##### Table of Contents



UNITED STATES
SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549
 FORM 10-Q (Mark One)  x QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
 For the quarterly period ended March 31, 2004 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: 0-19825 SCICLONE PHARMACEUTICALS, INC. 
  Delaware
    
    94-3116852(State or other jurisdiction of incorporation or organization)
    
    (I.R.S. employer Identification no.)901 Mariners Island Blvd., Suite 205, San Mateo, California
    
    94404(Address of principal executive offices)
    
    (Zip code)
 (650) 358-3456
(Registrants telephone number, including area code) Not Applicable 
  Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes x                                    No o Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Exchange Act). Yes x                                    No o As of March 31, 2004, 44,583,412 shares of the registrants Common Stock,
$0.001 par value, were issued and outstanding.




---



##### Table of Contents



SCICLONE PHARMACEUTICALS, INC. INDEX PAGE NO.PART I.
    
    FINANCIAL INFORMATIONItem 1.
    
    Condensed Consolidated Financial Statements (Unaudited)Condensed Consolidated Balance Sheets as of March 31, 2004 and December 31, 2003
    
    
    3Condensed Consolidated Statements of Operations for the Three-month periods ended March 31, 2004 and 2003
    
    
    4Condensed Consolidated Statements of Cash Flows for the Three-month periods ended March 31, 2004 and 2003
    
    
    5Notes to Condensed Consolidated Financial Statements
    
    
    6Item 2.
    
    Managements Discussion and Analysis of Financial Condition and Results of Operations
    
    
    10Item 3.
    
    Quantitative and Qualitative Disclosures About Market Risk
    
    
    25Item 4.
    
    Controls and Procedures
    
    
    25PART II.
    
    OTHER INFORMATIONItem 6.
    
    Exhibits and Reports on Form 8-K
    
    
    26Signatures
    
    
    
    
    28EXHIBIT 31.1EXHIBIT 31.2EXHIBIT 32.1EXHIBIT 32.2
 2




---



##### Table of Contents



PART I. FINANCIAL INFORMATION 
 Item 1. Condensed Consolidated Financial Statements SCICLONE PHARMACEUTICALS, INC. 
 CONDENSED CONSOLIDATED BALANCE SHEETS
 March 31,
    
    December 31,2004
    
    2003(unaudited)ASSETSCurrent assets:Cash and cash equivalents
    
    $
    48,121,000
    
    
    $
    52,899,000Restricted short-term investments
    
    
    694,000
    
    
    
    695,000Other short-term investments
    
    
    9,438,000
    
    
    
    9,381,000Accounts receivable, net of allowance of $638,000 in 2004 and 2003
    
    
    10,386,000
    
    
    
    10,142,000Inventories
    
    
    5,622,000
    
    
    
    5,778,000Prepaid expenses and other current assets
    
    
    2,001,000
    
    
    
    2,456,000Total current assets
    
    
    76,262,000
    
    
    
    81,351,000Property and equipment, net
    
    
    317,000
    
    
    
    325,000Intangible assets, net
    
    
    595,000
    
    
    
    612,000Other assets
    
    
    1,541,000
    
    
    
    1,534,000Total assets
    
    $
    78,715,000
    
    
    $
    83,822,000LIABILITIES AND STOCKHOLDERS EQUITYCurrent liabilities:Accounts payable
    
    $
    1,860,000
    
    
    $
    3,423,000Accrued compensation and employee benefits
    
    
    743,000
    
    
    
    1,440,000Accrued clinical trials expense
    
    
    2,487,000
    
    
    
    1,889,000Accrued professional fees
    
    
    161,000
    
    
    
    481,000Deferred revenue
    
    
    537,000
    
    
    
    537,000Other accrued expenses
    
    
    647,000
    
    
    
    631,000Total current liabilities
    
    
    6,435,000
    
    
    
    8,401,000Deferred revenue
    
    
    537,000
    
    
    
    671,000Other long term liabilities
    
    
    900,000
    
    
    
    900,000Convertible notes payable
    
    
    5,600,000
    
    
    
    5,600,000Commitments and contingenciesStockholders equity:Preferred stock; $0.001 par value;
10,000,000 shares authorized; no shares
outstanding in 2004 and 2003,
respectively
    
    
    
    
    
    
    Common stock; $0.001 par value;
75,000,000 shares authorized; 44,583,412
and 44,484,144 shares issued and
outstanding
    
    
    45,000
    
    
    
    44,000Additional paid-in capital
    
    
    206,389,000
    
    
    
    206,320,000Accumulated other comprehensive income
    
    
    232,000
    
    
    
    176,000Accumulated deficit
    
    
    (141,423,000
    )
    
    
    (138,290,000
    )Total stockholders equity
    
    
    65,243,000
    
    
    
    68,250,000Total liabilities and stockholders equity
    
    $
    78,715,000
    
    
    $
    83,822,000
 See notes to condensed consolidated financial statements 3




---



##### Table of Contents



SCICLONE
PHARMACEUTICALS, INC. 
 CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
 Three months endedMarch 31,2004
    
    2003Product sales
    
    $
    5,414,000
    
    
    $
    5,000,000Contract revenue
    
    
    228,000
    
    
    
    224,000Total revenue
    
    
    5,642,000
    
    
    
    5,224,000Cost of product sales
    
    
    1,142,000
    
    
    
    1,016,000Gross margin
    
    
    4,500,000
    
    
    
    4,208,000Operating expenses:Research and development
    
    
    3,931,000
    
    
    
    3,783,000Sales and marketing
    
    
    2,443,000
    
    
    
    2,229,000General and administrative
    
    
    1,293,000
    
    
    
    1,012,000Total operating expenses
    
    
    7,667,000
    
    
    
    7,024,000Loss from operations
    
    
    (3,167,000
    )
    
    
    (2,816,000
    )Interest and investment income
    
    
    116,000
    
    
    
    53,000Interest and investment expense
    
    
    (90,000
    )
    
    
    (91,000
    )Other income (expense), net
    
    
    8,000
    
    
    
    (8,000
    )Net loss
    
    $
    (3,133,000
    )
    
    $
    (2,862,000
    )Basic and diluted net loss per share
    
    $
    (0.07
    )
    
    $
    (0.08
    )Weighted average shares used in computing
basic and diluted net loss per share
    
    
    44,569,087
    
    
    
    37,320,130
 See notes to condensed consolidated financial statements 4




---



##### Table of Contents



SCICLONE
PHARMACEUTICALS, INC. 
 CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
 Three months endedMarch 31,2004
    
    2003Operating activities:Net loss
    
    $
    (3,133,000
    )
    
