##### Table of Contents



UNITED STATES SECURITIES AND EXCHANGE COMMISSION
 Washington, DC 20549
 Form 10-Q
  þ
    
    QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
 For the quarterly period ended September 30, 2006
 Or
 o
    
    TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF
1934
 For the transition period from          to .
 Commission File Number 0-28402
 Aradigm Corporation
 (Exact name of registrant as specified in its charter)
 California(State or other jurisdiction of 
incorporation or organization)
    
    94-3133088(I.R.S. Employer
Identification No.)
 3929 Point Eden Way
Hayward, CA 94545  (Address of principal executive offices including zip code)  (510) 265-9000  (Registrants telephone number, including area code)
 þ o
  o o þ
 o þ
  (Class) 
Common
    
    (Outstanding at October 31, 2006)
14,776,412




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##### 



ARADIGM CORPORATION
TABLE OF CONTENTS
 PagePART I. FINANCIAL INFORMATION
    
    
    3Item 1. Financial Statements:
    
    
    3Condensed Balance Sheets at September 30, 2006 and December 31, 2005 (unaudited)
    
    
    3Condensed Statements of Operations for the three months ended September 30,
2006 and 2005 (unaudited)
    
    
    4Condensed Statements of Operations for the nine months ended September 30, 2006
and 2005 (unaudited)
    
    
    5Condensed Statements of Cash Flows for the nine months ended September 30, 2006
and 2005 (unaudited)
    
    
    6Notes to Condensed Financial Statements (unaudited)
    
    
    7Item 2. Managements Discussion and Analysis of Financial Condition and Results of
Operations
    
    
    16Item 3. Quantitative and Qualitative Disclosure About Market Risk
    
    
    31Item 4. Controls and Procedures
    
    
    31PART II. OTHER INFORMATION
    
    
    32Item 1A. Risk Factors
    
    
    32Item 6. Exhibits
    
    
    42Signatures
    
    
    43EXHIBIT 31.1EXHIBIT 31.2EXHIBIT 32.1
  2




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PART I. FINANCIAL INFORMATION
 
 Item 1. FINANCIAL STATEMENTS
 ARADIGM CORPORATION
 
 CONDENSED BALANCE SHEETS
 (In thousands, except share data)
 September 30,
    
    December 31,2006
    
    2005(Unaudited)
    
    (Note 1)ASSETSCurrent assets:Cash and cash equivalents
    
    $
    32,280
    
    
    $
    27,694Short-term investments
    
    
    504
    
    
    
    Receivables
    
    
    623
    
    
    
    400Current portion of notes receivable from officers and employees
    
    
    
    
    
    
    62Prepaid expenses and other current assets
    
    
    790
    
    
    
    874Total current assets
    
    
    34,197
    
    
    
    29,030Property and equipment, net
    
    
    2,471
    
    
    
    9,875Non-current portion of notes receivable from officers and employees
    
    
    151
    
    
    
    129Other assets
    
    
    451
    
    
    
    463Total assets
    
    $
    37,270
    
    
    $
    39,497LIABILITIES, CONVERTIBLE PREFERRED STOCK AND SHAREHOLDERS
EQUITYCurrent liabilities:Accounts payable
    
    $
    705
    
    
    $
    3,034Accrued clinical and cost of other studies
    
    
    205
    
    
    
    398Accrued compensation
    
    
    2,471
    
    
    
    3,814Deferred revenue
    
    
    104
    
    
    
    222Other accrued liabilities
    
    
    496
    
    
    
    475Total current liabilities
    
    
    3,981
    
    
    
    7,943Non-current portion of deferred rent
    
    
    927
    
    
    
    714Note payable to related party
    
    
    7,593
    
    
    
    Commitments and contingenciesConvertible preferred stock, no par value; 2,050,000 shares
authorized; issued and outstanding shares: 1,544,626 at September
30, 2006 and December 31, 2005; liquidation preference of $41,866
at September 30, 2006 and December 31, 2005
    
    
    23,669
    
    
    
    23,669Shareholders equity:Common stock, no par value; authorized shares; 100,000,000 at
September 30, 2006 and 150,000,000 at December 31, 2005; issued
and outstanding shares: 14,776,412 at September 30, 2006 and
14,562,809 at December 31, 2005
    
    
    283,578
    
    
    
    282,004Accumulated other comprehensive income
    
    
    3
    
    
    
    5Accumulated deficit
    
    
    (282,481
    )
    
    
    (274,838
    )Total shareholders equity
    
    
    1,100
    
    
    
    7,171Total liabilities, convertible preferred stock and
shareholders equity
    
    $
    37,270
    
    
    $
    39,497
  3




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ARADIGM CORPORATION
 
 CONDENSED STATEMENTS OF OPERATIONS
 (In thousands, except per share data)
 (Unaudited)
 Three months endedSeptember 30,2006
    
    
    2005Contract and milestone revenues (including amounts from related parties
2006 - $9 2005 - $200)
    
    $
    1,126
    
    
    $
    719Operating expenses:Research and development
    
    
    4,547
    
    
    
    6,471General and administrative
    
    
    3,514
    
    
    
    2,326Restructuring and asset impairment
    
    
    347
    
    
    
    Total operating expenses
    
    
    8,408
    
    
    
    8,797Loss from operations
    
    
    (7,282
    )
    
    
    (8,078
    )Gain on sale of patent and royalty interest (to related parties)
    
