone  fees, net   |       | $        | 1,644      |     | $          | — |   |
| Acquired product  rights, net |       | 335      |       | 536      |       |
|                          |       | $        | 1,979      |     | $          | 536 |   |

 

Acquired product rights, net represent the unamortizedcomponent of the licensing fee paid to Atrix Laboratories, Inc. (now known asQLT USA, Inc.) in 2001 in exchange for the rights to market the Atrix Productsin the United States and is being amortized over seven years or throughDecember 31, 2007.

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Oracea milestone fees represent the unamortizedcomponent of Oracea formulation milestones paid post-FDA approval of Oracea andare being amortized on a straight-line basis over a fifteen year periodcommencing in July 2006.

**Note 6 — Line ofCredit**

On May 31, 2006, the Company entered into a Fifth LoanModification Agreement with Silicon Valley Bank, or the Modification Agreement,to amend and renew its revolving credit facility, which had expired on suchdate.  Pursuant to the terms of the Modification Agreement, among otherthings, (i) the expiration date of the amended credit facility was extended toMay 31, 2007 and (ii) covenants requiring the Company to (A) maintain a minimumadjusted quick ratio, as defined therein, and (B) maintain a minimum of $2,000in cash, net of borrowings, were eliminated. Under the amended credit facility, the Company was permitted to borrowup to the lesser of $5,000 or 80% of eligible receivables, as defined under theamended credit facility.  The amount available to the Company was reducedby any outstanding letters of credit issued under the amended credit facilityin amounts totaling up to $2,000.  As the Company paid down amounts underany letter of credit, the amount available to the Company under the creditfacility increased.  No letters of creditwere outstanding at September 30, 2006 and December 31, 2005.  The Companywas not obligated to draw down any amounts under the amended credit facilityand any borrowings bore interest, payable monthly, at Silicon Valley Bank’sprime rate, or 8.25% at September 30, 2006.  The Company was charged anunused line credit fee of 0.25% per annum. As of September 30, 2006 andDecember 31, 2005, the Company had no borrowings outstanding.

On October 9, 2006, the Company entered into a SixthLoan Modification Agreement with Silicon Valley Bank.  Pursuant to the terms of this agreement, theexpiration date of the credit facility has been extended to October 9,2008.  Under the amended credit facility,the Company may borrow up to the lesser of (i) $10,000 or (ii) 80% of eligiblereceivables plus certain specified amounts, subject to reduction during theperiod October 9, 2006 through December 31, 2007.  The amount available to the Company isreduced by any outstanding letters of credit that may be issued under theamended credit facility in amounts totaling up to $2,000.  As the Company pays down amounts under any letterof credit, the amount available to it under the credit facility increases.  The Company is not obligated to draw down anyamounts under the amended credit facility and any borrowings shall bearinterest, payable monthly, at Silicon Valley Bank’s prime rate.  Under the Sixth Loan Modification Agreement,the Company is charged an unused line credit fee of 0.25% per annum.  In addition, under the amended creditfacility, the Company is subject to financial covenants that require theCompany to maintain certain minimum liquidity and tangible net worth levels ona quarterly basis.

**Note 7 — Commitments**

During the nine months ended September 30, 2006, theCompany entered into an operating lease for commercial vehicles for certainmembers of its sales force.  Annual leasepayments under this program approximate $500. The lease term for the vehicles is approximately three years.  Additionally, during the third quarter of2006, the Company entered into a capital lease for its sales force automationprogram hardware and software with annual lease payments of approximately$120.  The lease term is three years.

On October 18, 2006, theCompany amended the change of control agreements with its corporate officers.Under the terms of the amended change in control agreements, in the event 

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the employment of an officer is terminated as a resultof an involuntary termination, within twenty-four months of a change ofcontrol, as defined in the applicable agreements, the officers are entitled toreceive, among other things, a lump sum payment of between 2 and 2.5 times basesalary and  between 2 and 2.5 times the average bonus paid for the threefiscal years prior to the termination date, health coverage and benefits for aperiod of twenty-four months, certain outplacement/administrative support for aperiod of eighteen months and an additional payment to each officer if theofficer would be subject to an excise tax, interest or penalty based on paymentprovided for in the agreement.  In addition, if a change in control, asdefined in the applicable agreements, occurs while the officers are employed bythe Company, then all stock options granted to these individuals prior to thechange in control shall become fully vested and exercisable as of the date ofthe change in control to the extent that such options are outstanding andunexercisable at the time of such change in control.

**Note 8 — Contractand License Revenues**

The Company recorded contract and license revenues of$431 and $1,084****for the three andnine months ended September 30, 2006, respectively, and $202 and $446 for thethree and nine months ended September 30, 2005, respectively.  During the nine months ended September 30,2005, $160 of license revenue was recorded to reflect the unamortized portionof upfront license revenue from the License and Supply Agreement with ShowaYakuhin Kako Co., Ltd., which was terminated in March 2005.  In June 2005, the Company entered into thePromotion Agreement with Primus, under which the Company will promote Alcortin,a prescription topical antifungal steroid combination, and Novacort, aprescription topical steroid and anesthetic. Under the Promotion Agreement, the Company receives a percentage of thegross profit arising from prescriptions written by dermatology professionals(or offices) that result in sales of the products in the United States.  Through June 30, 2006, the majority ofmarketing expenses, excluding sales force compensation and sample productcosts, related to the promotion of the Primus products were funded by Primusand the majority of product sample costs and all sales force compensation werefunded by the Company.  Effective July 1,2006, the Company and Primus amended the Promotion Agreement.  As a result of the amendment, sample expensesand marketing costs, excluding sales force compensation, are funded 60% by theCompany and 40% by Primus.

**Note 9 — LegalSettlements and Proceedings**

***Mutual***

In July 2003, the Company commenced an action againstMutual in the United States District Court for the Eastern District of New Yorkseeking to prevent Mutual from introducing 20 mg tablets of doxycycline hyclateinto the market in the United States. The Company’s suit alleged infringement of patents covering the Company’sPeriostat product.  On April 8, 2004, theCompany settled all pending litigation with Mutual.  As part of the settlement, the Company paidto Mutual $2,000, which represented a portion of the anticipated fees andexpenses that the Company would save as a result of the settlement of thepending actions with Mutual.

In connection with the settlement, the Company andMutual entered into a License and Supply Agreement pursuant to which Mutualreceived a license to sell a branded version of Periostat and would purchasethis product exclusively from the Company at prices below the Company’s averagemanufacturer’s price.  The License andSupply Agreement also provided for the Company to make price adjustments toMutual after a generic version of Periostat had 

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become available on the market at a price lower thanthe selling price of Mutual’s branded version of Periostat.  These adjustments were to take the form ofrebates or credits to Mutual to reduce the acquisition cost of the brandedversion of Periostat in Mutual’s inventory or to offset rebates and similarretroactive price adjustments requested by, and actually provided by, Mutual toits customers.

On May 13, 2005, the FDA approved a third partygeneric version of Periostat that was launched in late May 2005.  Upon this generic launch, the License and SupplyAgreement terminated and Mutual was no longer obligated to purchase its brandedversion of Periostat from the Company and ceased purchasing from the Company inJune 2005.

***IVAXand CorePharma***

On October 1, 2004, the Company filed a complaint forpatent infringement against IVAX Pharmaceuticals Inc., or IVAX, and CorePharmaLLC, or CorePharma, in the United States District Court for the EasternDistrict of New York.  In its complaint,the Company alleged that the submission of Abbreviated New Drug Applications byeach of IVAX and CorePharma for 20 mg tablets of doxycycline hyclate infringedUnited States Patent RE 34,656, for which the Company is the exclusivelicensee.  The Company also alleged thatany manufacture, importation, marketing and sale of generic 20 mg tablets ofdoxycycline hyclate by IVAX and CorePharma would infringe the RE 34,656patent.  The Company sought an injunctionpreventing IVAX and CorePharma from introducing 20 mg tablets of doxycycline hyclatein the United States.  The injunction wasdenied by the Court on June 16, 2005. The Company, IVAX and CorePharma have since agreed not to pursuelitigation on the merits of the Company’s patent infringement claims of thecounterclaims alleged by IVAX and CorePharma. On May 10, 2006, the Court in the Eastern District of New York entered aStipulated Order of Dismissal with Prejudice as to the matters at issue withCorePharma, and on September 20, 2006 a similar order was entered with respectto IVAX.

**Note 10 — LegalExpenses to Defend Periostat Patents**

Under the Company’s license agreement with theResearch Foundation of the State University of New York, or SUNY, coveringOracea and Periostat, the Company is entitled to deduct costs incurred todefend its patents, including the $2,000 settlement payment to Mutual in April2004, from current and future royalties due to SUNY on net sales of Oracea,Periostat and sales to Mutual of its branded version of Periostat.  The cumulative legal patent defense, litigationand settlement costs incurred as of September 30, 2006 exceed the amount of theroyalties earned and payable to SUNY by $3,801. These amounts, which have been expensed, are available to offset futureroyalties earned by SUNY, if any, on net product sales based on the SUNYtechnology and the future potential benefit is not capitalized in the CondensedBalance Sheet at September 30, 2006.