    $
    (2,862,000
    )Adjustments to reconcile net loss to net cash used in
operating activities:Depreciation and amortization
    
    
    50,000
    
    
    
    45,000Changes in operating assets and liabilities:Accounts receivable
    
    
    (244,000
    )
    
    
    (1,265,000
    )Inventories
    
    
    156,000
    
    
    
    46,000Prepaid expenses and other current assets
    
    
    441,000
    
    
    
    (83,000
    )Accounts payable and other accrued expenses
    
    
    (1,546,000
    )
    
    
    (476,000
    )Accrued compensation and employee benefits
    
    
    (697,000
    )
    
    
    (525,000
    )Accrued clinical trials expense
    
    
    598,000
    
    
    
    (29,000
    )Accrued professional fees
    
    
    (320,000
    )
    
    
    (117,000
    )Deferred revenue
    
    
    (134,000
    )
    
    
    (224,000
    )Net cash used in operating activities
    
    
    (4,829,000
    )
    
    
    (5,490,000
    )Investing activities:Purchase of property and equipment
    
    
    (19,000
    )
    
    
    (4,000
    )Net cash used in investing activities
    
    
    (19,000
    )
    
    
    (4,000
    )Financing activities:Proceeds from issuances of common stock, net of
financing costs
    
    
    70,000
    
    
    
    1,948,000Net cash provided by financing activities
    
    
    70,000
    
    
    
    1,948,000Net decrease in cash and cash equivalents
    
    
    (4,778,000
    )
    
    
    (3,546,000
    )Cash and cash equivalents, beginning of period
    
    
    52,899,000
    
    
    
    20,233,000Cash and cash equivalents, end of period
    
    $
    48,121,000
    
    
    $
    16,687,000
 See notes to condensed consolidated financial statements 5




---



##### Table of Contents



SCICLONE
PHARMACEUTICALS, INC. 
 Notes to Condensed Consolidated Financial Statements
(unaudited)
  1.
    
    Basis of PresentationSciClone was reincorporated in the State of Delaware on July 18, 2003. The
accompanying unaudited condensed consolidated financial statements have
been prepared in conformity with generally accepted accounting principles
consistent with those applied in, and should be read in conjunction with,
the audited financial statements for the year ended December 31, 2003
included in the Companys Form 10-K as filed with the Securities and
Exchange Commission. The interim financial information reflects all
adjustments, consisting of only normal recurring adjustments, which are, in
the opinion of management, necessary for a fair presentation of the results
for the interim periods presented. The results of operations for the
three months ended March 31, 2004 are not necessarily indicative of results
for subsequent interim periods or for the full year. The condensed
consolidated balance sheet data at December 31, 2003 is derived from the
audited financial statements at that date, but does not include all of the
information and footnotes required by generally accepted accounting
principles for complete financial statements.2.
    
    Significant Accounting PoliciesRevenue RecognitionThe Company recognizes revenue from product sales at the time of shipment.
There are no significant customer acceptance requirements or post shipment
obligations on the part of the Company. Sales to importing agents or
distributors are recognized at time of shipment when title to the product
is transferred to them, and they do not have contractual rights of return
except under limited terms regarding product quality. However, the Company
will replace products that have expired or are deemed to be damaged or
defective when delivered. Payments by the importing agents and distributors
are not contingent upon sale to the end user by the importing agents or
distributors.Contract revenue for research and development is recorded as earned based
on the performance requirements of the contract. Nonrefundable contract
fees for which no further performance obligations exist, and there is no
continuing involvement by the Company, are recognized on the earlier of
when the payments are received or when collection is assured. 6




---



##### Table of Contents



Revenue associated with substantive performance milestones is recognized
based on the achievement of the milestones, as defined in the respective
agreements and provided that (i) the milestone event is substantive and its
achievement is not reasonably assured at the inception of the agreement,
and (ii) there are no future performance obligations associated with the
milestone payment.Net Loss Per ShareNet loss per share is computed using the weighted average number of shares
of common stock outstanding. Potentially dilutive common shares from
convertible debt, stock options and warrants are excluded, as their effect
is antidilutive.Accounting For Stock-Based CompensationThe Company accounts for its stock option and employee stock purchase plans
under the provisions of Accounting Principles Board Opinion 25 (APB 25)
and related Interpretations. Accordingly, the Company does not recognize
compensation expense in accounting for its stock option and employee stock
purchase plans for awards to employees and directors granted with exercise
prices at fair market value.Pro forma information regarding net loss and net loss per share is required
by Statement of Financial Accounting Standards No. 123 Accounting for
Stock-Based Compensation (SFAS 123) as amended by Statement of Financial
Accounting Standards No. 148 Accounting for Stock-Based
Compensation-Transition and Disclosure (SFAS 148) and has been
determined as if the Company had accounted for its stock awards under the
fair value method of that Statement. The fair value for the options was
estimated at the date of grant using a Black-Scholes option pricing model
with the following weighted-average assumptions for both the three-month
period ended March 31, 2004 and the corresponding period in 2003: risk-free
interest rate of 2.20% and 2.00%, respectively; dividend yield of 0%;
volatility of 0.93 and 0.95, respectively, and a weighted average expected
life of the option of 4.00 years.The Black-Scholes option valuation model was developed for use in
estimating the fair value of traded options which have no vesting
restrictions and are fully transferable. In addition, option valuation
models require the input of highly subjective assumptions including the
expected stock price volatility. Because the Companys employee stock
awards have characteristics significantly different from those of traded
options, and because changes in subjective input assumptions can materially
affect the fair value estimate, in the Companys opinion, the existing
models do not necessarily provide a reliable single measure of the fair
value of its employee and director stock options and stock purchases.The following table illustrates the Companys pro forma net loss and net
loss per share, had compensation expense for the Companys option and
employee purchase plans been determined based on the fair value at the
grant date consistent with the provisions of SFAS 123, as amended by SFAS
148: Three Months EndedMarch 31,2004
    
    2003Net loss  as reported
    
    $
    (3,133,000
    )
    
    $
    (2,862,000
    )Total stock-based employee compensation expense
determined under the fair value based method for
all awards
    
    
    (836,000
    )
    
    
    (552,000
    )Net loss  pro forma
    
    $
    (3,969,000
    )
    
    $
    (3,414,000
    )Basic and diluted net loss per share  as reported
    
    $
    (0.07
    )
    
    $
    (0.08
    )Basic and diluted net loss per share  pro forma
    
    $
    (0.09
    )
    
    $
    (0.09
    )
  The effects of applying SFAS 123 for pro forma disclosures are not likely
to be representative of the effects on reported net loss for future years
due to the different number of options granted each year. 7




---



##### Table of Contents



3.
    