    
    20,000
    
    
    
    Interest income
    
    
    459
    
    
    
    342Interest expense
    
    
    (95
    )
    
    
    Other income (expense)
    
    
    (7
    )
    
    
    8Net income (loss)
    
    $
    13,075
    
    
    $
    (7,728
    )Basic net income (loss) per common share
    
    $
    0.89
    
    
    $
    (0.53
    )Diluted net income (loss) per common share
    
    $
    0.82
    
    
    $
    (0.53
    )Shares used in computing basic net income (loss) per common share
    
    
    14,660
    
    
    
    14,518Shares used in computing diluted net income (loss) per common share
    
    
    15,982
    
    
    
    14,518
  4




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ARADIGM CORPORATION
 
 CONDENSED STATEMENTS OF OPERATIONS
 (In thousands, except per share data)
 (Unaudited)
 Nine months endedSeptember 30,2006
    
    
    2005Contract and milestone revenues (including amounts
from related parties: 2006 - $59; 2005 - $7,911)
    
    $
    4,006
    
    
    $
    9,645Operating expenses:Research and development
    
    
    17,645
    
    
    
    20,858General and administrative
    
    
    9,051
    
    
    
    8,274Restructuring and asset impairment
    
    
    5,717
    
    
    
    Total operating expenses
    
    
    32,413
    
    
    
    29,132Loss from operations
    
    
    (28,407
    )
    
    
    (19,487
    )Gain on sale
of patent and royalty interest (to related parties)
    
    
    20,000
    
    
    
    Interest income
    
    
    839
    
    
    
    980Interest expense
    
    
    (101
    )
    
    
    Other income (expense)
    
    
    26
    
    
    
    (37
    )Net loss
    
    $
    (7,643
    )
    
    $
    (18,544
    )Basic and diluted net (loss) per common share
    
    $
    (0.52
    )
    
    $
    (1.28
    )Shares used in computing basic and diluted net (loss) per common share
    
    
    14,625
    
    
    
    14,497
  5




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ARADIGM CORPORATION
 
 CONDENSED STATEMENTS OF CASH FLOWS
 (In thousands)
 (Unaudited)
 Nine months endedSeptember 30,2006
    
    
    2005Cash flows from operating activities:Net loss
    
    $
    (7,643
    )
    
    $
    (18,544
    )Adjustments to reconcile net loss to cash used in operating activities:Non-cash asset impairment charge on property and equipment
    
    
    4,014
    
    
    
    Depreciation and amortization
    
    
    698
    
    
    
    1,074Stock-based compensation expense related to employee stock options and
employee stock purchases
    
    
    1,286
    
    
    
    Loss on retirement and sale of property and equipment
    
    
    21
    
    
    
    25Cost of warrants and stock options for services
    
    
    
    
    
    
    94Amortization of deferred compensation
    
    
    
    
    
    
    10Amortization and accretion of investments
    
    
    
    
    
    
    6Gain on sale of patents and royalty interest
    
    
    (20,000
    )
    
    
    Changes in operating assets and liabilities:Receivables
    
    
    (222
    )
    
    
    (187
    )Prepaid and other current assets
    
    
    84
    
    
    
    629Other assets
    
    
    12
    
    
    
    (111
    )Accounts payable
    
    
    (2,329
    )
    
    
    (975
    )Accrued compensation
    
    
    (1,344
    )
    
    
    421Other accrued liabilities
    
    
    (79
    )
    
    
    (795
    )Deferred rent
    
    
    214
    
    
    
    (1,283
    )Deferred revenue
    
    
    (118
    )
    
    
    (7,201
    )Net cash used in operating activities
    
    
    (25,406
    )
    
    
    (26,837
    )Cash flows from investing activities:Capital expenditures
    
    
    (1,329
    )
    
    
    (4,047
    )Proceeds from the sale of property and equipment
    
    
    4,000
    
    
    
    50,292Purchases of available-for-sale investments
    
    
    (507
    )
    
    
    (5,330
    )Proceeds from maturities and sales of available-for-sale investments
    
    
    
    
    
    
    4,457Proceeds from sale of patents and royalty interest
    
    
    20,000
    
    
    
    Net cash provided by (used in) investing activities
    
    
    (22,164
    )
    
    
    45,372Cash flows from financing activities:Proceeds from issuance of note payable to related party
    
    
    7,500
    
    
    
    Proceeds from issuance of common stock, net
    
    
    286
    
    
    
    457Proceeds from exercise of options and warrants for common stock
    
    
    2
    
    
    
    42Payments received on notes receivable from officers and employees
    
    
    40
    
    
    
    58Net cash provided by financing activities
    
    
    7,828
    
    
    
    557Net increase in cash and cash equivalents
    
    
    4,586
    
    
    
    19,092Cash and cash equivalents at beginning of period
    
    
    27,694
    
    
    
    14,308Cash and cash equivalents at end of period
    
    $
    32,280
    
    
    $
    33,400
  6




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ARADIGM CORPORATION
 
 NOTES TO THE UNAUDITED CONDENSED FINANCIAL STATEMENTS
 September 30, 2006
 1. Organization and Basis of Presentation
 Organization
  Basis of Presentation
   2. Summary of Significant Accounting Policies
 Use of Estimates
  Revenue Recognition
  7