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** **

**Note 11 — AccruedExpenses**

Accrued expensesat September 30, 2006 and December 31, 2005 consist of the following:

|                                         | ** ** | **2006** | ** ** | **2005** | ** ** |
|-----------------------------------------|------------|----------|------------|----------|------------|
| Research and  development project costs |       | $        | 1,862      |     | $          | 739 |   |
| Sales and marketing  costs              |       | 516      |       | 239      |       |
| Payroll and related  costs              |       | 2,081    |       | 2,097    |       |
| Professional and  consulting fees       |       | 364      |       | 232      |       |
| Foreign taxes                           |       | 945      |       | 945      |       |
| Product returns                         |       | 928      |       | 1,267    |       |
| Product distribution  fees and rebates  |       | 523      |       | 237      |       |
| State and franchise  taxes              |       | 146      |       | 110      |       |
| Other                                   |       | 81       |       | 100      |       |
|                                    |       | $        | 7,446      |     | $          | 5,966 |   |

 

**Note 12 — CommonStock Offering**

On December 21,2005, the Company entered into definitive agreements with institutional andother investors to sell 2,900,000 shares of the Company’s common stock for anaggregate purchase price of $29,000.  On December 23, 2005, the Companyclosed on the first tranche of the offering and issued 1,550,000 shares ofcommon stock in exchange for proceeds of $14,388, net of approximately $1,069in placement agency fees and other estimated offering expenses that were accruedby the Company at December 31, 2005.  All placement agency fees andrelated expenses accrued at December 31, 2005 were paid in the first quarter of2006.  On January 6, 2006, the Companyclosed on the second tranche of the offering and issued 1,350,000 shares ofcommon stock in exchange for $12,663 of net proceeds.

**Note 13 — Restructuring**

On May 16, 2005,the Company announced the restructuring of the Company’s sales force followingthe FDA’s approval of a third party generic version of Periostat.  As a result of the restructuring, the Companyceased all sales activities related to Periostat.  The Company incurred a $1,184 restructuringcharge during the nine months ended September 30, 2005.  Of this charge, $813 related to employeeseverance costs while the remaining portion was primarily related to thewrite-off of assets associated with the Company’s dental sales and marketingactivities that could no longer be utilized by the Company.  At September 30, 2006, substantially all ofthese restructuring costs have been paid by the Company.

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

Our management’s discussion and analysis of ourfinancial condition and results of operations include the identification ofcertain trends and other statements that may predict or anticipate futurebusiness or financial results.  There areimportant factors that could cause our actual results to differ materially fromthose indicated.  See “Part II, Item 1A.,Risk Factors.”

**Overview**

CollaGenex Pharmaceuticals, Inc. and subsidiaries is aspecialty pharmaceutical company currently focused on developing and marketinginnovative proprietary medical therapies to the dermatology market.  We currently market four prescriptionpharmaceutical products to the dermatology market through our professionaldermatology sales force and generate revenues from four other prescriptionpharmaceutical products that we continue to sell to the dental market.  In May 2006, the U.S. Food and Drug Administration,or the FDA, granted us marketing approval for OraceaTM for the treatment ofinflammatory lesions (papules and pustules) of rosacea in adult patients.  Oracea is the first FDA approved,orally-administered, systemically-delivered drug to treat rosacea.  In July 2006, we launched Oracea to the U.S.dermatology community.

Our strategy is to become a leading developer andmarketer of innovative prescription pharmaceutical products to the dermatologymarket.  We intend to continue to marketour current products, including Oracea, and develop and launch new productsbased on our proprietary platform technologies as well as othertechnologies.  Our lead developmentcandidates are: incyclinide (formerly known as COL-3), which is currently inPhase II dose-finding clinical trials for the treatment of acne; COL-118, atopical compound currently in Phase I clinical trials that we are developingfor the treatment of erythema (skin redness) associated with dermatologicalconditions; and our Restoraderm® dermal drug delivery system, which iscurrently under development.

Our marketed dermatology products are: Oracea;Pandel®, a prescription corticosteroid we licensed from Altana, Inc. inMay 2002; AlcortinTM, a prescription topical antifungal steroidcombination; and NovacortTM, a prescription topical steroid and anesthetic.  In June 2005, we executed a Promotion andCooperation Agreement with Primus Pharmaceuticals Inc., or Primus, to marketAlcortin and Novacort to dermatologists.

Our original dental product, Periostat®, is anorally-administered, prescription pharmaceutical product that was approved bythe FDA in September 1998 for the treatment of adult periodontitis.  We launched Periostat in January 1999, and,by 2005, Periostat was the largest branded prescription pharmaceutical productin the dental market. Between April 2004 and June 2005, we also sold aseparately branded version of Periostat to United Research Laboratories,Inc./Mutual Pharmaceutical Company, Inc., or Mutual, pursuant to a License andSupply Agreement executed in April 2004 as part of a settlement of ouroutstanding patent litigation with Mutual. On May 20, 2005, we terminated our dental sales force and promotionalactivities for Periostat following the introduction of a third party genericversion of the product and, as a result of this generic launch, Mutual ceasedpurchasing product from us during June 2005. We also discontinued the promotion of our other dental products on May20, 2005.  We continue to generate salesfrom Periostat and three other dental products, which include Atridox®,Atrisorb FreeFlow® and Atrisorb-D®, also referred to as the Atrix Products, andare 

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licensed from Atrix Laboratories, Inc. (now known asQLT USA, Inc.).  Based on data providedby an independent prescription tracking service, we estimate that Periostat’sshare of the 20 mg doxycycline market was approximately 6% at September 30,2006.

In addition to our marketed products, we have apipeline of product candidates in clinical and preclinical development.  These products are based on our proprietaryplatform technologies, IMPACSTM, SansRosaTM****andRestoraderm.  IMPACS (Inhibitors ofMultiple Proteases And CytokineS) are a group of compounds that demonstrate arange of anti-inflammatory activities as well as the ability to inhibit thebreakdown of connective tissue.  Periostatand Oracea are our FDA-approved IMPACS products.  incyclinide is an IMPACS compound currentlyin clinical development for the treatment of acne.  Our IMPACS technology is licensed on aperpetual basis from the Research Foundation of the State University of NewYork at Stony Brook, or SUNY.  OurSansRosa technology was acquired in connection with our acquisition of SansRosaPharmaceutical Development Inc., or SansRosa, and is in Phase I clinical trialsas a topical treatment (COL-118) for the redness associated with rosacea.  Our Restoraderm technology is a proprietary,foam-based, topical drug delivery technology that originated from a Swedishcollaborator.  We have acquired allrights, title and interest to the Restoraderm technology.  We have formulated several potential productsincorporating the Restoraderm technology with active ingredients commonly usedto treat dermatological conditions, although we have not yet developedtimetables for the clinical development or the commercial launch of any ofthese products.

We were founded in 1992 and completed an initialpublic offering of our common stock in 1996. We recorded our first profit in the third quarter of 2002.  We incurred net losses allocable to commonstockholders of $30.0 million for the nine months ended September 30, 2006 and$18.8 million for the year ended December 31, 2005, respectively.  Although we achieved net income of $6.5million and $6.4 million for the years ended December 31, 2004 and 2003,respectively, we have incurred losses in every other year since inception andhave an accumulated deficit of $118.7 million at September 30, 2006.  We do not expect to generate net income forthe year ending December 31, 2006.

**Significant RecentDevelopments**

In May 2006, the FDA approved Oracea for the treatmentof inflammatory lesions (papules and pustules) of rosacea in adultpatients.  Oracea is the first FDA-approved,orally-administered, systemically-delivered drug to treat rosacea.  In July 2006, we launched Oracea to the U.S.dermatology community.

On May 17, 2006, we announced that we had submittedadditional references to the U.S. Patent and Trademark Office, or the USPTO,that may be relevant to the examination of U.S. Patent Application, Serial No.10/117,709, or the 709 Patent, and other applications based thereon.  This application relates to the use ofsub-antimicrobial and non-antimicrobial tetracyclines for the treatment of acneand acne rosacea, including Oracea and incyclinide.  The USPTO had previously issued a Notice ofAllowance of this application in August 2005, and a patent was scheduled toissue on May 23, 2006, but the application was withdrawn from issuance forconsideration of the additional references. On July 20, 2006, we announced that the USPTO had issued a non-finalrejection of this patent application directed to methods for treating acne withOracea.

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On September 1, 2006, we announced that we hadsubmitted our response to the non-final rejection from the USPTO.   We limited the scope of our response to theuse of sub-antimicrobial tetracyclines since the non-antimicrobialtetracyclines are the subject of application Serial No. 10/757,656, or the 656Application.  On November 3, 2006, weannounced that the USPTO had listed the status of the 709 Patent as “allowed,”and that the allowed claims cover the use of sub-antimicrobial tetracyclinesfor the treatment of acne and acne rosacea. We will continue to prosecute the 656 Application.

On October 9, 2006, we entered into a Sixth LoanModification Agreement, or the Subsequent Modification Agreement, with SiliconValley Bank, or SVB, to amend and renew the Loan and Security Agreement betweenthe parties dated March 19, 2001, as previously amended, or the LoanAgreement.  Pursuant to the terms of theSubsequent Modification Agreement, the expiration date of amended creditfacility has been extended to October 9, 2008. Under the amended credit facility, we may borrow up to the lesser of (i)$10.0 million or (ii) 80% of eligible receivables plus certain specified amounts,subject to reduction during the period October 9, 2006 through December 31,2007.  The amount available to us isreduced by any outstanding letters of credit that may be issued under theamended credit facility in amounts totaling up to $2.0 million.  As we pay down amounts under any letter ofcredit, the amount available to us under the credit facility increases.  We are not obligated to draw down any amountsunder the amended credit facility and any borrowings shall bear interest,payable monthly, at SVB’s prime rate. Under the Subsequent Modification Agreement, we are charged an unusedline credit fee of 0.25% per annum.  Inaddition, under the amended credit facility, we are subject to financialcovenants that require us to maintain minimum liquidity levels and tangible networth levels on a quarterly basis.