    Comprehensive LossFor the three-month periods ended March 31, 2004 and 2003, the Companys
total comprehensive loss amounted to $3,077,000 and $2,883,000
respectively.4.
    
    Available-For-Sale SecuritiesThe following is a summary of available-for-sale securities at March 31,
2004 and December 31, 2003: Gross
    
    EstimatedAmortized
    
    Unrealized
    
    FairCost
    
    Gains
    
    ValueMarch 31, 2004:Certificate of deposit
    
    $
    798,000
    
    
    $
    
    
    
    $
    798,000U.S. government obligations
    
    
    32,867,000
    
    
    
    
    
    
    
    32,867,000Short-term municipal securities
    
    
    9,050,000
    
    
    
    
    
    
    
    9,050,000Corporate equity securities
    
    
    51,000
    
    
    
    232,000
    
    
    
    283,000$
    42,766,000
    
    
    $
    232,000
    
    
    $
    42,998,000December 31, 2003:Certificate of deposit
    
    $
    798,000
    
    
    $
    
    
    
    $
    798,000U.S. government obligations
    
    
    38,259,000
    
    
    
    
    
    
    
    38,259,000Short-term municipal securities
    
    
    9,050,000
    
    
    
    
    
    
    
    9,050,000Corporate equity securities
    
    
    51,000
    
    
    
    176,000
    
    
    
    227,000$
    48,158,000
    
    
    $
    176,000
    
    
    $
    48,334,000
  As of March 31, 2004, the available-for-sale securities are included as
follows: $32,867,000 in cash            and cash equivalents, $694,000 in
restricted short-term investments and $9,437,000 in other short-term
investments. As of December 31, 2003, the available-for-sale securities
are included as follows: $38,259,000 in cash and cash equivalents, $695,000
in restricted short-term investments and $9,380,000 in other short-term
investments. As of March 31, 2004 and December 31, 2003 all available-for
sale securities excluding the short-term municipal securities had
maturities of 12 months or less. The short-term municipal
securities are
auction rate securities which have final maturities of 21-36 years,
however, because they are highly rated, highly liquid and their interest
rate is reset at auction every 30 days, our interest rate risk associated
with these securities is limited due to this interest rate reset mechanism.  5.
    
    Inventories  The following is a summary of inventories at March 31, 2004 and
December 31, 2003: March 31,
    
    December 31,2004
    
    2003Raw materials
    
    $
    2,287,000
    
    
    $
    1,577,000Work in progress
    
    
    706,000
    
    
    
    1,906,000Finished goods
    
    
    2,629,000
    
    
    
    2,295,000$
    5,622,000
    
    
    $
    5,778,000
 8




---



##### Table of Contents



6.
    
    Intangible Assets  The following is a summary of intangible assets: March 31,
    
    December 31,2004
    
    2003Product rights
    
    $
    2,456,000
    
    
    $
    2,456,000Accumulated amortization
    
    
    (1,861,000
    )
    
    
    (1,844,000
    )$
    595,000
    
    
    $
    612,000
  Acquired ZADAXIN product rights are being amortized on a straight-line
basis beginning in September 1998. Amortization expense for each of the
three-month periods ended March 31, 2004 and 2003 was $17,500. For the
years ending December 31, 2004 through 2012, annual amortization expense is
expected to be $70,000. Based upon the progress in the ZADAXIN clinical
trials and the Companys actual experience of product sales, the Company
has assessed that the acquired product rights will be useful to the Company
through 2012 when the European patent for the use of ZADAXIN in the
treatment of hepatitis C expires. The Companys policy is to identify and
record impairment losses, as circumstances dictate, on intangible product
rights when events and circumstances indicate that the assets might be
impaired and the undiscounted cash flows estimated to be generated by those
assets are less than the carrying amounts of those assets.7.
    
    Deferred RevenueIn January 2002, the Company received $2,685,000 from its European partner,
Sigma-Tau under the terms of its collaborative agreement announced in late
December 2001. This receipt has been recorded as deferred revenue and is
being recognized as contract revenue over the course of the ZADAXIN
hepatitis C U.S. clinical program beginning in April 2002 and through the
period of sharing the clinical data from this program with Sigma-Tau, the
substantive performance requirements under the contract. For the
three-month period ended March 31, 2004 and 2003, the Company recognized
$134,000 and $224,000, respectively as contract revenue from this
agreement. 9




---



##### Table of Contents



Item 2. Managements Discussion and Analysis of Financial Condition and Results of Operations Special Note Regarding Forward-Looking Statements This Quarterly Report on Form 10-Q contains forward-looking statements
within the meaning of Section 27A of the Securities Act of 1933, as amended,
and Section 21E of the Securities Exchange Act of 1934, as amended. These
forward-looking statements are based on our current expectations, estimates and
projections about our business, industry, managements beliefs and certain
assumptions made by us. Words such as anticipate, expect, intend, plan,
believe or similar expressions are intended to identify forward-looking
statements including those statements we make regarding our future financial
results; anticipated product sales and net sales and levels; the timing and
outcome of clinical trials; ZADAXINs ability to complement existing therapies;
prospects for ZADAXIN and our plans for its enhancement and commercialization;
our ability to submit applications and obtain marketing and regulatory
approvals for ZADAXIN; future financing plans; research and development and
other expense levels; cash levels; levels of gross margin and cost of product
sales and the allocation of financial resources to certain trials and programs.
These statements are not guarantees of future performance and are subject to
certain risks, uncertainties and assumptions that are difficult to predict.
Therefore, our actual results could differ materially and adversely from those
expressed in any forward-looking statements as a result of various factors
including, but not limited to, those described under the caption Risk Factors
in this Quarterly Report on Form 10-Q. We undertake no obligation to revise or
update publicly any forward-looking statements for any reason. Overview SciClone Pharmaceuticals, Inc. is a biopharmaceutical company engaged in
the development and commercialization of therapeutics to treat life-threatening
diseases. We are currently evaluating our lead product, ZADAXIN, in several
late stage clinical trials for the treatment of patients with the hepatitis C
virus, or HCV, the hepatitis B virus, or HBV, and certain types of cancer. Our
primary focus is the successful completion of our two ongoing ZADAXIN phase 3
HCV clinical trials in the United States. We believe the worldwide market for
HCV therapies was approximately $3 billion in 2003 and could exceed $8 billion
in 2012. If approved by the U.S. Food and Drug Administration (FDA), we expect
ZADAXIN to complement other HCV therapies and to expand the HCV market
opportunity. In addition to the HCV trials in the United States, we are also
evaluating ZADAXIN in a recently completed phase 3 HBV clinical trial in Japan,
an ongoing phase 2 malignant melanoma clinical trial in Europe with our
exclusive marketing partner for Western Europe, Sigma-Tau, two ongoing phase 2
pilot studies in the United States for the treatment of liver cancer, an
ongoing HCV pilot clinical trial in Mexico and an ongoing HBV clinical trial in
Taiwan. Our other principal drug development candidate is SCV-07, a potentially
orally available therapeutic to treat viral and infectious diseases. Results of Operations Total Revenue Product sales were $5,414,000 for the three-month period ended March 31,
2004 and $5,000,000 for the corresponding period in 2003. All product sales in
each period were derived from sales of ZADAXIN. The increase was attributable
to a higher volume of product sold as prices have remained stable. Sales to
customers in China accounted for approximately 88% and 87% of this revenue for
the three-month periods ended March 31, 2004 and 2003, respectively. For the three-month period ended March 31, 2004, sales to two importing
agents in China accounted for approximately 50% and 38% of our product sales
respectively. For the three-month period ended March 31, 2003, one importing
agent accounted for 87% of our product sales; however, this importing agent
accounted for only 38% of our product sales in the three-month period ended
March 31, 2004. We rely on six 10