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Impairment or Disposal of Long-Lived Assets
  Recent Accounting Pronouncements
 Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year
Financial Statements, .
 Fair Value Measurement, .
 3. Stock-Based Compensation
 Accounting for Stock Issued to Employees Accounting
for Stock-Based Compensation Accounting for
Stock-Based Compensation  Transition and Disclosure
 Share-Based Payment
 8




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Employee Stock Plans
  2005 Equity Incentive Plan
     9




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1996 Non-Employee Directors Plan
  Employee Stock Purchase Plan
   10




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Pro Forma Information for Periods Prior to Adoption of SFAS No.123R
  Three months
    
    
    Nine monthsended
    
    
    endedSeptember 30,
    
    
    September 30,2005
    
    
    2005Net loss, as reported
    
    $
    (7,728
    )
    
    $
    (18,544
    )Add: Stock-based employee compensation expense included in
reported net loss
    
    
    3
    
    
    
    10Less: Total stock-based employee compensation expense
determined under fair value method
    
    
    (827
    )
    
    
    (2,432
    )Pro forma net loss
    
    $
    (8,552
    )
    
    $
    (20,966
    )Basic and diluted net loss per share, as reported
    
    $
    (0.53
    )
    
    $
    (1.28
    )Basic and diluted pro forma loss per share
    
    $
    (0.59
    )
    
    $
    (1.45
    )
  Valuation Assumptions
   11




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Three months ended September 30,
    
    Nine months ended September 30,2006
    
    2005
    
    2006
    
    2005Employee Stock OptionsDividend yield
    
    
    0.0
    %
    
    
    0.0
    %
    
    
    0.0
    %
    
    
    0.0
    %Volatility factor
    
    
    87.4
    %
    
    
    86.3
    %
    
    
    86.7
    %
    
    
    97.8
    %Risk-free interest rate
    
    
    4.8
    %
    
    
    4.1
    %
    
    
    4.9
    %
    
    
    3.7
    %Expected life (years)
    
    
    4.2
    
    
    
    4.0
    
    
    
    4.2
    
    
    
    4.0Weighted-average fair value of
options granted during the
periods
    
    $
    1.22
    
    
    $
    3.50
    
    
    $
    1.42
    
    
    $
    4.20Employee Stock Purchase PlanDividend yield
    
    
    0.0
    %
    
    
    0.0
    %
    
    
    0.0
    %
    
    
    0.0
    %Volatility factor
    
    
    85.7
    %
    
    
    87.3
    %
    
    
    85.7
    %
    
    
    87.3
    %Risk-free interest rate
    
    
    4.8
    %
    
    
    3.5
    %
    
    
    4.8
    %
    
    
    3.5
    %Expected life (years)
    
    
    0.7
    
    
    
    1.2
    
    
    
    0.7
    
    
    
    1.2Weighted-average fair value of
employee stock purchases during
the periods
    
    $
    1.33
    
    
    $
    2.67
    
    
    $
    1.33
    
    
    $
    2.67
 Adoption of SFAS No.123R
  Three months
    
    
    Nine monthsended
    
    
    endedSeptember 30,
    
    
    September 30,2006
    
    
    2006Costs and expenses:Research and
development
    
    $
    196
    
    
    $
    665General and
administrative
    
    
    229
    
    
    
    614Total stock-based
compensation expense
    
    $
    425
    
    
    $
    1,279Impact on basic and
diluted net loss per
share
    
    $
    (0.03
    )
    
    $
    (0.09
    )
   Stock Option Activity
  12




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Weighted-Weighted-
    
    averageNumber
    
    average
    
    remaining
    
    Aggregateof
    
    exercise
    
    contractual
    
    intrinsicshares
    
    price
    
    life ( in years)
    
    valueOptions
outstanding at
January 1, 2006
    
    
    1,730
    
    
    $
    19.47
    
    
    
    7.10
    
    
    $
    Options granted
    
    
    2,361
    
    
    
    2.15
    
    
    
    
    
    
    
    Options exercised
    
    
    (645
    )
    
    
    2.83
    
    
    
    
    
    
    
    Options cancelled
    
    
    (836
    )
    
    
    10.18
    
    
    
    
    
    
    
    Options outstanding
at September 30,
2006
    
    
    3,254
    
    
    
    9.29
    
    
    
    8.4
    
    
    
    120Options exercisable
at September 30,
2006
    
    
    1,294
    
    
    $
    19.92
    
    
    
    6.48
    
    
    $
    30
   Options Outstanding
    
    Options ExercisableWeighted-averageremaining
    
    Weighted-
    
    
    
    
    
    Weighted-Number
    
    contractual
    
    average
    
    Number
    
    AverageRange of
    
    outstanding
    
    life
    
    exercise
    
    exercisable
    
    ExerciseExercise Price
    
    (in thousands)
    
    (in years)
    
    price
    
    (in thousands)
    
    Price$1.29-$1.70
    
    
    616
    
    
    
    9.71
    
    
    $
    1.50
    
    
    
    98
    
    
    $
    1.38$1.80-$1.80
    
    
    685
    
    
    
    9.91
    
    
    $
    1.80
    
    
    
    91
    
    
    $
    1.80$1.87-$1.87
    
    
    500
    
    
    
    9.86
    
    
    $
    1.87
    
    
    
    0
    
    
    $
    0.00$3.14-$5.20
    
    
    330
    
    
    
    8.54
    
    
    $
    3.93
    
    
    
    103
    
    
    $
    4.61$5.30-$5.95
    
    
    330
    
    
    
    8.05
    
    
    $
    5.65
    
    
    