**Resultsof Operations**

*ThreeMonths Ended September 30, 2006 Compared to Three Months EndedSeptember 30, 2005*

**Revenues**
| ***Revenues  (dollars in thousands)*** | ** ** | **2006** | ** ** | **Change** | ** ** | **2005** | ** ** |
|--------------------------------------------------|------------|----------|------------|------------|------------|----------|------------|
| Net Oracea Product  Sales                        |       | $        | 2,236      |       | 100        | %        | $          | — |   |
| Other Net Product Sales                          |       | 2,755    |       | (35.90     | )%         | 4,298    |       |
| Total Net  Product Sales                         |       | 4,991    |       | 16.12      | %          | 4,298    |       |
| Contract and License  Revenues                   |       | 431      |       | 113.4      | %          | 202      |       |
| Grant Revenues                                   |       | 211      |       | 100        | %          | —   |       |
| Total Revenues                                   |       | $        | 5,633      |       | 25.2       | %        | $          | 4,500 |   |

Net product sales ofOracea, Periostat, Pandel and the Atrix Products during the three months endedSeptember 30, 2006 were approximately $5.0 million.  The increase in net product sales wasprimarily due to the incremental net sales of Oracea following its marketlaunch in July 2006, which were partially offset by lower Periostat net salesand the elimination of sales of Mutual’s branded version of Periostat as aresult of the launch of a third party generic competitor in May 2005.  Oracea net sales were recognized on aprescription-basis during the three months ended September 30, 2006 and reflectpromotional launch discounts, allowances and rebates, which totaledapproximately 35% of gross Oracea sales. For the remainder of 2006, we anticipate total discounts, allowances andrebates as a percentage of Oracea gross sales to be in the range at 15 to 20%.

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We estimate that Periostat’s share of the 20 mgdoxycycline market was 6% at September 30, 2006, compared to 22% at September30, 2005.  Contract revenues during thethree months ended September 30, 2006 were derived primarily from our Promotionand Cooperation Agreement with Primus for the Alcortin and Novacortproducts.  During the three months endedSeptember 30, 2005, contract revenues were primarily derived from residualcontract revenue from our expired agreement with Merck & Co., Inc. forVioxx®.  License revenues during each ofthe three-month periods ended September 30, 2006 and 2005 consisted primarilyof international licensing revenues for Periostat.  Grant revenues of $211,000 recognized duringthe three months ended September 30, 2006, represent reimbursements receivedduring the quarter from the National Institutes of Health, or NIH, pursuant tothe November 2005 grant funding a portion of our incyclinide developmentprogram.

**Cost of Product Sales**
| ***Cost of Product Sales   (dollars in thousands)*** | ** ** | **2006** | ** ** | **Change** | ** ** | **2005** | ** ** |
|------------------------------------------------------------------------------------|------------|----------|------------|------------|------------|----------|------------|
| Cost of Product Sales                                                              |       | $        | 1,326      |       | 55.6       | %        | $          | 852 |   |
| Percent of Net Product Sales                                                       |       | 26.6     | %          | N/A        |       | 19.8     | %          |
|                                                                                    |            |          |            |            |            |          |            |  |  |

 

Cost of product sales includes product packaging,third party royalties, amortization of product licensing and development fees,and the costs associated with the manufacturing, storage and stability ofOracea (in 2006), Periostat and Mutual’s branded version of Periostat (in2005), Pandel and the Atrix Products, as well as charges taken to reflectdecreases in inventory carrying value, if any.

Cost of product sales during the three months endedSeptember 30, 2006 includes a charge of $160,000 associated with a write-downof excess and short-dated inventories.

**Research and Development**
| ***Research and Development  (dollars in thousands)*** | ** ** | **2006** | ** ** | **Change** | ** ** | **2005** | ** ** |
|----------------------------------------------------------------------------|------------|----------|------------|------------|------------|----------|------------|
| Research and  development                                                  |       | $        | 3,991      |       | 1.2        | %        | $          | 3,942 |   |
|                                                                            |            |          |            |            |            |          |            |  |  |

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

Significant development projects conducted during thethree months ended September 30, 2006 included:

·                  clinicaland manufacturing development work for incyclinide of approximately $2.3million;

·                  variousPhase IV clinical trials and post-approval studies related to Oracea ofapproximately $271,000; and

·                  researchand development costs related to COL-118 of approximately $115,000.

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Personnel and overhead expenses, including consulting,regulatory and stock-based compensation costs incurred during the three monthsended September 30, 2006, were approximately $870,000.

We estimate that if incyclinide is developed to thepoint of commercialization, the additional formulation and clinical developmentexpenses and milestone fees expected to be incurred over the next five yearswould be approximately $30.0 million.  Wehave discontinued all development work on Periostat-MRTM following the launch ofgeneric competition to Periostat in May 2005 and our decision to exit thedental business.  We are currentlyconducting formulation and stability work on various products incorporating ourRestoraderm technology, and we are reviewing product options and the timetableassociated with clinical development or commercial launch.  It is premature to estimate futuredevelopment and clinical costs associated with the SansRosa technology.

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

·                  clinical and manufacturingdevelopment work for Oracea, which accounted for total costs of approximately$2.0 million;

·                  clinical and manufacturingdevelopment and formulation work for Periostat-MR, which accounted for totalcosts of approximately $313,000;

·                  clinical and manufacturingdevelopment work for incyclinide, totaling $820,000; and

·                  stabilitytesting and formulation costs related to our Restoraderm technology, whichaccounted for total costs of approximately $236,000.

Personnel and overhead expenses, including consultingand regulatory incurred during the three months ended September 30, 2005, wereapproximately $600,000.

**Selling, General andAdministrative**
| ***Selling, General and Administrative  (dollars in thousands)*** | ** ** | **2006** | ** ** | **Change** | ** ** | **2005** | ** ** |
|--------------------------------------------------------------------------------------------|------------|----------|------------|------------|------------|----------|------------|
| Selling, General and  Administrative                                                       |       | $        | 10,594     |       | 115.4      | %        | $          | 4,918 |   |
|                                                                                            |            |          |            |            |            |          |            |  |  |

Selling, general andadministrative expenses consist primarily of personnel salaries and benefits,including non-cash, stock-based compensation expense in 2006, direct marketingcosts, professional, legal and consulting fees, insurance and general officeexpenses.

Significant components of selling, general andadministrative expenses incurred during the three months ended September 30,2006 included approximately $4.5 million in direct selling and sales trainingexpenses, approximately $3.8 million in marketing expenses (includingadvertising and promotion expenditures related to Oracea, the Primus productsand Pandel) and approximately $2.3 million in general and administrativeexpenses, which include business development, finance, legal and corporateactivities.  Significant components ofselling, general and administrative expenses incurred during the three monthsended September 30, 2005 included approximately $2.1****million in direct selling and sales training expenses,approximately $1.4 million in marketing expenses (including advertising andpromotion expenditures for the

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Primus products and Pandel) and approximately $1.5****million in general and administrativeexpenses, which include business development, finance, legal and corporateactivities.  The increase in selling,general and administrative expense of approximately $5.7 million during thethree months ended September 30, 2006 compared to the three months endedSeptember 30, 2005, was primarily due to increased marketing costs ofapproximately $2.5 million primarily associated with the launch and relatedpromotional activities of Oracea, higher direct sales force and sales trainingcosts of approximately $2.4 million related to Oracea and non-cash, stock-basedcompensation expense in 2006 of approximately $739,000.

**Interest Income**
| ***Interest Income  (dollars in thousands)*** | ** ** | **2006** | ** ** | **Change** | ** ** | **2005** | ** ** |
|--------------------------------------------------------------|------------|----------|------------|------------|------------|----------|------------|
| Interest income                                              |       | $        | 403        |       | 39.93      | %        | $          | 288 |   |
|                                                              |            |          |            |            |            |          |            |  |  |

The increase in interestincome was due primarily to higher average investment yields in 2006 comparedto 2005.

**Preferred Stock Dividend**

Preferred stock dividends included in net lossallocable to common stockholders were $500,000 during the three months endedSeptember 30, 2006 and $454,000 during the three months ended September 30,2005.  Such preferred stock dividends arepaid in cash and are the result of our obligations in connection with theissuance of our Series D Cumulative Convertible Preferred Stock, or the SeriesD Stock, in May 1999.  On December 15,2005, we executed a Restructuring and Exchange Agreement with each of theholders of our outstanding Series D Stock, pursuant to which, among otherthings, the Series D stockholders agreed to effect an exchange, whereby weexchanged all 200,000 outstanding shares of our Series D Stock for 200,000shares of our Series D-1 Cumulative Convertible Preferred Stock, or the SeriesD-1 Stock.

Pursuant to the terms of our Series D-1 Stock, theholders of the Series D-1 Stock are entitled to dividends payable in cash at acurrent rate of 10.0% per annum, which are declared and paid every sixmonths.  The annual dividend rateincreased by 1.0% on May 19, 2006 and will increase by 1% per annum each subsequentanniversary thereof until the earlier of the date that all of the shares ofSeries D-1 Stock are (i) converted into shares of common stock, or (ii)redeemed.