---



##### Table of Contents



importers to supply substantially all of our product in China, and our
sales to any single importing agent can vary substantially from quarter to
quarter depending on the size and timing of the orders. As of March 31, 2004,
approximately $9,323,000, or 85%, of our accounts receivable were attributable
to four customers in China. We perform on-going credit evaluations of our
customers financial condition, and generally do not require collateral from
our customers. Contract revenue was $228,000 and $224,000 for the three-month periods
ended March 31, 2004 and 2003, respectively. We recognized $134,000 of
contract revenue for the three-month period ended March 31, 2004, and all of
the contract revenue for the corresponding period in 2003 in connection with
the $2,685,000 payment we received from Sigma-Tau in January 2002. This revenue
is recognized as contract revenue over the course of the ZADAXIN hepatitis C
U.S. clinical program and the period of sharing the clinical data from this
program with Sigma-Tau in accordance with the requirements under our contract
with Sigma-Tau. We also recognized $94,000 of contract revenue in the
three-month period ended March 31, 2004 in connection with a National
Institutes of Health grant that we earned in the period. Cost of Product Sales and Gross Margin Gross margin on sales was 79% for the three-month period ended March 31,
2004, and 80% for the corresponding period in 2003. The decrease in gross
margin percentage was primarily the result of temporarily higher product costs
in connection with our use of a new manufacturer for ZADAXIN and foreign
currency rate fluctuations, as purchases from one of our contract manufacturers
are denominated in euros. We expect cost of product sales, and therefore gross
margin, to vary from period to period, depending upon the level of ZADAXIN
sales, the absorption of product-related fixed costs, and any charges
associated with excess or expiring finished product inventory. Research and Development Research and development expenses were $3,931,000 for the three
month-period ended March 31, 2004 and $3,783,000 for the corresponding period
in 2003. The increase was primarily to support our ZADAXIN phase 3 clinical
trials in the United States. The initiation and continuation of our current
clinical development programs has had and will continue to have a significant
effect on our research and development expenses. We expect a substantial
increase in research and development expenses during the second quarter of 2004
compared to the first quarter of the current year and to the second quarter of
2003. The expected increase is primarily due to an anticipated increase in
expenses relating to our phase 3 HCV clinical trials and other increases in
research and development expenses. Due to the uncertain nature of the clinical
trial process, and enrollment rates in particular, it is not possible to
determine the timing of completion or total cost expected to be incurred for
each trial. In general, we expect research and development expenses to
increase significantly at least over the next two years and to vary
substantially from quarter to quarter as we pursue our strategy of initiating
additional preclinical and clinical trials and testing, acquiring product
rights, and expanding regulatory activities. Sales and Marketing Sales and marketing expenses were $2,443,000 for the three-month period
ended March 31, 2004 and $2,229,000 for the corresponding period in 2003. The
increase was related to increased payroll expenses and expenses for advertising
and conferences associated with the expansion of our markets for ZADAXIN. We
expect sales and marketing expenses to increase in the next several quarters
and years as we expand our commercialization and marketing efforts. 11




---



##### Table of Contents



General and Administrative General and administrative expenses were $1,293,000 for the three-month
period ended March 31, 2004 and $1,012,000 for the corresponding period in
2003. The increase was primarily attributable to greater general and
administrative activities associated with increased securities regulation
requirements. In the near term, we expect general and administrative expenses
to vary quarter to quarter as we increase our general and administrative
activities and resources to support increased expenditures on preclinical and
clinical trials and testing, and regulatory, pre-commercialization and
marketing activities. Interest and Investment Income and Expense Interest and investment income was approximately $116,000 for the
three-month period ended March 31, 2004 and $53,000 for the corresponding
period in 2003. The increase was primarily the result of larger cash balances
earning interest in the 2004 period due to the proceeds we received from our
follow-on public offering of common stock during the third quarter of 2003.
Interest expense relating to $5,600,000 of convertible notes payable was
$84,000 for each of the three-month periods ended March 31, 2004 and 2003. Liquidity and Capital Resources At March 31, 2004 and December 31, 2003, we had $58,253,000 and
$62,975,000, respectively, in cash, cash equivalents and short-term
investments. We currently estimate that cash, cash equivalents and short-term
investments at December 31, 2004 will be lower than the balance at March 31,
2004. The expected decrease in this balance is attributable to an expected net
loss and no plans for a financing during the current fiscal year. The
short-term investments consist primarily of highly liquid marketable
securities. We have two letters of credit each secured by a certificate of
deposit. At March 31, 2004 and December 31, 2003, the letters of credit
totaled $694,000, one for $633,000 under our lease agreement, the other for
$61,000 to facilitate our value added tax filings in Europe. Net cash used in operating activities totaled $4,829,000 and $5,490,000
for the three-month periods ended March 31, 2004 and 2003, respectively. Net
cash used in operating activities for the three-month period ended March 31,
2004 was more than the net loss primarily due to a $1,563,000 decrease in
accounts payable. Net cash provided by financing activities totaled $70,000 and $1,948,000
for the three-month periods ended March 31, 2004 and 2003, respectively. Net
cash provided by financing activities for the three-month period ended March
31, 2003 primarily consisted of approximately $1,800,000 generated from the
issuance of common stock to Sigma-Tau. We intend to give priority use of our financial resources to ZADAXIN
clinical programs in the United States. We believe our existing capital
resources and funds from product sales are sufficient to complete our current
U.S. phase 3 clinical trials and, if the trials are successful and we receive
FDA approval, to begin commercialization of ZADAXIN in the United States.
However, we cannot assure you that such funds will be sufficient, or that sales
of ZADAXIN, if approved in the United States, will result in profitable
operations. An expansion or significant extension of our clinical development
programs may require us to seek additional capital resources. In the event we
need to raise additional funds, the unavailability or the inopportune timing of
any financing could prevent or delay our long-term product development and
commercialization programs, either of which would severely hurt our business.
The need, timing and amount of any such financing would depend upon numerous
factors, including the level of ZADAXIN sales, the timing and amount of
manufacturing costs related to ZADAXIN, the availability of complementary
products, technologies and businesses, the initiation and continuation of
preclinical and clinical trials and testing, the timing of regulatory
approvals, developments in relationships with existing or future collaborative
parties and the status of competitive products. 12