    238
    
    
    $
    5.64$6.25-$17.20
    
    
    335
    
    
    
    6.78
    
    
    $
    11.76
    
    
    
    306
    
    
    $
    11.78$17.25-$60.00
    
    
    331
    
    
    
    4.56
    
    
    $
    28.44
    
    
    
    331
    
    
    $
    28.44$60.31-$112.50
    
    
    120
    
    
    
    2.67
    
    
    $
    81.49
    
    
    
    120
    
    
    $
    81.49$115.00-$115.00
    
    
    1
    
    
    
    4.08
    
    
    $
    115.00
    
    
    
    1
    
    
    $
    115.00$120.63-$120.63
    
    
    7
    
    
    
    3.36
    
    
    $
    120.63
    
    
    
    7
    
    
    $
    120.633,254
    
    
    
    
    
    
    
    
    
    
    
    1,294
  4. Net Income (Loss) Per Share
  Three months ended
    
    
    Nine months endedSeptember 30,
    
    
    September 30,2006
    
    
    2005
    
    
    2006
    
    
    2005Numerator:Net income (loss)
    
    $
    13,075
    
    
    $
    (7,728
    )
    
    $
    (7,643
    )
    
    $
    (18,544
    )Denominator:Basic Weighted average number of
common shares outstanding
    
    
    14,660
    
    
    
    14,518
    
    
    
    14,625
    
    
    
    14,497Effect of dilutive securities:Restricted stock awards
    
    
    86
    
    
    
    
    
    
    
    
    
    
    
    Convertible preferred
stock
    
    
    1,236
    
    
    
    
    
    
    
    
    
    
    
    Shares used in calculating
diluted net income (loss) per
share
    
    
    15,982
    
    
    
    14,518
    
    
    
    14,625
    
    
    
    14,497Basic net income (loss) per common share
    
    
    0.89
    
    
    
    (0.53
    )
    
    
    (0.52
    )
    
    
    (1.28
    )Diluted net income (loss) per common share
    
    
    0.82
    
    
    
    (0.53
    )
    
    
    (0.52
    )
    
    
    (1.28
    )
 13




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Three months ended
    
    Nine months endedSeptember 30,
    
    September 30,2006
    
    2005
    
    2006
    
    2005Common stock
equivalents from
stock options
    
    
    2,919
    
    
    
    1,654
    
    
    
    2,232
    
    
    
    1,730Convertible shares
    
    
    
    
    
    
    1,236
    
    
    
    1,236
    
    
    
    1,236Unearned restricted
stock
    
    
    
    
    
    
    
    
    
    
    86
    
    
    
    Warrants to
purchase common
shares
    
    
    2,120
    
    
    
    2,130
    
    
    
    2,120
    
    
    
    2,130
 5. Comprehensive Income (Loss)
  Three months ended
    
    
    Nine months endedSeptember 30,
    
    
    September 30,2006
    
    
    2005
    
    
    2006
    
    
    2005Net income (loss)
    
    $
    13,075
    
    
    $
    (7,728
    )
    
    $
    (7,634
    )
    
    $
    (18,544
    )Other comprehensive income (loss):Change in unrealized gain (loss)
on available-for-sale securities
    
    
    4
    
    
    
    4
    
    
    
    (2
    )
    
    
    3Comprehensive income (loss)
    
    $
    13,079
    
    
    $
    (7,724
    )
    
    $
    (7,636
    )
    
    $
    (18,541
    )
 6. Cash, Cash Equivalents and Investments
  September
    
    
    December30, 2006
    
    
    31, 2005Cash and cash equivalents:Money market fund
    
    $
    1,426
    
    
    $
    1,321Commercial paper
    
    
    30,854
    
    
    
    26,373$
    32,280
    
    
    $
    27,694Short-term investments:Corporate and government notes
    
    $
    504
    
    
    $
    
  14




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7. Reverse Stock Split
  8. Restructuring and Asset Impairment
 Accounting for Costs Associated with Exit or Disposal
  Balance atRestructuring
    
    
    Non-cash
    
    
    
    
    
    
    
    
    
    
    September 30,Type of Liability
    
    Charges
    
    
    impairment
    
    
    Adjustments
    
    
    Payments
    
    
    2006Nine months ended September 30, 2006Severance and related benefits
    
    $
    1,866
    1
    
    $
    
    
    
    $
    (233
    ) 2
    
    $
    (948
    )
    
    $
    685Out-placement services
    
    
    70
    
    
    
    
    
    
    
    
    
    
    
    (42
    )
    
    
    28Impairment on Intraject-related assets
    
    
    
    
    
    
    4,014
    
    
    
    
    
    
    
    
    
    
    
    $
    1,936
    
    
    $
    4,014
    
    
    $
    (233
    )
    
    $
    (990
    )
    
    $
    713
 
 1.
    
    Initial restructuring charges of $1.3 million and an increase of $566,000 in severance
charges related to V. Bryan Lawlis the Companys former President and Chief Executive Officer,
and Bobba Venkatadri the Companys former Senior Vice President of Operations.2.
    