*NineMonths Ended September 30, 2006 Compared to Nine Months EndedSeptember 30, 2005*

**Revenues**
| ***Revenues  (dollars in thousands)*** | ** ** | **2006** | ** ** | **Change** | ** ** | **2005** | ** ** |
|--------------------------------------------------|------------|----------|------------|------------|------------|----------|------------|
| Net Oracea Product  Sales                        |       | $        | 2,236      |       | 100        | %        | $          | — |   |
| Other Net Product Sales                          |       | 9,450    |       | (58.92     | )%         | 23,006   |       |
| Total Net  Product Sales                         |       | 11,686   |       | (49.20     | )%         | 23,006   |       |
| Contract and License  Revenues                   |       | 1,084    |       | 143.1      | %          | 446      |       |
| Grant Revenues                                   |       | 377      |       | 100        | %          | —   |       |
| Total Revenues                                   |       | $        | 13,147     |       | (43.9      | )%       | $          | 23,452 |   |

 

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Net product sales duringthe nine months ended September 30, 2006 included approximately $11.7 millionin net product sales of Oracea, Periostat, Pandel and the Atrix Products.  The decrease in net product sales was primarilydue to lower Periostat net sales and the elimination of sales of the brandedversion of Periostat to Mutual as a result of the launch of a third partygeneric competitor in May 2005, offset in part by sales of Oracea following theJuly 2006 commercial launch.  Oracea netproduct sales (which began in July 2006) were recognized on aprescription-basis during the nine months ended September 30, 2006 and reflectpromotional launch discounts, allowances and rebates, which totaledapproximately 35% of gross Oracea sales. For the remainder of 2006, we anticipate total discounts, allowances andrebates as a percentage of Oracea gross sales to be in the range at 15 to20%.  We estimate that Periostat’s shareof the 20 mg doxycycline market was 6% at September 30, 2006 as compared to 22%at September 30, 2005.  Contract revenuesduring the nine months ended September 30, 2006 were derived primarily from ourPromotion and Cooperation Agreement with Primus for the Alcortin and Novacortproducts.  During the nine months endedSeptember 30, 2005, contract revenues were primarily derived from residualcontract revenue from our expired agreement with Merck & Co., Inc. forVioxx.  Licensing revenues during thenine months ended September 30, 2006 consisted of international licensingrevenues for Periostat.  Licensingrevenues during the nine months ended September 30, 2005 consisted primarily ofinternational licensing revenues for Periostat and $160,000 in license revenuerepresenting the unamortized portion of upfront license revenue received in2000 from the License and Supply Agreement with Showa Yakuhin Kako Co., Ltd.,which was terminated in March 2005. Grant revenues of $377,000 recognized during the nine month period endedSeptember 30, 2006 represent reimbursements received from the NIH pursuant tothe November 2005 grant funding a portion of our incyclinide developmentprogram.

**Cost of Product Sales**
| ***Cost of Product Sales   (dollars in thousands)*** | ** ** | **2006** | ** ** | **Change** | ** ** | **2005** | ** ** |
|------------------------------------------------------------------------------------|------------|----------|------------|------------|------------|----------|------------|
| Cost of Product Sales                                                              |       | $        | 3,311      |       | (34.0      | )%       | $          | 5,017 |   |
| Percent of Net Product Sales                                                       |       | 28.3     | %          |       |       | 21.8     | %          |
|                                                                                    |            |          |            |            |            |          |            |  |  |

Cost of product salesincludes product packaging, third party royalties, amortization of productlicensing fees and development, and the costs associated with themanufacturing, storage and stability of Oracea (in 2006), Periostat and Mutual’sbranded version of Periostat (in 2005), Pandel and the Atrix Products, as wellas charges taken to reflect decreases in inventory carrying value, if any.

Cost of product sales during the nine months endedSeptember 30, 2006 includes a charge of $250,000 associated with a write-downof excess and short-dated inventories. Cost of product sales for the nine months ended September 30, 2005includes a charge of approximately $979,000 associated with the excessinventories of Periostat and Mutual’s branded version of Periostat followingthe launch by a third party generic competitor which occurred in May 2005. Theincrease in cost of product sales as a percentage of net product sales is adirect result of decreased Periostat revenues in 2006, which is a higher marginproduct than our other existing products.

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**Research andDevelopment**
| ***Research and Development  (dollars in thousands)*** | ** ** | **2006** | ** ** | **Change** | ** ** | **2005** | ** ** |
|----------------------------------------------------------------------------|------------|----------|------------|------------|------------|----------|------------|
| Research and  development                                                  |       | $        | 10,587     |       | (5.8       | )%       | $          | 11,237 |   |
|                                                                            |            |          |            |            |            |          |            |  |  |

Research and developmentexpenses consist primarily of funds paid to third parties for the provision ofservices and materials for drug development, pre-FDA approval manufacturing andproduction costs related to Oracea, prior to May 26, 2006, including milestonefees, manufacturing and formulation enhancements, clinical trials, purchasedin-process research and development, statistical analysis and report writingand regulatory compliance costs (including drug approval submission and filingfees).

Significant development projects conducted during thenine months ended September 30, 2006 included:

·                  clinicaland manufacturing development work for incyclinide of approximately $5.2million;

·                  variousPhase IV clinical trials and post-approval studies related to Oracea ofapproximately $537,000;

·                  clinicaland manufacturing work (including pre-FDA approval production costs) andregulatory compliance costs for Oracea of approximately $1.0 million; and

·                  in-processresearch and development and manufacturing development costs related to COL-118of approximately $490,000.

Personnel and overhead expenses, including consulting,regulatory and stock-based compensation costs incurred during the nine monthsended September 30, 2006, were approximately $2.8 million.

We estimate that if incyclinide is developed to the pointof commercialization, the additional formulation and clinical developmentexpenses and milestone fees expected to be incurred over the next five yearswould be approximately $30.0 million.  Wehave discontinued all development work on Periostat-MR following the launch ofgeneric competition to Periostat in May 2005 and our decision to exit thedental business. We are currently conducting formulation and stability work onvarious products incorporating our Restoraderm technology, and we are reviewingproduct options and the timetable associated with clinical development orcommercial launch.  It is premature toestimate future development and clinical costs associated with the SansRosatechnology.

Significant development projects conducted during thenine months ended September 30, 2005 included:

·                  clinical and manufacturingdevelopment work for Oracea, which accounted for total costs of approximately$5.2 million;

·                  clinical and manufacturingdevelopment and formulation work for Periostat-MR, which accounted for totalcosts of approximately $1.3 million;

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·                  clinical and manufacturingdevelopment work for incyclinide, totaling approximately $2.0 million; and

·                  stability testing and formulationcosts for related to our Restoraderm technology, which accounted for totalcosts of approximately $740,000.

Personnel and overhead expenses, including consulting,and regulatory incurred during the nine months ended September 30, 2005, wereapproximately $2.0 million.

**Selling, General andAdministrative**
| ***Selling, General and Administrative  (dollars in thousands)*** | ** ** | **2006** | ** ** | **Change** | ** ** | **2005** | ** ** |
|--------------------------------------------------------------------------------------------|------------|----------|------------|------------|------------|----------|------------|
| Selling, General  and Administrative                                                       |       | $        | 29,291     |       | 52.8       | %        | $          | 19,175 |   |
| Restructuring  charge                                                                      |       | —   |       | N/A        |       | $        | 1,184      |   |
| Total                                                                                      |       | $        | 29,291     |       | 43.9       | %        | $          | 20,359 |   |

Selling, general andadministrative expenses consist primarily of personnel salaries and benefits,including non-cash stock-based compensation expense in 2006, direct marketingcosts, professional, legal and consulting fees, insurance and general officeexpenses.

Significant components of selling, general andadministrative expenses incurred during the nine months ended September 30,2006 included approximately $12.4 million in direct selling and sales trainingexpenses, approximately $9.5 million in marketing expenses (includingadvertising and promotion expenditures related to Oracea, the Primus productsand Pandel) and approximately $7.4 million in general and administrativeexpenses, which include business development, finance, legal and corporateactivities.  Significant components ofselling, general and administrative expenses incurred during the nine monthsended September 30, 2005 included approximately $8.8 million in direct sellingand sales training expenses, approximately $5.0 million in marketing expenses(including advertising and promotion expenditures related to Periostat, theAtrix Products, the Primus products and Pandel) and approximately $5.4 millionin general and administrative expenses, which include business development,finance, legal and corporate activities. The increase in selling, general and administrative expense ofapproximately $10.1 million during the nine months ended September 30, 2006compared to the nine months ended September 30, 2005, was primarily due to $2.2million of non-cash stock-based compensation expense, increased marketing costsof $4.2 million primarily associated with Oracea pre-launch and post-launchactivities and increased direct sales force and sales training costs related toOracea of approximately $2.7 million.

The restructuring charge during the nine months endedSeptember 30, 2005 consisted of a $1.2 million charge related to areorganization following the approval of a third party generic version ofPeriostat.  Of this charge, $813,000related to employee severance costs while the remaining portion was primarilyrelated to the write-off of assets.  As aresult of the restructuring, we ceased all sales activities related toPeriostat and our dental franchise.

**InterestIncome**
| ***Interest Income  (dollars in thousands)*** | ** ** | **2006** | ** ** | **Change** | ** ** | **2005** | ** ** |
|--------------------------------------------------------------|------------|----------|------------|------------|------------|----------|------------|
| Interest income                                              |       | $        | 1,438      |       | 88.47      | %        | $          | 763 |   |
|                                                              |            |          |            |            |            |          |            |  |  |

 

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The increase in interestincome was due to higher average short-term investment and cash equivalentyields in 2006 compared to 2005.

**Preferred Stock Dividend**

Preferred stock dividends included in net lossallocable to common stockholders were $1.4 million during the nine months endedSeptember 30, 2006 and $1.3 million during the nine months ended September 30,2005.  Such preferred stock dividends arepaid in cash and are the result of our obligations in connection with the issuanceof our Series D Stock in May 1999.  OnDecember 15, 2005, we executed a Restructuring and Exchange Agreement with eachof the holders of our outstanding Series D Stock, pursuant to which, amongother things, the Series D stockholders agreed to effect an exchange, wherebywe exchanged all 200,000 outstanding shares of our Series D Stock for 200,000shares of our Series D-1 Stock.

Pursuant to the terms of our Series D-1 Stock, theholders of the Series D-1 Stock are entitled to dividends payable in cash at acurrent rate of 10.0% per annum, which are declared and paid every sixmonths.  The annual dividend rateincreased by 1.0% on May 19, 2006 and will increase by 1% per annum on eachsubsequent anniversary thereof until the earlier of the date that all of theshares of Series D-1 Stock are (i) converted into shares of common stock, or(ii) redeemed.