---



##### Table of Contents



Contractual Obligations There were no material changes to our contractual obligations in the
three-month period ended March 31, 2004. Off-Balance Sheet Arrangements There were no off-balance sheet arrangements in the three-month period
ended March 31, 2004. Risk Factors You should carefully consider the risks described below, in addition to
the other information in this report onForm 10-Qand our report on Form 10-K
for the year ended December 31, 2003, before making an investment decision.
Each of these risk factors could adversely affect our business, financial
condition, and operating results as well as adversely affect the value of an
investment in our common stock. If we are unable to commercialize ZADAXIN in various markets for multiple
indications, particularly in the United States for the treatment of HCV, our
business will be harmed. Our ability to achieve and sustain operating profitability depends in
large part on our ability to commence, execute and complete clinical programs
and obtain additional regulatory approvals, for ZADAXIN and other drug
candidates, particularly in the United States, Europe and Japan. We are also
dependent on our ability to increase ZADAXIN sales in existing markets and
launch ZADAXIN in new markets. In particular, our ability to achieve and
sustain profitability will depend in large part on our ability to commercialize
ZADAXIN for the treatment of HCV in the United States. We cannot assure you
that we will achieve significant levels of sales or that we will receive
approval for ZADAXIN for the treatment of HCV in the United States or for the
treatment of HCV or other indications in other countries. If we are unable to
do so, our business will be harmed. If we do not obtain regulatory approval for ZADAXIN for the intended
indications that we are evaluating, our revenues will be limited and we will
not become profitable. Our ability to execute on our business strategy requires that we obtain
regulatory approval for the use of ZADAXIN, particularly for the treatment of
HCV in the United States, both HBV and HCV in Japan and both HCV and malignant
melanoma in Europe. If our current phase 3 trials in the United States and
current and future trials in Europe yield favorable results, we intend to
submit applications for marketing approval of ZADAXIN for the treatment of HCV
in the United States and through our partner, Sigma-Tau, for the treatment of
HCV and malignant melanoma in Europe. Based on the results of our recently
completed phase 3 trial in Japan, we intend to submit a regulatory filing for
the treatment of HBV in Japan. The regulatory approval processes in the United
States, Europe and Japan are demanding and typically require 12 months or more
in the United States and 18 months or more in Europe and Japan from the date of
submission of a New Drug Application. We have committed significant resources,
including capital and time, to develop ZADAXIN, particularly for HCV in the
United States, with the goal of obtaining such approvals. If we do not obtain
these approvals, we will be unable to achieve any substantial increase in our
revenue. All new drugs, including our products, which have been developed or are
under development, are subject to extensive and rigorous regulation by the FDA
and comparable agencies in state and local jurisdictions and in foreign
countries. These regulations govern, among other things, the development,
testing, manufacturing, labeling, storage, pre-market approval, importation,
advertising, promotion, sale and distribution of our products. These
regulations may change from time to time and new regulations may be adopted. 13




---



##### Table of Contents



Obtaining regulatory approval in developing countries is also
time-consuming and expensive. In some countries where we are contemplating
marketing and selling ZADAXIN, the regulatory approval process often relies on
prior approvals obtained in the United States, Europe or Japan. Without such
prior approvals, our ability to obtain regulatory approvals for ZADAXIN in
these countries may be delayed or prevented. In addition, to secure these
regulatory approvals, we will need, among other things, to demonstrate
favorable results from additional clinical trials of ZADAXIN. Even if we are
able to complete the clinical trials we have sponsored or are planning in a
timely or cost-effective manner, these trials may not fulfill the applicable
regulatory approval criteria, in which case we will not be able to obtain
regulatory approval in these countries. We cannot assure you that we will
ultimately obtain regulatory approvals in our targeted countries in a timely
and cost-effective manner or at all. If we fail to obtain the required
regulatory approvals to develop, market and sell our products in countries
where we currently do not have such rights, our revenues will be limited. Satisfaction of government regulations may take several years and the time
needed to satisfy them varies substantially based on the type, complexity and
novelty of the pharmaceutical product. As a result, government regulation may
cause us to delay the introduction of, or prevent us from marketing, our
existing or potential products for a considerable period of time and impose
costly procedures upon our activities. Even if we obtain regulatory approval
for our products, such approval may impose limitations on the indicated uses
for which our products may be marketed. Unsatisfactory data resulting from
clinical trials may also adversely affect our ability to market and sell
ZADAXIN in markets where it is approved for sale. If the results of our clinical trials are not favorable, we will be unable to
obtain regulatory approval for the intended indications we are evaluating. To obtain regulatory approvals, we must, among other requirements,
complete carefully controlled and well-designed clinical trials demonstrating
that a particular drug is safe and effective for the applicable disease. We
cannot depend on data from prior trial results to predict or demonstrate that
our drug products are safe and efficacious under regulatory guidelines to
qualify for commercial sale. We cannot assure you, nor can you rely on our
previous clinical trial results to predict, that our ongoing or future clinical
trials will yield favorable results. Adverse or inconclusive clinical results
would prevent us from filing for regulatory approval of ZADAXIN for the
indications that we are evaluating, and our current programs in those areas
would fail. In the past, Alpha 1 Biomedical, from which we acquired certain
rights to thymosin alpha 1, conducted a phase 3 clinical trial of thymosin
alpha 1 as a therapy for HBV that did not produce statistically significant
results and Alpha 1 Biomedical did not submit a new drug application to the
FDA. We are currently conducting phase 3 clinical trials based on the use of
ZADAXIN in combination with pegylated interferon alpha for the treatment of HCV
patients who did not previously respond to treatment. We cannot assure you that
these phase 3 clinical trials will yield sufficient or adequate data to
demonstrate appropriate safety and efficacy under FDA guidelines. Any failure
to obtain sufficient or adequate data could delay or prevent us from securing
FDA approval. Our two phase 3 HCV clinical trials in the United States have been
designed to show that the combination of ZADAXIN and pegylated interferon alpha
adds a significant clinical benefit when compared to the use of pegylated
interferon alpha alone in non-responders. We cannot assure you that the results
of this combination therapy will yield the favorable results we expect, or that
the independent use of pegylated interferon alpha will not perform better than
anticipated, which could reduce the chances that a new drug application, or
NDA, will be approved. If the combination therapy of ZADAXIN and pegylated
interferon alpha causes significant adverse side effects beyond those caused by
pegylated interferon alpha alone, our clinical trials could be delayed,
patients may drop out at a greater than anticipated rate, we may be forced to
halt the trials or the FDA may reject an NDA due to safety issues. If any of
the foregoing occurs, our efforts to 14