    Reduction of $233,000 related to former employees transferred as part of the sale of
Intraject-related assets to Zogenix. 9. Related Party Transactions
   15




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10. Sale of Intraject-Related Assets
   11. Subsequent Event
   
 Item 2. MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
 The discussion below contains forward-looking statements that are based on the beliefs of
management, as well as assumptions made by, and information currently available to, management. Our
future results, performance or achievements could differ materially from those expressed in, or
implied by, any such forward-looking statements as a result of certain factors, including, but not
limited to, those discussed in this section as well as in the section entitled Risk Factors and
elsewhere in our filings with the Securities and Exchange Commission.
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Our
business is subject to significant risks including, but not limited
to, the success of product development efforts, our dependence on
collaborators for certain programs, obtaining and enforcing patents
important to our business, clearing the lengthy and expensive
regulatory approval process and possible competition from other
products. Even if product candidates appear promising at various
stages of development, they may not reach the market or may not be
commercially successful for a number of reasons. Such reasons
include, but are not limited to, the possibilities that the potential
products may be found to be ineffective during clinical trials, may
fail to receive necessary regulatory approvals, may be difficult to
manufacture on a large scale, are uneconomical to market, may be
precluded from commercialization by proprietary rights of third
parties or may not gain acceptance from health care professionals and
patients.
 Investors are cautioned not to place undue reliance on the forward-looking statements
contained herein. We undertake no obligation to update these forward-looking statements in light of
events or circumstances occurring after the date hereof or to reflect the occurrence of
unanticipated events.
 Overview
   Restructured Relationship with Novo Nordisk
  ®
 
    
    an amended and restated license agreement amending the development and license
agreement previously in place with Novo Nordisk, expanding Novo Nordisks development and
manufacturing rights to the AERx® iDMS program and providing for royalties to
us on future AERx® iDMS net sales in lieu of a percentage interest in the
gross profits from the commercialization of the AERx® iDMS, which royalties
run until the later of last patent expiry or
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last use of our intellectual property and
which apply to future enhancements or generations of our AERx® delivery
technology;
    
    a three-year agreement under which NNDT agreed to perform contract manufacturing of
AERx® iDMS-identical devices and dosage forms filled with compounds provided
by us in support of preclinical and initial clinical development of other products that
incorporate our AERx® delivery system; and
    
    an amendment of the common stock purchase agreement in place with Novo Nordisk prior
to the closing of the restructuring transaction, (i) deleting the provisions whereby we
can require Novo Nordisk to purchase certain additional amounts of common stock, (ii)
imposing certain restrictions on the ability of Novo Nordisk to sell shares of our common
stock and (iii) providing Novo Nordisk with certain registration and information rights
with respect to these shares.
 ®
 ®
 
    
    our transfer to Novo Nordisk of the ownership of 23 issued United States patents and
their corresponding non-United States counterparts, if any, as well as related pending
applications, in exchange for $12.0 million paid to us in cash. We
retained exclusive, royalty-free control of these patents outside the field of glucose
control and will continue to be entitled to royalties with respect to any inhaled insulin
products marketed or licensed by Novo Nordisk.
    
    our receipt of a royalty prepayment of $8.0 million in exchange for a one percent
reduction on our average royalty rate for the commercialized AERx® iDMS
product. As a result, we will receive royalty rates under our agreement with Novo
Nordisk that will rise to an average of five percent or higher (instead of six percent or
higher) by the fifth year after commercialization.
    
    our issuance of an eight-year promissory note to Novo Nordisk in connection with our
receipt from Novo Nordisk of a loan in the principal amount of $7.5 million that will be
payable to Novo Nordisk in three equal annual payments commencing in six years at a five
percent annual interest rate. Our obligations under the note are secured by royalty
payments upon any commercialization of the AERx® iDMS product.
   18




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Purchase and Sale of Intraject Technology
     Product Candidates
   Product Candidate
    
    Indication
    
    Stage of DevelopmentProprietary Programs Under
DevelopmentARD-3100 (Liposomal ciprofloxacin)
    
    Cystic Fibrosis
    
    PreclinicalARD-1100 (Liposomal ciprofloxacin)
    
    Inhalation Anthrax
    
    PreclinicalCollaborative Programs Under DevelopmentAERx iDMS (Insulin)
    
    Type 1 and Type 2 Diabetes
    
    In Phase 3ARD-1300 (Hydroxychloroquine)
    
    Asthma
    
    In Phase 2ARD-1500 (Liposomal treprostinil)
    
    Pulmonary Arterial
Hypertension
    
    Preclinical
  Liposomal Ciprofloxacin
  19




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ARD-3100  Liposomal Ciprofloxacin for the Treatment of Cystic Fibrosis
  Pseudamonas aeruginosa,
  Development
   20




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ARD-1100  Liposomal Ciprofloxacin for the Treatment of Inhalation Anthrax
   Development
 Francisella tularensis, F. tularensis
  AERx iDMS  Inhaled Insulin for the Treatment of Diabetes
  21




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Development
   
    
    HbAlc levels, a key marker of blood glucose control, are
statistically the same in patients using AERx iDMS and
patients using subcutaneous insulin injections.
    
    The onset of action of inhaled insulin via AERx iDMS is not
significantly different from subcutaneous injection of
rapid-acting insulin, but significantly faster than
subcutaneous injection of human regular insulin.
    
    The duration of action of inhaled insulin via AERx iDMS is
not significantly different from subcutaneous injection of
human regular insulin, but significantly longer than
subcutaneous injection of rapid-acting insulin.
    