**Liquidityand Capital Resources**

***CashRequirements/Sources and Uses of Cash***

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

·                  Publicofferings and private placements of our preferred and common stock;

·                  Cashflows from operations; and

·                  Exerciseof stock options and warrants.

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

·                  Thecost of commercialization activities, including product marketing and sales;

·                  Thesuccessful commercialization of Oracea;

·                  Thesuccess of our dermatology franchise;

·                  Thesuccess of our prosecution of the 656 Application related to the use ofnon-antimicrobial tetracyclines for the treatment of acne and acne rosacea,including incyclinide;

·                  Receiptof marketing approvals from the FDA and similar foreign regulatory authoritiesfor our product candidates;

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·                  Thesuccess of our preclinical, clinical and development programs (research anddevelopment expenses are estimated to be approximately $16.0 million in 2006);

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

·                  Theterms and conditions of our outstanding Series D-1 Stock;

·                  Our ability tocontinue to meet the covenant requirements under our amended revolving creditfacility with SVB;

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

·                  Theextent to which we acquire or invest in businesses, products and technologies;

·                  Thecosts involved in obtaining regulatory approvals and clearances required tomarket and sell our products;

·                  Ourability to establish and maintain additional collaborations; and

·                  Thereceptivity of the capital markets to any future financings.

At September 30, 2006, we had cash, cash equivalentsand short-term investments of approximately $25.9 million compared to theapproximately $44.4 million balance at December 31, 2005.

On May 31, 2006, we entered into a Fifth LoanModification Agreement, or the Modification Agreement, with SVB to amend andrenew the Loan Agreement, which expired on May 31, 2006.  Pursuant to the terms of the ModificationAgreement, among other things, (i) the expiration date of amended creditfacility was extended to May 31, 2007 and (ii) covenants requiring us to (A)maintain a Minimum Adjusted Quick Ratio, as defined therein, and (B) maintain aminimum of $2.0 million in cash, net of borrowings under the Loan Agreement,were eliminated.  Under the amendedcredit facility, we were permitted to borrow up to the lesser of $5.0 millionor 80% of eligible receivables, as defined under the Loan Agreement.  The amount available to us was reduced by anyoutstanding letters of credit issued under the amended credit facility inamounts totaling up to $2.0 million.  Aswe paid down amounts under any letter of credit, the amount available to usunder the amended credit facility increased. No letters of credit were outstanding at September 30, 2006.  We were not obligated to draw down anyamounts under the amended credit facility and any borrowings bore interest,payable monthly, at SVB’s prime rate, or 8.25%, at September 30, 2006.  Under the Modification Agreement, we werecharged an unused line credit fee of 0.25% per annum.  We had no borrowings outstanding at September30, 2006.

On October 9, 2006, we entered into the SubsequentModification Agreement with SVB to amend and renew the Loan Agreement.  Pursuant to the terms of the SubsequentModification Agreement, the expiration date of amended credit facility has beenextended to October 9, 2008.  Under theamended credit facility, we may borrow up to the lesser of (i) $10.0 million or(ii) 80% of eligible receivables plus certain specified amounts, subject toreduction during the period

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October 9, 2006 through December 31, 2007.  The amount available to us is reduced by anyoutstanding letters of credit that may be issued under the amended creditfacility in amounts totaling up to $2.0 million.  As we pay down amounts under any letter ofcredit, the amount available to us under the credit facility increases.  We are not obligated to draw down any amountsunder the amended credit facility and any borrowings shall bear interest,payable monthly, at SVB’s prime rate. Under the Subsequent Modification Agreement, we are charged an unusedline credit fee of 0.25% per annum.  Inaddition, under the amended credit facility, we are subject to financialcovenants that require us to maintain minimum liquidity and tangible net worthlevels on a quarterly basis.

In accordance with investment guidelines approved byour Board of Directors, cash balances in excess of those required to fundoperations have been invested in government notes, commercial paper,certificates of deposit and money market funds. Our working capital at September 30, 2006 was $20.4 million compared to$34.6 million at December 31, 2005. During the nine months ended September 30, 2006, we investedapproximately $386,000 in capital expenditures and $200,000 for in-process researchand development, paid approximately $1.8 million in cash dividends to theholders of our Series D-1 Stock and received proceeds of approximately $1.9million (net of purchases) of short-term investments.

We anticipate that our (i) current cash, cashequivalents and short-term investments at September 30, 2006, (ii) theavailability of funds from our line of credit with SVB and (iii) our ability tocontrol variable spending, will be sufficient to fund our operations through atleast the end of 2007.**** In addition, we mayalso finance our cash needs through public or private equity offerings, debtfinancings, corporate collaboration or licensing arrangements. However, thereis no assurance that these financing alternatives will be available onattractive terms, if at all, when needed or in amounts sufficient to fund ouroperations. Our forecast of the period of time through which our financialresources will be adequate to support our operations is a forward-lookingstatement that involves risks and uncertainties, and actual results could varymaterially.

***Cash Flows/CashManagement***

The principal use of cash in operating activitiesduring the nine months ended September 30, 2006 was the payment of operatingexpenses and related working capital liabilities.  Cash flows from operations can varysignificantly due to various factors including the timing of payments made toour vendors, including research and development vendors, vendor payment terms,customer mix and customer payment terms, including the extended payment termsassociated with the Oracea launch quantities sold in July 2006.

Investing activities during the nine months endedSeptember 30, 2006 consisted primarily of purchases and sales of short-terminvestments, capital expenditures and acquired in-process research anddevelopment.  Financing activities duringthe nine months ended September 30, 2006 consisted primarily of the cashinflows from the completion of the second tranche of our common stock offeringand stock option exercises and cash outflows from the payment of preferreddividends to the holders of our Series D-1 Stock.

***ContractualObligations***

Our major outstanding contractual obligations relateto cash dividends on our outstanding Series D-1 preferred stock and operatingleases for our office space.  Thedisclosures relating to our contractual obligations in our Annual Report onForm 10-K for the year ended December 31, 2005 have not materially changedsince we filed that report.  During 2006,we entered into an operating lease for commercial vehicles for certain membersof our sales force.  Annual leasepayments under this program approximate $500,000.  The lease term for the vehicles is approximatelythree years.  Additionally, during 2006,we entered into a capital lease for our

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sales force automation computer hardware and softwarewith annual lease payments of approximately $120,000.  The lease term is three years.

**Critical AccountingPolicies and Estimates**

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

***RevenueRecognition***

We historically recognized revenues for product salesupon shipment to wholesale customers, net of estimated returns and estimatesfor chargebacks, applicable wholesale distribution fees and rebates providedthat collection was probable and no significant obligations remained.  Following the launch of a third party genericcompetitor to Periostat in May 2005 and commencing with the second quarter of2005, we began recognizing Periostat sales revenue based on product sales toend-users, which are estimated using prescription dispensing data generated byan independent prescription tracking service, as well as on-hand inventoryestimates in the distribution channel. Since the launch of generic competition to Periostat resulted in increasedproduct returns from the wholesale and retail channels.  As of September 30, 2006, we have a liabilityof $688,000 for potential Periostat product returns in accrued expenses on theCondensed Consolidated Balance Sheet.

For new product launches, including the Oracea launchin July 2006, our policy is to recognize revenue on a net prescription valuebasis using dispensing data generated by a an independent prescription trackingservice until trade channel inventories are reduced to targeted stocking levelsand we have sufficient data to determine product acceptance in the marketplacewhich will enable us to estimate product returns based on historical data ofsimilar products.  Net prescription valueis calculated by deducting estimates for chargebacks, wholesale distributionfees, patient rebates, government rebates and any other discounts offered fromthe applicable gross sales value.  Wheninventories have been reduced to launch targeted wholesale and retail levelsand we have the ability to estimate product returns, we will recognize productsales upon shipment, net of discounts, returns and allowances described in thefirst paragraph.  As of September 30,2006, we deferred $2,652,000 of Oracea revenues as a result of recognizingOracea revenues on a net prescription basis during the third quarter of 2006.

As described above, we record sales discounts,allowances and returns upon recognizing product sales. We only accept returnsof damaged or expired products. The return allowance, when estimatable, isbased on an analysis of the historical returns of the product and we considercurrent end user demand and wholesale and retail inventory levels. If productreturns are not estimatable, we defer revenue recognition for all outstanding productin the wholesale and retail channel that is subject to return.  Chargebacks, wholesale distribution fees andrebates are based on an analysis of the applicable agreements and historicalexperience. In addition, we also consider the volume and price of the productin the channel, trends in wholesaler and retailer inventory levels,

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conditions that might affect end-user demand (such asgeneric competition) and other relevant factors.

During the third quarter of 2006, we launched Oraceato the U.S. dermatology community.  Aspart of such launch, we introduced a patient rebate program for Oraceaprescriptions.  The rebate card wasincluded in marketing materials that our sales representatives gave to theirdermatologists, and only patients presenting the computer-coded card to theirpharmacists were entitled to receive the rebate.  In accordance with Emerging Issues Task Force,Issue No. 01-09, *“Accounting for Consideration Given by aVendor to a Customer”*, we have accounted for these patient rebatesas a reduction of net product sales on our Condensed Consolidated Statements ofOperations for the three and nine month periods ended September 30, 2006.

***ContractRevenue***

Pursuant to our Promotion and Cooperation Agreementwith Primus, contract revenues for Alcortin and Novacort, are fee-basedarrangements where contract revenue is earned as prescriptions are filled andrecognized as a percentage of the gross profit earned by Primus.  We do not take title to the inventory sold byPrimus under the Promotion and Cooperation Agreement.