---



##### Table of Contents



market and sell ZADAXIN in the United States will be significantly
impaired, our business will suffer and the price of our stock may decline. Our phase 3 HBV clinical trial in Japan was designed to demonstrate a
clinical benefit measured by an analysis of a combination of safety and
efficacy data points. We cannot assure that the results of this study will
warrant favorable consideration by the Japanese Ministry of Health and Welfare
or result in a marketing registration of ZADAXIN. If additional studies or
other data are required for regulatory consideration, our efforts to market and
sell ZADAXIN in Japan will be significantly impaired, our business will suffer
and the price of our stock may decline. If we experience delays in patient enrollment in our clinical trials, we may
not be able to obtain regulatory approval in accordance with our anticipated
timeline. Each of our two current phase 3 HCV clinical trials in the United States
are designed to enroll 500 patients, one trial treating patients with no liver
damage and the other trial treating patients with mild cirrhosis of the liver.
The 500 patient enrollment is complete in the first trial, however if we are
unable to enroll a sufficient number of patients in the second trial, if such
enrollment is delayed or if patient drop out rates in either trial are higher
than anticipated, our ability to proceed with our clinical trials and prepare
an NDA would be adversely affected. In particular, we are experiencing
competition for patients with mild cirrhosis of the liver, from trials
sponsored by other commercial drug developers and from a trial sponsored by the
National Institutes of Health. Competition for the enrollment of similar
patients in other clinical trials or other delays in enrollment may prevent us
from enrolling patients quickly enough to meet our current timing expectations
for completing our phase 3 trials, which would delay the preparation of an NDA.
If we are not able to fully enroll patients for both of these clinical trials
or patient drop out rates are higher than anticipated, it could reduce the
chances that our NDA will be approved. We cannot predict the safety profile of the use of ZADAXIN when used in
combination with other drugs. Many of our trials involve the use of ZADAXIN in combination with other
drugs. Some of these drugs are known to cause adverse patient reactions. Even
if ZADAXIN does not produce adverse side effects when used alone, we cannot
predict how it will work with other drugs, including causing possible adverse
side effects not directly attributable to the other drugs that could compromise
the safety profile of ZADAXIN when used in certain combination therapies. Due to the outbreak of SARS in China, sales of ZADAXIN in the second quarter of
2003 were significantly higher than expected and are not indicative of future
sales. Our sales for the quarter ended June 30, 2003 were more than 200% greater
than sales for any quarter in our history as a result of a previously
unanticipated increase in sales of ZADAXIN to hospitals in China. This increase
was related to the use of immune system enhancers, including ZADAXIN, in
connection with the treatment of severe acute respiratory syndrome, or SARS. In
future quarters, sales of ZADAXIN for the treatment of SARS could be affected
by changes in treatment in China, changes in the rate of infection and the
emergence of evidence as to the effectiveness or ineffectiveness of ZADAXIN or
of other potential treatments for SARS. As a result of the containment of the SARS epidemic, we expect sales in
future quarters to be more consistent with sales patterns of the third and
fourth quarters of 2003 and the quarter ended March 31, 2004, each of which
have significantly lower sales results than those of the second quarter in
2003. We could experience fluctuations in sales in future quarters as a result
of similar factors. 15




---



##### Table of Contents



Our sales of ZADAXIN may fluctuate due to seasonality of product orders and
sales in any quarter may not be indicative of future sales. Our sales for the quarter ended June 30, 2003 were greatly affected by the
demand in China for ZADAXIN in connection with the treatment of SARS. It is not
possible to predict at this time if SARS will re-emerge, like influenza, as a
seasonal public health problem and what effect, if any, this would have on
future sales of ZADAXIN. To the extent that ZADAXIN is purchased in connection
with future outbreaks of SARS or other seasonal viral contagions, product sales
could become more concentrated in certain quarters of the calendar year.
Quarterly sales levels could fluctuate and sales in any quarter may not be
indicative of sales in future periods. Our revenue is dependent on the sale of ZADAXIN in foreign countries,
particularly China, and if we experience difficulties in our foreign sales
efforts, our financial condition will be harmed. Our product revenue in the near term is highly dependent on the sale of
ZADAXIN in foreign countries. If we experience difficulties in our foreign
sales efforts, our business will suffer and our financial condition will be
harmed. Substantially all of our ZADAXIN sales are to customers in China. Sales
of ZADAXIN in China may be limited due to the low average personal income, lack
of patient cost reimbursement, poorly developed infrastructure and existing and
potential competition from other products, including generics. Several local
companies have introduced lower priced locally manufactured generic competitive
products. If these sales continue, there could be a negative impact on the
price and the volume of ZADAXIN sold in China and this would harm our business. In addition, our ZADAXIN sales and operations in other parts of Asia, as
well as in Latin America and the Middle East, are subject to a number of risks,
including difficulties and delays in obtaining registrations, permits, pricing
approvals and reimbursement and unexpected changes in regulatory requirements.
In addition, we experience other issues with managing foreign sales operations
including long payment cycles, difficulties in accounts receivable collection
and, especially from significant customers, fluctuations in the timing and
amount of orders. Operations in foreign countries also expose us to risks
relating to difficulties in enforcing our proprietary rights, currency
fluctuations and adverse or deteriorating economic conditions. We do not have product sales in the United States with which to offset any
decrease in our revenue from ZADAXIN sales in Asia, Latin America and the
Middle East. In addition, some countries in these regions, including China,
regulate pharmaceutical prices and pharmaceutical importation. These
regulations may reduce prices for ZADAXIN to levels significantly below those
that would prevail in an unregulated market, limit the volume of product which
may be imported and sold or place high import duties on the product, any of
which may limit the growth of our revenues or cause them to decline. Because of Chinas tiered method of importing and distributing finished
pharmaceutical products, our quarterly results may vary substantially from one
period to the next. China uses a tiered method to import and distribute finished
pharmaceutical products. At each port of entry, and prior to moving the product
forward to the distributors, government-licensed importing agents must process
and evaluate each shipment to determine whether such shipment satisfies Chinas
quality assurance requirements. In order to efficiently manage this process,
the importing agents typically place large, and therefore relatively few,
orders within any six month period. Therefore, our sales to an importing agent
can vary substantially from quarter to quarter depending on the size and timing
of the orders, which has in the past and may in the future cause our quarterly
results to fluctuate. We rely on six importers to supply substantially all of
our product in China. Because we use a small number of importing agents in
China, our 16