    Although small declines were seen on some pulmonary
function parameters following 12-24 months of dosing on
AERx iDMS, these declines were not considered to be of
clinical significance, and the findings are not expected to
have an impact on overall pulmonary safety of the product.
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ARD-1300  Hydroxychloroquine for the Treatment of Asthma
   Development
   23




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ARD-1500  Treprostinil for the Treatment of Pulmonary Arterial Hypertension
   Development
  Additional Potential Product Applications
  
    
    Smoking Cessation.Based on internal work and work funded
under grants from the National Institutes of Health, we are
developing intellectual property in the area of smoking
cessation. To date, we have two issued United States
patents containing claims directed towards the use of
titrated nicotine replacement therapy for smoking
cessation.
    
    Pain Management System.Based on our internal work and a
currently dormant collaboration with GlaxoSmithKline, we
have developed a significant body of preclinical and Phase
1 clinical data on the use of inhaled morphine and
fentanyl, and Phase 2 clinical data on inhaled morphine,
with our proprietary AERx delivery system for the treatment
of breakthrough pain in cancer and post-surgical patients.
  24




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Critical Accounting Policies and Estimates
  Revenue Recognition
  Impairment of Long-Lived Assets
  Stock-Based Compensation Expense
 Share-Based Payment,(
  25




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Results of Operations
 Three Months Ended September 30, 2006 and 2005
 Revenues:
 Three months endedSeptember 30(in thousands)Change in
    
    
    Change in2006
    
    
    2005
    
    
    Dollars
    
    
    PercentRevenues:Contract revenues
    
    $
    1,029
    
    
    $
    638
    
    
    $
    391
    
    
    
    61
    %Percentage of total revenues
    
    
    91
    %
    
    
    89
    %Milestone revenues
    
    
    97
    
    
    
    81
    
    
    
    16
    
    
    
    20
    %Percentage of total revenues
    
    
    9
    %
    
    
    11
    %Total revenues
    
    $
    1,126
    
    
    $
    719
    
    
    $
    407
    
    
    
    57
    %
  Research and Development
 Three months endedSeptember 30,(in thousands)Change in
    
    
    Change in2006
    
    
    2005
    
    
    Dollars
    
    
    PercentResearch and development expense:Collaborative
    
    $
    999
    
    
    $
    1,140
    
    
    $
    (141
    )
    
    
    (12
    )%Self-initiated
    
    
    3,548
    
    
    
    5,331
    
    
    
    (1,783
    )
    
    
    (33)
    %Total research and development
expense
    
    $
    4,547
    
    
    $
    6,471
    
    
    $
    (1,924
    )
    
    
    (30
    )%
   26




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General and Administrative
 Three months endedSeptember 30,(in thousands)Change in
    
    Change in2006
    
    2005
    
    Dollars
    
    PercentGeneral and administrative expenses
    
    $
    3,514
    
    
    $
    2,326
    
    
    $
    1,188
    
    
    
    51
    %
   Restructuring and Asset Impairment
  Gain on sale of patents and royalty interest
  27




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Interest income, interest expense and other income (expense):
 Three months endedSeptember 30,(in thousands)Change in
    
    
    Change in2006
    
    
    2005
    
    
    Dollars
    
    
    PercentInterest income, interest expense and other
income (expense):Interest income
    
    $
    459
    
    
    $
    342
    
    
    $
    117
    
    
    
    34
    %Interest expense
    
    
    (95
    )
    
    
    
    
    
    
    (95
    )
    
    
    (100)
    %Other income (expense)
    
    
    (7
    )
    
    
    8
    
    
    
    (15
    )
    
    
    (188)
    %Total interest income, interest and other expense
    
    $
    357
    
    
    $
    350
    
    
    $
    7
    
    
    
    2
    %
  Nine months ended September 30, 2006 and 2005
 Revenues:
 Nine months endedSeptember 30,(in thousands)Change in
    
    Change in2006
    
    2005
    
    Dollars
    
    PercentRevenues:Contract revenues
    
    $
    3,715
    
    
    $
    4,378
    
    
    $
    (663
    )
    
    
    (15%
    )Percentage of total revenues
    
    
    93
    %
    
    
    45
    %Milestone revenues
    
    
    291
    
    
    
    5,267
    
    
    
    (4,976
    )
    
    
    (94%
    )Percentage of total revenues
    
    
    7
    %
    
    
    55
    %Total Revenues
    
    $
    4,006
    
    
    $
    9,645
    
    
    $
    (5,639
    )
    
    
    (58%
    )
  Research and Development:
 Nine months endedSeptember 30,(in thousands)Change in
    
    
    Change in2006
    
    
    2005
    
    
    Dollars
    
    
    PercentResearch and development expense:Collaborative
    
    $
    4,107
    
    
    $
    4,372
    
    
    $
    (265
    )
    
    
    (6)
    %Self-initiated
    
    
    13,538
    
    
    
    16,486
    
    
    
    (2,948
    )
    
    
    (18)
    %Total research and development expense
    
    $
    17,645
    
    
    $
    20,858
    
    
    $
    (3,213
    )
    
    
    (15)
    %
  28




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General and Administrative
 Nine months endedSeptember 30,(in thousands)Change in
    
    Change in2006
    
    2005
    
    Dollars
    
    PercentGeneral and administrative expenses
    
    $
    9,051
    
    
    $
    8,274
    
    
    $
    777
    
    
    
    9
    %
   Restructuring and Asset Impairment
  Gain on sale of patents and royalty interest
  29




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Interest income, interest expense and other income (expense):
 Nine months endedSeptember 30,(in thousands)Change in
    