***GrantRevenues***

During the fourth quarter of 2005, we received noticethat a grant had been approved by the NIH to fund additional research by us andour collaborators on the potent anti-inflammatory effects of incyclinide.  We expense such research expenditures as theyare incurred and recognize grant revenue when earned for the portion of theexpenditures that are reimbursable by the NIH. We recognized $211,000 and $377,000 in grant revenues during the threeand nine months ended September 30, 2006.

***Deferred Taxes***

In assessing the realizability of deferred tax assets,we consider the likelihood that part or all of the deferred tax assets will notbe realized.  This assessment requiressignificant judgment and estimates.  Theultimate realization of the deferred tax assets is dependent upon thegeneration of future taxable income during the period in which those temporarydifferences become deductible.  Weconsider our history of losses, scheduled reversal of deferred tax assets andliabilities and projected future taxable income over the periods in which thedeferred tax asset items are deductible. The Tax Reform Act of 1986 contains provisions that may limit the netoperating loss and research and experimentation credit carryforwards availableto be used in any given year upon the occurrence of certain events, includingsignificant changes in ownership interest. We have incurred a net loss for the nine months ended September 30, 2006and for the year ended December 31, 2005, and uncertainty regarding our futureprofitability has prevented us from reaching the “more likely than not”conclusion required under the applicable literature to recognize deferred taxassets on our Consolidated Balance Sheet.

***Intangible Assets***

***Product rights and Oracea milestone fees are stated at cost,amortized over the shorter of the estimated useful life of the products or thecontract term which such rights have been***

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licensed, using the straight-line method.  Amortization of product rights and Oracea milestonefees are charged to cost of product sales.

We are required to test for asset impairment ofacquired product rights and Oracea milestone fees whenever events orcircumstances indicate that the carrying value of an asset may not berecoverable.  We apply SFAS No. 144, “Accountingfor the Impairment or Disposal of Long-Lived Assets,” in order to determinewhether or not an asset was impaired. This standard requires an impairment analysis when indicators ofimpairment are present.  If suchindicators are present, the standard indicates that if the sum of the futureexpected cash flows from the asset, undiscounted and without interest charges,is less than the carrying value, an asset impairment must be recognized in the financialstatements.  The amount of the impairmentis the difference between the fair value of the asset and the carrying value ofthe asset.

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

***Inventories***

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

During the three and nine months ended September 30,2006, we recorded a charge of $160,000 and $250,000 for excess inventories,respectively. During the nine months ended September 30, 2005, we recorded acharge of $979,000 for the excess inventory of Periostat and Mutual’s brandedversion of Periostat due to the anticipated decreased demand following theintroduction of a third party generic version of Periostat that occurred in May2005.

***Pre-LaunchManufacturing Costs***

We classify direct manufacturing costs relating toinventory and samples manufactured in advance of a new product launch asresearch and development expense until such time as we receive an approval letterfrom the FDA for a new product. Following FDA approval of the product, we begin to capitalize anyinventory costs relating to that product that were not previously recognized asR&D expense.

***Stock-BasedCompensation***

As part of our adoption of SFAS No. 123R as ofJanuary 1, 2006, we recognized the fair value of stock-based compensationawards in our consolidated financial statements using the modified prospectivemethod. We apply the Black-Scholes option pricing model to determine the fairvalue of stock options on the date of grant, and we estimate key assumptionsthat are important elements in the model, such as the expected stock-pricevolatility and expected stock option life. Our estimates of these importantassumptions and expected forfeiture rates are based on historical data andjudgment regarding market trends and factors.

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

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***RecentlyIssued Accounting Pronouncements***

***In September2006, the Securities and Exchange Commission issued Staff Accounting Bulletin(SAB) No. 108, “Considering the Effects of Prior Year Misstatements whenQuantifying Financial Misstatements in Current Year Financial Statements,”which expresses the Staff’s views regarding the process of quantifyingfinancial statement misstatements. Registrants are required to quantify theimpact of correcting all misstatements, including both the carryover andreversing effects of prior year misstatements, on the current year financialstatements. The techniques most commonly used in practice to accumulate andquantify misstatements are generally referred to as the “rollover” (current yearincome statement perspective) and “iron curtain” (year-end balance perspective)approaches. The financial statements would require adjustment when eitherapproach results in quantifying a misstatement that is material, afterconsidering all relevant quantitative and qualitative factors. SAB No. 108 iseffective for annual financial statements covering the first fiscal year endingafter November 15, 2006. We do not expect this guidance to have a materialeffect on our financial condition, results of operations and cash flows.***

In June 2006, the Financial Accounting StandardsBoard, or the FASB, issued Interpretation No. 48, “*Accounting for Uncertainty in Income Taxes**—**An Interpretation of FASB StatementNo. 109*,” (“FIN No. 48”).  FIN No. 48 clarifiesthe accounting for uncertainty in income taxes recognized in an enterprise’sfinancial statements in accordance with FASB Statement No. 109, “*Accounting for Income Taxes*.” FIN No. 48 also prescribes a recognition threshold and measurementattribute for the financial statement recognition and measurement of a taxposition taken or expected to be taken in a tax return that results in a taxbenefit.  Additionally, FIN No. 48 provides guidance onde-recognition, income statement classification of interest and penalties,accounting in interim periods, disclosure, and transition.  Thisinterpretation is effective for fiscal years beginning after December 15,2006.  We are currently evaluating the effect that the application of FIN No.48 will have on its consolidated results of operations and financial condition,but given its current net operating losses and operating loss carryforwards,does not expect a significant effect on its results of operations or financialcondition as a result of adopting FIN No. 48.

In November 2005, the FASB issued FASB Staff PositionSFAS 123(R)-3, *Transition Election Related to Accountingfor the Tax Effects of Share-based Payment Awards,* that provides anelective alternative transition method of calculating the pool of excess taxbenefits available to absorb tax deficiencies recognized subsequent to theadoption of SFAS No. 123R to the method otherwise required by paragraph 81 ofSFAS No. 123R.  We may take up to oneyear from the effective date of the FSP to evaluate our available alternativesand make our one-time election.  We arecurrently evaluating the alternative methods in connection with our adoption ofSFAS No. 123R.

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

We had cash and cash equivalents and short-terminvestments at September 30, 2006 which are exposed to the impact of interestrate changes and our interest income fluctuates as interest rates change.  Due to the short-term nature of our investmentsin money market funds, the carrying values of our cash equivalents approximatetheir fair value at September 30, 2006. Our short-term investments incommercial paper, certificates of deposit and government notes are carried atfair value.

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**Item 4.**                          Controlsand Procedures.

Our management, with the participation of our chiefexecutive officer and chief financial officer, evaluated the effectiveness ofthe Company’s disclosure controls and procedures as of September 30, 2006.  The term “disclosure controls and procedures,”as defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act, meanscontrols and other procedures of a company that are designed to ensure thatinformation required to be disclosed by a company in the reports that it filesor submits under the Exchange Act is recorded, processed, summarized andreported, within the time periods specified in the SEC’s rules and forms.  Disclosure controls and procedures include,without limitation, controls and procedures designed to ensure that informationrequired to be disclosed by a company in the reports that it files or submitsunder the Exchange Act is accumulated and communicated to the company’smanagement, including its principal executive and principal financial officersas appropriate to allow timely decisions regarding required disclosure.  Our management recognizes that any controlsand procedures, no matter how well designed and operated, can provide onlyreasonable assurance of achieving their objectives and management necessarilyapplies its judgment in evaluating the cost-benefit relationship of possiblecontrols and procedures.  Based on theevaluation of our disclosure controls and procedures as of September 30, 2006,our chief executive officer and chief financial officer concluded that, as ofsuch date, our disclosure controls and procedures were effective at thereasonable assurance level.

No change in our internal control over financialreporting (as defined in Rules 13a-15(f) and 15d-15(f) underthe Exchange Act) occurred during the fiscal quarter ended September 30, 2006that has materially affected, or is reasonably likely to materially affect, ourinternal control over financial reporting.

 

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** **

**PART II.  OTHERINFORMATION**

**Item 1A.**                 Risk Factors

*Statements contained or incorporatedby reference in this Quarterly Report on Form 10-Q that are not based onhistorical fact are “forward-looking statements” within the meaning of thePrivate Securities Litigation Reform Act of 1995, Section 27A of the SecuritiesAct of 1933, as amended, and Section 21E of the Securities Exchange Act of1934, as amended.  These forward-lookingstatements regarding future events and our future results are based on currentexpectations, estimates, forecasts, and projections and the beliefs andassumptions of our management including, without limitation, our expectationsregarding results of operations, selling, general and administrative expenses,research and development expenses, the sufficiency of our cash for futureoperations, our intellectual property portfolio and the success of ourpreclinical, clinical and development programs and our dermatologyfranchise.  Forward-looking statementsmay be identified by the use of forward-looking terminology such as “may,” “could,”“will,” “expect,” “estimate,” “anticipate,” “continue,” or similar terms,variations of such terms or the negative of those terms.*

*We cannot assure investors that ourassumptions and expectations will prove to have been correct.  Important factors could cause our actualresults to differ materially from those indicated or implied by forward-lookingstatements.  Such factors that couldcause or contribute to such differences include those factors discussed below.  We undertake no intention or obligation toupdate or revise any forward-looking statements, whether as a result of newinformation, future events or otherwise. If any of the following risks actually occur, our business, financialcondition, results of operations or liquidity would likely suffer.*

The following discussion includes six revised riskfactors (“We are depending heavily on the commercial success Oracea.  If we are unable to successfullycommercialize Oracea our business will be materially harmed”, “We cannot relyon regulatory protections to prevent the approval of generic equivalents of ourproducts”, “If we are not able to obtain and enforce patent protection forOracea or our other discoveries, our ability to commercialize our product candidatessuccessfully will be harmed and we may not be able to operate our businessprofitably”, “We cannot assure you that our pursuit of business in thedermatology market will be successful”, “If we lose our sole supplier ofdoxycycline or our manufacturer of Oracea, our sales of Oracea will beinterrupted, halted or less profitable” and “We will need substantial fundingand may be unable to raise additional capital if needed, which would force usto delay, reduce or eliminate our product development programs andcommercialization efforts”) that reflect developments subsequent to thediscussion of risk factors included in our most recent Annual Report on Form10-K.  In addition, we have deleted therisk factors entitled “We cannot predict with certainty the effect on ourbusiness of the decline in revenues generated by the dental business followingthe commercial launch of generic versions of Periostat and the termination ofour dental sales force” and “Changes in stock option accounting rules may havea significant adverse affect on our operating results.”