---



##### Table of Contents



receivables from any one importing agent are material, and if we were
unable to collect receivables from any importer, our business and cash-flow
would be adversely affected. If we fail to protect our products, technologies and trade secrets, we may not
be able to successfully use, manufacture, market or sell our products, or we
may fail to advance or maintain our competitive position. Our success depends significantly on our ability to obtain and maintain
meaningful patent protection for our products and technologies and to preserve
our trade secrets. Our pending patent applications may not result in the
issuance of patents in the future. Our patents or patent applications may not
have priority over others applications. Our existing patents and additional
patents that may be issued, if any, may not provide a competitive advantage to
us or may be invalidated or circumvented by our competitors. Others may
independently develop similar products or design around patents issued or
licensed to us. Patents issued to, or patent applications filed by, other
companies could harm our ability to use, manufacture, market or sell our
products or maintain our competitive position with respect to our products.
Although many of our patents relating to ZADAXIN have expired, including
composition of matter patents, we have rights to other patents and patent
applications relating to ZADAXIN and ZADAXIN analogues, including method of use
patents with respect to the use of ZADAXIN for certain indications. If other
parties develop generic forms of ZADAXIN for other indications, including
conducting clinical trials for such indications, our patents and other rights
might not be sufficient to prohibit them from marketing and selling such
generic forms of ZADAXIN. If other parties develop analogues or derivatives of
ZADAXIN, our patents and other rights might not be sufficient to prohibit them
from marketing these analogues or derivatives. Pharmaceutical products are either not patentable or have only recently
become patentable in some of the countries in which we market or may market
ZADAXIN. Past enforcement of intellectual property rights in many of these
countries, including China in particular, has been limited or non-existent.
Future enforcement of patents and proprietary rights in many other countries
will likely be problematic or unpredictable. We are aware that other companies
are marketing generic thymosin alpha 1 in China, possibly in violation of our
trademark or other rights, and we expect such violations of our rights to
continue. Moreover, the issuance of a patent in one country does not assure the
issuance of a similar patent in another country. Claim interpretation and
infringement laws vary by nation, so the extent of any patent protection is
uncertain and may vary in different jurisdictions. If we are involved in intellectual property claims and litigation, the
proceedings may divert our resources and subject us to significant liability
for damages, substantial litigation expense and the loss of our proprietary
rights. Our commercial success depends in part on us not infringing valid,
enforceable patents or proprietary rights of third parties, and not breaching
any licenses that may relate to our technologies and products. We are aware of
a third-party patent that may relate to our products and may cover a method of
action used by ZADAXIN. We cannot assure you that our mechanism of action does
not infringe on their claim. In addition, we may not be aware of all patents or
patent applications that may impact our ability to make, use or sell any of our
potential products. For example, U.S. patent applications may be kept
confidential for up to 18 months while pending in the Patent and Trademark
Office, and patent applications filed in foreign countries are often first
published six months or more after filing. It is possible that we may
unintentionally infringe these patents or other patents or proprietary rights
of third parties. We may in the future receive notices claiming infringement
from third parties as well as invitations to take licenses under third-party
patents. Any legal action against us or our collaborative partners claiming
damages and seeking to enjoin commercial activities relating to our products
and processes affected by third-party rights may require us or our
collaborative partners to obtain licenses in order to continue to manufacture
or market the affected products and processes. Our efforts to defend against
any of these claims, regardless of merit, would require us to devote resources
and attention that could have been directed to our operations and growth plans.
In addition, these actions may 17




---



##### Table of Contents



subject us to potential liability for damages. We or our collaborative
partners may not prevail in a patent action and any license required under a
patent may not be made available on commercially acceptable terms, or at all.
Any conflicts resulting from the patent rights of others could significantly
reduce the coverage of our patents and limit our ability to obtain meaningful
patent protection. If other companies obtain patents with conflicting claims, we may be
required to obtain licenses to those patents or develop or obtain alternative
technology to manufacture or market the affected products and processes. We may
not be able to obtain any such licenses on acceptable terms or at all. Any
failure to obtain such licenses could delay or prevent us from pursuing the
development or commercialization of our potential products. Our efforts to
defend against any of these claims would require us to devote resources and
attention that could have been directed to our operations and growth plans. We may need to initiate litigation, which could be time-consuming and
expensive, to enforce our proprietary rights or to determine the scope and
validity of others rights. If litigation results, a court may find our patents
or those of our licensors invalid or may find that we have infringed on a
competitors rights. If any of our competitors have filed patent applications
in the United States which claim technology we also have invented, the Patent
and Trademark Office may require us to participate in expensive interference
proceedings to determine who has the right to a patent for the technology.
These actions may subject us to potential liability for damages. We or our
collaborative partners may not prevail in a patent action and any license
required under a patent may not be made available on commercially acceptable
terms, or at all. We rely on third parties to supply our clinical trial and commercial products.
Deficiencies in their work could delay or harm one or more important areas of
our business including our sales, clinical trials or the regulatory approval
process. We rely on third parties, who are subject to regulatory oversight, to
supply our clinical and commercial products. Typically we have at any time only
one supplier for each phase of manufacturing of our product. If unanticipated
deficiencies in these suppliers occur, we could experience delays in our
ability to assemble a timely and acceptable NDA. If sales of ZADAXIN were to
increase dramatically, our third-party suppliers may not be able to supply
ZADAXIN quickly enough, which could limit our ability to satisfy increased
demand or could adversely affect the ability of these suppliers to provide
products for our clinical trials. Not all of the ZADAXIN planned to be used in
our HCV clinical trials has been manufactured and received. Roche is our
exclusive supplier of pegylated interferon alpha for our current U.S. clinical
trials, and we have not received all the pegylated interferon to be used in the
clinical trials. Roches agreement with us to provide our supply of pegylated
interferon alpha can be terminated by them without cause on 30-days notice, in
which case we would need to purchase their product for use in the clinical
trials. Any delay in receiving, or a recall of, pegylated interferon alpha or
ZADAXIN, including by reason of Roches termination of its supply arrangement
with us, could delay the clinical trials or detract from the integrity of the
trial data. If any of the foregoing occurs, our ability to complete our
clinical trials in the United States and to market and sell ZADAXIN worldwide
will be delayed or impaired, our business will suffer and the price of our
stock may decline. We have been in the process of qualifying a new manufacturer
of ZADAXIN and if we encounter problems with this process of validation, our
sales or our clinical trials could be adversely affected. If we are not able to establish and maintain adequate manufacturing
relationships, the development and sale of our products could be impaired. To be successful, our products must be manufactured in commercial
quantities, in compliance with stringent regulatory requirements and at an
acceptable cost. Typically we have at any time only one supplier for each phase
of manufacturing of our product. Manufacturing interruptions or failure to
comply with regulatory requirements could significantly delay clinical
development of potential products and reduce third-party or clinical researcher
interest and support of proposed trials. These interruptions or failures could
also 18