    
    Change in2006
    
    
    2005
    
    
    Dollars
    
    
    PercentInterest income, interest expense and other
income (expense):Interest Income
    
    $
    839
    
    
    $
    980
    
    
    $
    (141
    )
    
    
    (14
    )%Interest expense
    
    
    (101
    )
    
    
    
    
    
    
    (101
    )
    
    
    (100
    )%Other Income (Expense)
    
    
    26
    
    
    
    (37
    )
    
    
    63
    
    
    
    170
    %Total interest income, interest and other expense
    
    $
    764
    
    
    $
    943
    
    
    $
    (179
    )
    
    
    (19
    )%
  Liquidity and Capital Resources
     30




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Contractual Obligations
  Payment Due by Period(amounts in thousands)Total
    
    
    2006(1)
    
    
    1 - 2 years
    
    
    3-5 years
    
    
    +5 yearsContractual obligations:Operating lease obligations
    
    $
    21,766
    
    
    $
    404
    
    
    $
    4,798
    
    
    $
    4,631
    
    
    $
    11,933Unconditional purchase obligations
    
    
    2,352
    
    
    
    2,352
    
    
    
    
    
    
    
    
    
    
    
    Total contractual commitments
    
    $
    24,118
    
    
    $
    2,756
    
    
    $
    4,798
    
    
    $
    4,631
    
    
    $
    11,933
 
 (1)
    
    For three months ending December 31, 2006 Off-Balance Sheet Financings and Liabilities
  
 Item 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
 Market Risk Disclosures
   
 Item 4. CONTROLS AND PROCEDURES
 Evaluation of Disclosure Controls and Procedures.
 Changes in internal control.
 Limitations on the effectiveness of controls.
 31




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PART II. OTHER INFORMATION
 
 Item 1A. RISK FACTORS
 The
risk factors included herein include any material changes to and supersede the risk factors associated with our business previously disclosed in Item A to
Part I of our 2005 Annual Report on Form 10-K . In addition to the other information contained in
this Form 10-Q , and risk factors set forth in our most recent SEC filings, the following risk
factors should be considered carefully in evaluating our business. Our business, financial
condition, or results of operations could be materially adversely affected by any of these risks.
Additional risks not presently known to us or that we currently deem immaterial may also impair our
business and operations.
 Risks Related to Our Business
 None of our product candidates has been approved or commercialized, and we may never successfully
develop any products.
  We recently changed our product development strategy, and if we do not successfully implement this
new strategy our business and reputation will be damaged.
  We will need additional capital and we may not be able to obtain it.
  
    
    our progress in the application of our delivery and formulation technologies, which may
require further refinement of these technologies;
    
    the number of product development programs we pursue and the pace of each program;
    
    our progress with formulation development;
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
    
    the scope, rate of progress, results and costs of preclinical testing and clinical trials;
    
    the time and costs associated with seeking regulatory approvals;
    
    our ability to outsource the manufacture of our product candidates and the costs of doing so;
    
    the time and costs associated with establishing in-house resources to market and sell
certain of our products;
    
    our ability to establish and maintain collaborative arrangements with others and the terms
of those arrangements;
    
    the costs of preparing, filing, prosecuting, maintaining and enforcing patent claims; and
    
    our need to acquire licenses or other rights for our product candidates.
  We have a history of losses, we expect to incur losses for at least the foreseeable future, and we
may never attain or maintain profitability.
  
    
    expand drug product development efforts;
    
    conduct preclinical testing and clinical trials;
    
    pursue additional applications for our existing delivery technologies;
    
    outsource the commercial-scale production of our products; and
    
    establish a sales and marketing force to commercialize certain of our
proprietary products if these products obtain regulatory approval.
  Our dependence on collaborators may delay or prevent the progress of certain of our programs.
 33




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The results of later stage clinical trials of our product candidates may not be as favorable as
earlier trials and that could result in additional costs and delay or prevent commercialization of
our products.
  If our clinical trials are delayed because of patient enrollment or other problems, we would incur
additional cost and postpone the potential receipt of revenues.
  34




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We are subject to extensive regulation, including the requirement of approval before any of our
product candidates can be marketed. We may not obtain regulatory approval for our product
candidates on a timely basis, or at all.
   Regulatory authorities may not approve our product candidates even if the product candidates meet
safety and efficacy endpoints in clinical trials or the approvals may be too limited for us to earn
sufficient revenues.
  Even if we are granted initial FDA approval for any of our product candidates, we may not be able
to maintain such approval, which would reduce our revenues.
  35




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Since one of our key proprietary programs, the ARD-3100 liposomal ciprofloxacin program, relies on
the FDAs granting of orphan drug designation for potential market exclusivity, the product may not
be able to obtain market exclusivity and could be barred from the market for up to seven years.
  We have limited manufacturing capacity and will have to depend on contract manufacturers and
collaborators; if they do not perform as expected, our revenues and customer relations will suffer.
     36




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We rely on a small number of vendors and contract manufacturers to supply us with specialized
equipment, tools and components; if they do not perform as we need them to, we will not be able to
develop or commercialize products.
  In order to market our proprietary products, we are likely to establish our own sales, marketing
and distribution capabilities. We have no experience in these areas, and if we have problems
establishing these capabilities, the commercialization of our products would be impaired.
  If any products that we or our collaborators may develop do not attain adequate market acceptance
by healthcare professionals and patients, our business prospects and results of operations will
suffer.
  