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

We have invested a significant portion of our recentefforts and financial resources in the development of Oracea for the treatmentof rosacea.  Our ability to generate substantial product revenues fromOracea will depend heavily on the successful commercialization of Oracea.  

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While we have begun to generate revenue from Oraceasales in connection with the product’s July trade-launch, it is premature todetermine the future success and growth, if any, of the Oracea productbrand.  The success of Oracea will depend primarily on the acceptance ofthe product by patients, the medical community and third party payors.

Although we currently derive additional revenue frommarketing and/or selling other products other than Oracea (Periostat, the AtrixProducts, the Primus products and Pandel) our revenue and profitability in thenear future will depend on our ability to market and sell Oracea successfully.

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

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

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

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

With limited or no market exclusivity it can be moredifficult for us to prevent competitors from seeking approval for copies of ourproprietary products, and in such a case the value of such products would bematerially adversely affected.  Withoutmarket exclusivity, generic versions of our products could quickly gain marketentry if they meet regulatory approval criteria.  Thus, despite the FDA’s May 2006 approval ofOracea, because it will not be entitled to market exclusivity, third partiesmay enter the market which would materially harm our business.

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

Our success depends, in part, on our ability toprotect proprietary methods and technologies that we develop under the patentand other intellectual property laws of the United States and other countries,so that we can prevent others from using our inventions and 

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proprietary information.  However, we may not hold or obtainproprietary rights to some patents related to our current or future productsand technologies, and we may not, under relevant patent laws, be considered tobe inventors of technologies we believe we have developed.

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

Our strategy depends on our ability to identify ourdiscoveries rapidly and to seek patent protection for them.  This process is expensive and time consuming,and we may not be able to file and prosecute all necessary or desirable patentapplications at a reasonable cost or in a timely manner.  Despite our efforts to protect ourproprietary rights, unauthorized parties may be able to obtain and useinformation that we regard as proprietary. The issuance of a patent does not guarantee that it is valid orenforceable, so even if we obtain patents, they may not be valid or enforceableagainst third parties.  In addition, theissuance of a patent does not guarantee that we have the right to practice thepatented invention.  Third parties mayhave blocking patents that could be used to prevent us from marketing our ownpatented product and practicing our own patented technology.

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

A number of our pending patent applications arerelated and include claims that cover Oracea and/or incyclinide.  On May 17, 2006, we announced that wehad submitted additional references to the USPTO that may be relevant to theexamination of the 709 Patent and other applications based thereon.  This application relates to the use ofsub-antimicrobial and non-antimicrobial tetracyclines for the treatment of acneand acne rosacea, including Oracea and incyclinide.   The USPTO had previously issued a Notice ofAllowance of this application in August 2005, and a patent was scheduled toissue on May 23, 2006, but the application was withdrawn from issuance forconsideration of the additional references. On July 20, 2006, we announced the USPTO had issued a non-finalrejection of our patent application directed to 

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methods for treating acne with Oracea.  On September 1, 2006, we announced that wehad submitted our response to the non-final rejection to the USPTO.  We limited the scope of our response to theuse of sub-antimicrobial tetracyclines since the non-antimicrobialtetracyclines are the subject of the 656 Application.  On November 3, 2006, we announced that theUSPTO had listed the status of the 709 Patent as “allowed,” and that allowedclaims cover the use of sub-antimicrobial tetracyclines for the treatment ofacne and acne rosacea.  We will continueto prosecute the 656 Application.

Our issued patent relating to Oracea, and if issued,our patents relating to incyclinide, may not contain claims sufficiently broadto protect us against third parties with similar products, or provide us withany competitive advantage.  Moreover,once issued, any of our patents may be challenged, narrowed, invalidated orcircumvented.  In addition, the patentrights in our products that derive from claims under method of use patents maybe hard to assert or enforce if medical professionals prescribe similar(including generic), though non-approved, doxycycline products for indicationscovered by our patents.  If our patents are invalidated or otherwiselimited, other companies will be better able to develop products andtechnologies that compete with ours, which could adversely affect ourcompetitive business position, business prospects and financial condition.

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

We continue to implement our plans to expand into thedermatology market. In May 2006, the FDA approved Oracea for the treatment ofrosacea in adults, and in July 2006, we commenced our trade launch ofOracea.  While we have begun to generaterevenue from Oracea sales in connection with the product’s July trade-launch,it is premature to determine the future success and growth, if any, of theOracea product brand.  We continue toseek additional product licensing opportunities to enhance our near-termofferings to the dermatology market.

While we have experience in the sales and marketing ofdental products, we have limited experience in the dermatology market.  This market is very competitive and some ofour competitors have substantially greater resources than we have.  Our future success will depend on, amongother things, our ability to: (i) achieve market acceptance for any current orfuture dermatological offerings; (ii) hire and retain personnel with experiencein the dermatology market; (iii) execute our business plan with respect to thismarket segment; and (iv) adapt to technical or regulatory changes onceoperational.

At the same time, new product development is alengthy, complex and uncertain process that will require significant attentionand resources from management.  A productcandidate can fail at any stage of the development process due to, among otherthings, efficacy or safety concerns, the inability to obtain necessaryregulatory approvals, the difficulty or excessive cost to manufacture and/orthe infringement of patents or intellectual property rights of others.  Furthermore, the sales of new products mayprove to be disappointing and fail to reach anticipated levels.  We therefore cannot assure you that we willbe successful in our pursuit of business in the dermatology market, or that wecan sustain any business in which we achieve initial success.

The success of our current technology platforms, andthat of any other future technology platforms we may purchase or in-license,will depend on the quality and integrity of the technologies licensed or soldto us.  Despite our due diligence and thesafeguards we have in 

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place, we cannot guarantee the effectiveness orintegrity of such technologies, nor can we be certain that others do not haveintervening rights in such technologies. If any of our in-licensed technologies proved ineffective, or if a thirdparty successfully asserted any right to such technologies, our ability todevelop new products and implement our strategies would be materially adverselyaffected.

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

Failure to obtain regulatory approval for a productcandidate will prevent us from commercializing the product candidate.  Other than Oracea and Periostat, we have notreceived regulatory approval to market any of our product candidates in anyjurisdiction.  We have only limitedexperience in filing and prosecuting the applications necessary to gainregulatory approvals.  Securing FDAapproval requires the submission of extensive preclinical and clinical data,information about product manufacturing processes and inspection of facilitiesand supporting information to the FDA for each therapeutic indication toestablish the product candidate’s safety and efficacy.  Our future products may not be effective, maybe only moderately effective or may prove to have undesirable or unintendedside effects, toxicities or other characteristics that may preclude ourobtaining regulatory approval or prevent or limit commercial use.

The process of obtaining regulatory approvals isexpensive, often takes many years, if approval is obtained at all, and can varysubstantially based upon, among other things, the type, complexity and noveltyof the product candidates involved.  Changesin the regulatory approval policy during the development period, changes in orthe enactment of additional statutes or regulations, or changes in regulatoryreview for each submitted product application, may cause delays in the approvalor rejection of an application.

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

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

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

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

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We rely on a supplier, Hovione International Limited,or Hovione, as our sole supplier for doxycycline, the active ingredient inOracea.  Hovione has two FDA-approved,validated manufacturing facilities that we believe will provide us with someprotection against supplying interruption. We are, however, seeking a back-up supplier, but there are relativelyfew alternative suppliers of doxycycline, and Hovione produces the majority ofthe doxycycline used in the United States. Our current supply agreement withHovione expires on May 14, 2008 and thereafter automatically renews forsuccessive two-year periods unless, 90 days prior to the expiration of any suchperiods, either party gives the other party written notice of termination.  In addition, in the event of a default, uncuredfor 90 days, the non-defaulting party can terminate the supply agreementeffective immediately at the end of such ninety-day period.  Although Hovione maintains two manufacturinglocations, if we are unable to procure a commercial quantity of doxycyclinefrom Hovione on an ongoing basis at a competitive price, if Hovione fails tocomply with current Good Manufacturing Practices or if we cannot find areplacement supplier in a timely manner or with favorable pricing terms, ourcosts may increase significantly and we may experience delays in the supply andsale of Oracea.

We entered into an agreement effective December 31,2005 with Cardinal Health PTS, LLC, or PTS, pursuant to which PTS has agreed tomanufacture Oracea for us.  We intend tocontract with additional manufacturers for the commercial manufacture of anOracea capsule.  We believe, however,that it could take up to one year to validate successfully a secondarymanufacturer.  We cannot be certain thatwe will be able to enter into additional agreements on acceptable terms, if atall.  In the event that we are unable toobtain sufficient quantities of doxycycline or Oracea on commerciallyreasonable terms, or in a timely manner, our business, financial condition andresults of operations would be materially adversely affected.

***If the federalregulatory status of Alcortin or Novacort changes, we may be unable to continueto market one or both of these products.***

We market two products, Alcortin and Novacort, under aPromotion and Cooperation Agreement with Primus.  Sixty percent of sample product and promotioncosts and all sales force compensation related to our promotion of Alcortin andNovacort are funded by us.  Primus is responsible for the manufacture ofAlcortin and Novacort and it has not sought FDA approval for these productsbecause it believes that no approval is required.  We cannot be sure thatFDA will not object to the lack of approval for these products. If the FDA wereto assert that these products required approval, it could at any time seek totake administrative or judicial actions which could prevent us from marketingthese products.  Our inability to market these products could result in atemporary or permanent loss of revenue, which may be partially offset by areduction in our promotional expenses related to these products.

***Our products couldbe subject to restrictions or withdrawal from the market and we may be subjectto penalties if we fail to comply with regulatory requirements. Both before andafter approval or clearance, we, our vendors and suppliers, and our productsand product candidates are subject to extensive regulatory requirements. Failure to comply with these requirements could subject us to administrativeand judicial sanctions.***

Both before and after approval or clearance of ourproducts, we, our products, and our manufacturers are subject to extensiveregulatory requirements covering, among other things, manufacturing,advertising and promotion, labeling, adverse event reporting, post-approvalcommitments, registration, record-keeping, export, and distribution ofsamples.  Failure to comply withregulatory requirements may result in:

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·                  restrictionson such products, manufacturers or manufacturing processes;

·                  warningletters;

·                  withdrawalof the products from the market;

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

·                  recall;

·                  fines;

·                  suspensionor withdrawal of regulatory approvals;

·                  refusalto permit the import or export of our products;

·                  productseizure; and

·                  injunctionsor the imposition of civil or criminal penalties.

***We will needsubstantial funding and may be unable to raise additional capital if needed,which would force us to delay, reduce or eliminate our product developmentprograms and commercialization efforts.***

We expect that our research and development expenseswill increase in connection with our ongoing activities and that we will incursignificant commercialization expenses as we expand our marketing and salesefforts.  We will need substantialadditional funding to meet these additional expenses and may be unable to raisecapital when needed or on attractive terms, which would force us to delay,reduce or eliminate our research and development programs and commercializationactivities.

If we generate revenues and incur expenses at ouranticipated levels, we anticipate that our current cash, cash equivalents andshort-term investments at September 30, 2006 will be sufficient to fund ouroperations through at least the end of 2007. However, our forecast of the period of time through which our financialresources will be adequate to support our operations involves risks anduncertainties, and actual results could vary materially.  Our future funding requirements will dependon many factors, including:

·                  thecost of commercialization activities, including product marketing and sales;

·                  thesuccessful commercialization of Oracea;

·                  thesuccess of our dermatology franchise;

·                  thesuccess of our prosecution of the 656 Application related to the use ofnon-antimicrobial tetracyclines for the treatment of acne and acne rosacea,including incyclinide;

·                  receiptof marketing approvals from the FDA and similar foreign regulatory authoritiesfor our product candidates;

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·                  thesuccess of our preclinical, clinical and development programs;

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

·                  theterms and conditions of our outstanding Series D-1 Stock;

·                  ourability to continue to meet the covenant requirements under our amendedrevolving credit facility with Silicon Valley Bank;

·                  thecosts involved in preparing, filing, prosecuting, maintaining and enforcingpatent claims and other patent-related costs, including potential litigationcosts and the results of such litigation;

·                  theextent to which we acquire or invest in businesses, products and technologies;

·                  thecosts involved in obtaining regulatory approvals and clearances required tomarket and sell our products;

·                  ourability to establish and maintain additional collaborations; and

·                  thereceptivity of the capital markets to any future financings.

Until such time, if ever, as we can generatesubstantial product revenues, we expect to finance our cash needs throughpublic or private equity offerings, debt financings and corporate collaborationand licensing arrangements.  If we raiseadditional funds by issuing equity securities, our stockholders may experiencedilution.  Debt financing, if available,may involve agreements that include covenants limiting or restricting ourability to take specific actions, such as incurring additional debt, makingcapital expenditures or declaring dividends. Any debt financing or additional equity that we raise may contain terms,such as liquidation and other preferences that are not favorable to us or ourstockholders. If we raise additional funds through collaboration and licensingarrangements with third parties, it may be necessary to relinquish valuablerights to our technologies, research programs or products or grant licenses onterms that may not be favorable to us.

***We cannot assureyou that our clinical trials will be completed in a timely manner or will meetagreed upon end-points.***

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

As a result of patent infringement claims, or in orderto avoid potential claims, we or our collaborators may choose or be required toseek a license from the third party and be required to pay license fees orroyalties or both.  These licenses maynot be available on acceptable terms, or at all.  Even if we or our collaborators were able toobtain a license, the rights may be nonexclusive, which could result in ourcompetitors gaining access to the same intellectual property.  Ultimately, we could be prevented fromcommercializing a product, or be forced to cease some aspect of our businessoperations, if, as a result of actual or threatened patent infringement claims,we or our collaborators are unable to enter into licenses on acceptableterms.  This could harm our businesssignificantly.

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

***We depend uponthird party researchers and providers of clinical services to perform ascontractually required if we are to be successful in bringing new products tomarket.***

We do not have the ability independently to conductthe clinical trials required to obtain regulatory approval for ourproducts.  We rely on independent clinicalinvestigators, contract research organizations and other third party serviceproviders for successful execution of our clinical trials, but do not controlmany aspects of their activities.  We areresponsible for ensuring that each of our clinical trials is conducted inaccordance with the general investigational plan, protocols for the trial andapplicable regulatory requirements. Moreover, the FDA requires us to comply with standards, commonlyreferred to as Good Clinical Practices, for conducting and recording andreporting the results of clinical trials to assure that data and reportedresults are credible and accurate and that the rights, integrity andconfidentiality of trial participants are protected.  Our reliance on third parties that we do notcontrol does not relieve us of these responsibilities and requirements.  Third parties may not, however, completeactivities on 

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schedule, or may not conduct our clinical trials inaccordance with regulatory requirements or our stated protocols.  Furthermore the data that they generate maynot be accurate or may, in extreme cases, be fraudulent.

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

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

Our IMPACS technology is licensed from SUNY, referredto herein as the SUNY License, and other academic and research institutionscollaborating with SUNY.  Under the SUNYLicense, we have an exclusive worldwide license to SUNY’s rights in certainpatents and patent applications to make and sell products employingtetracyclines to treat certain disease conditions.  The SUNY License imposes various payment andreporting obligations on us, and our failure to comply with these requirementspermits SUNY to terminate the SUNY License. If the SUNY License is terminated, we would lose our right to excludecompetitors from commercializing similar products, and we could be excludedfrom marketing the same products if SUNY licensed the underlying technology toa competitor after terminating the SUNY License.  The SUNY License is terminable by SUNY on 90days prior notice only upon our failure to make timely payments, reimbursementsor reports, if the failure is not cured by us within 90 days.  The termination of the SUNY License, or thefailure to obtain and maintain patent protection for our technologies, wouldhave a material adverse effect on our business, financial condition, liquidityand results of operations.

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

Our business may be adversely affected by potentialproduct liability claims arising out of the testing, manufacturing andmarketing of Periostat, Oracea and other products developed by or for us or forwhich we have licensing or promotion and cooperation rights.  We have an aggregate of $10.0 million inproduct liability insurance covering Periostat, Mutual’s branded version ofPeriostat and Oracea, our product candidates and products for which we havelicensing or promotion and cooperation rights.

Our insurer has also notified us that our generalproduct liability policy will not cover claims arising from our past sales ofVioxx, to the extent such claims are made after December 31, 2004.  This does not affect our rights under theCo-Promotion Agreement with Merck, which provides for indemnification of us byMerck against any claims arising from manufacturing or design defects in theVioxx product or for which we, as the seller of the product, may be strictlyliable as a seller of an inherently dangerous product.

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

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***Our stock price ishighly volatile and, therefore, the value of your investment may fluctuatesignificantly.***

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

The following table sets forth the high and low lastsale prices per share for our common stock for each of the quarters in theperiod beginning October 1, 2004 through September 30, 2006, as reported on theNASDAQ Global Market:

| Quarter Ended  | ** ** | **High** | ** ** | **Low** | ** ** |
|---------------------|------------|----------|------------|---------|------------|
| December 31,  2004  |       | $        | 7.49       |    | $          | 5.37 |   |
|                |       |     |       |    |       |
| March 31, 2005      |       | $        | 7.52       |    | $          | 4.50 |   |
| June 30, 2005       |       | $        | 7.61       |    | $          | 3.99 |   |
| September 30,  2005 |       | $        | 9.95       |    | $          | 7.15 |   |
| December 31,  2005  |       | $        | 12.07      |    | $          | 8.50 |   |
|                |       |     |       |    |       |
| March 31, 2006      |       | $        | 14.80      |    | $          | 11.27 |   |
| June 30, 2006       |       | $        | 14.67      |    | $          | 10.52 |   |
| September 30, 2006  |       | $        | 13.22      |    | $          | 8.52 |   |

 

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

 

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**SIGNATURES**

Pursuantto the requirements of the Securities Exchange Act of 1934, the registrant hasduly caused this report to be signed on its behalf by the undersigned thereuntoduly authorized.
|                               |   | CollaGenex Pharmaceuticals, Inc. |
|-------------------------------|--------|----------------------------------|
|                          |   |                             |
|                          |   |                             |
| Date:  November  9, 2006 |   | By:                              |   | /s/ Colin W. Stewart |
|                          |   |                             |   | Colin W. Stewart |
|                          |   |                             |   | President and  Chief Executive Officer |
|                          |   |                             |   | (Principal  Executive Officer) |
|                          |   |                             |   |   |
|                          |   |                             |   |   |
| Date:  November  9, 2006 |   | By:                              |   | /s/ Nancy C. Broadbent |
|                          |   |                             |   | Nancy C.  Broadbent |
|                          |   |                             |   | Chief Financial  Officer (Principal |
|                          |   |                             |   | Financial and  Accounting Officer) |

 

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