    
    the demonstration of efficacy and safety in clinical trials;
    
    the existence, prevalence and severity of any side effects;
    
    the potential or perceived advantages or disadvantages compared to alternative treatments;
    
    the timing of market entry relative to competitive treatments;
    
    the relative cost, convenience, product dependability and ease of administration;
    
    the strength of marketing and distribution support;
    
    the sufficiency of coverage and reimbursement of our product candidates by governmental
and other third-party payors; and
    
    the product labeling or product insert required by the FDA or regulatory authorities in
other countries.
  We depend upon our proprietary technologies, and we may not be able to protect our potential
competitive proprietary advantage.
  37




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We may infringe on the intellectual property rights of others and any litigation could force us to
stop developing or selling potential products and could be costly, divert management attention and
harm our business.
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##### Table of Contents



We are in a highly competitive market and our competitors have developed or may develop alternative
therapies for our target indications, which would limit the revenue potential of any product we may
develop.
  If we do not continue to attract and retain key employees, our product development efforts will be
delayed and impaired.
  Acquisition of complementary businesses or technologies could result in operating difficulties and
harm our results of operations.
  
    
    diversion of our management from the development and commercialization of our
pipeline product candidates;
    
    difficulty in assimilating and efficiently using the acquired assets or personnel; and
    
    inability to retain key personnel.
  39




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If we market our products in other countries, we will be subject to different laws and we may not
be able to adapt to those laws, which could increase our costs while reducing our revenues.
  We may be exposed to product liability claims, which would hurt our reputation, market position and
operating results.
  If we cannot arrange for adequate third-party reimbursement for our products, our revenues will
suffer.
  Our use of hazardous materials could subject us to liabilities, fines and sanctions.
  40




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If we are unable to effectively implement or maintain a system of internal controls over financial
reporting, we may not be able to accurately or timely report our financial results and our stock
price could be adversely affected.
  Risks Related to Our Common Stock
 Our common stock is no longer listed on the Nasdaq Capital Market; our stock may have less market
liquidity and the price may decline.
  Our stock price is likely to remain volatile.
  
    
    investor perception of us;
    
    our ability to maintain the listing of our common stock on the Nasdaq Capital Market;
    
    research analyst recommendations and our ability to meet or exceed quarterly performance
expectations of analysts or investors;
    
    fluctuations in our operating results;
    
    market conditions relating to our segment of the industry or the securities markets in general;
    
    announcements of technological innovations or new commercial products by us or our competitors;
    
    publicity regarding actual or potential developments relating to products under development by
us or our competitors;
    
    failure to maintain existing or establish new collaborative relationships;
    
    developments or disputes concerning patents or proprietary rights;
    
    delays in the development or approval of our product candidates;
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##### Table of Contents




    
    regulatory developments in both the United States and foreign countries;
    
    concern of the public or the medical community as to the safety or efficacy of our products,
or products deemed to have similar safety risk factors or other similar characteristics to our
products;
    
    period-to-period fluctuations in financial results;
    
    future sales or expected sales of substantial amounts of common stock by shareholders;
    
    our ability to raise financing; and
    
    economic and other external factors.
  We have implemented certain anti-takeover provisions, which make it less likely that we would be
acquired and you would receive a premium price for your shares.
   We have never paid dividends on our capital stock, and we do not anticipate paying cash dividends
for at least the foreseeable future.
  
 Item 6. EXHIBITS
 ExhibitNumber
    
    Description10.2(1)+
    
    2005 Equity Incentive Plan, as amended.10.7(1)+
    
    Employee Stock Purchase Plan, as amended.10.20(1)
    
    Promissory Note and Security Agreement, dated July 3, 2006, by and between the Company and Novo Nordisk A/ S.10.21(1)@
    
    Asset Purchase Agreement, dated as of August 25, 2006, by and between the Company and Zogenix, Inc.10.22(1)+
    
    Employment Agreement, dated as of August 10, 2006, with Dr. Igor Gonda.31.1
    
    Certification by the Companys Chief Executive Officer
pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.31.2
    
    Certification by the Companys Chief Financial Officer
pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.32.1
    
    Certification by the Companys Chief Executive Officer and
Chief Financial Officer pursuant to Section 906 of the
Sarbanes-Oxley Act of 2002.
 
    42




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SIGNATURES
  ARADIGM CORPORATION(Registrant)/s/ Igor GondaDr. Igor GondaPresident and Chief Executive Officer/s/ Thomas C. ChestermanThomas C. ChestermanSenior Vice President and Chief Financial Officer
  43




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INDEX TO EXHIBITS
 ExhibitNumber
    
    Description10.2(1)+
    
    2005 Equity Incentive Plan, as amended.10.7(1)+
    
    Employee Stock Purchase Plan, as amended.10.20(1)
    
    Promissory Note and Security Agreement, dated July 3, 2006, by and between the Company and Novo Nordisk A/ S.10.21(1)@
    
    Asset Purchase Agreement, dated as of August 25, 2006, by and between the Company and Zogenix, Inc.10.22(1)+
    
    Employment Agreement, dated as of August 10, 2006, with Dr. Igor Gonda.31.1
    
    Certification by the Companys Chief Executive Officer
pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.31.2
    
    Certification by the Companys Chief Financial Officer
pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.32.1
    
    Certification by the Companys Chief Executive Officer and
Chief Financial Officer pursuant to Section 906 of the
Sarbanes-Oxley Act of 2002.