---



##### Table of Contents



impede commercialization of our products, including sales of ZADAXIN in
approved markets, and impair our competitive position. Any of these
developments would harm our business. We are in the process of changing suppliers for ZADAXIN and such changes
require qualification of the new suppliers with regulatory agencies, quality
assurance and other steps which could cause delays or interruptions of supply.
If we do not obtain the required regulatory approvals for a manufacturing
change in a timely fashion, especially in China, our sales may be interrupted
until the manufacturing change is approved. Although we are increasing
inventories to prepare to manage any such occurrences, we may still experience
interruptions in supply which could adversely affect our results. In some countries, a manufacturing change may require additional
regulatory approvals which may delay ZADAXIN marketing approvals in new
markets. In addition, manufacturing, supply and quality control problems may arise
as we, either alone or with subcontractors, attempt to scale-up our
manufacturing procedures. We may not be able to scale-up in a timely manner or
at a commercially reasonable cost, either of which could cause delays or pose a
threat to the ultimate commercialization of our products and harm our business. We may not be able to successfully develop or commercialize our products. While we have limited sales of ZADAXIN in certain markets, we do not yet
have regulatory approval for ZADAXIN for our principal target markets, and, in
this respect, ZADAXIN is still being developed. Our other potential products
are in earlier stages of development than ZADAXIN. To fully develop our
products, we will need to commit substantial resources to extensive research,
development, pre-clinical testing, clinical trials, manufacturing scale-up and
regulatory approval prior to being ready for sale. We cannot assure that our
efforts will produce commercially viable products. We face significant
technological risks inherent in developing these products. We may also abandon
some or all of our proposed products before they become commercially viable. If
any of our products, even if developed and approved, cannot be successfully
commercialized in a timely manner, our business will be harmed and the price of
our stock may decline. We have not yet sold any product other than ZADAXIN and our sales have
been primarily in a single country, China. Our future revenue growth depends on
increased market acceptance and commercialization of ZADAXIN in additional
countries, particularly in the United States, Europe and Japan. If we fail to
successfully market ZADAXIN, or if we cannot commercialize this drug in the
United States and other additional markets, our revenue and operating results
will suffer. If unexpected and serious adverse events are reported, or if
expected efficacy results are not achieved, it would have a material adverse
effect on our business. Our future revenue will also depend in part on our
ability to develop other commercially viable and accepted products. Market
acceptance of our products will depend on many factors, including our ability
to convince prospective customers to use our products as an alternative to
other treatments and therapies and to convince prospective strategic partners
to market our products effectively and to manufacture our products in
sufficient quantities with acceptable quality and at an acceptable cost. In
addition, doctors must opt to use treatments involving our products. If doctors
elect to use a different course of treatment, demand for our drug products
would be reduced. Failure to do any of the above will hurt our operations. We rely on third-party clinical investigators to conduct our clinical trials
and, as a result, we may encounter delays outside our control. We have limited experience in conducting and managing clinical trials and
we rely, in part, on third parties, particularly clinical research
organizations and our development partners, to assist us in managing 19




---



##### Table of Contents



and monitoring clinical trials. Our reliance on these third parties may
result in delays in completing, or failure to complete, these clinical trials
if third parties fail to fulfill their obligations to us. We may need to obtain additional capital to support our long-term product
development and commercialization programs. We believe our existing resources will be sufficient to complete our
current U.S. phase 3 clinical trials and, if the trials are successful and we
receive FDA approval, to begin commercialization of ZADAXIN in the United
States. However, we cannot assure that such funds will be sufficient, or that
sales of ZADAXIN, if approved in the United States, will result in profitable
operations. In addition, we may need additional funds in the future to support
future growth and achieve profitability. If we need to raise additional funds
in the future and such funds are not available on reasonable terms, if at all,
our commercialization efforts may be impeded, our revenues may be limited and
our operating results may suffer. We have a history of operating losses and an accumulated deficit. We expect to
continue to incur losses in the near term and may never achieve profitability. We have experienced significant operating losses since our inception, and
as of March 31, 2004, we had an accumulated deficit of approximately $141
million. We expect our operating expenses to increase over the next several
years as we plan to dedicate substantially all of our resources to expanding
our development, testing and marketing capabilities, particularly in the United
States, and these losses may increase if we cannot increase or sustain revenue.
As a result, we may never achieve profitability. We have limited sales, marketing and distribution capabilities, which may
adversely affect our ability to successfully commercialize our products. We currently have limited sales, marketing and distribution capabilities,
and we anticipate that we may be relying on third-party collaborators to sell,
market and distribute our products for the foreseeable future. If our
arrangements with these third parties are not successful, or if we are unable
to enter into additional third-party arrangements, we may need to substantially
expand our sales, marketing and distribution force. Our efforts to expand may
not succeed, or we may lack sufficient resources to expand in a timely manner,
either of which will harm our operating results. Moreover, if we are able to
further expand our sales, marketing and distribution capabilities, we will
begin competing with other companies that have experienced and well-funded
operations. If we cannot successfully compete with these larger companies, our
revenues may not grow and our business may suffer. Commercialization of some of our products depends on collaborations with
others. If our collaborators are not successful, or if we are unable to find
future collaborators, we may not be able to properly develop and commercialize
our products. We depend in part on our distributors and business partners to develop
and/or promote our drugs, and if they are not successful in their efforts or
fail to do so, our business will suffer. For example, Sigma-Tau is responsible
for the development and marketing of ZADAXIN in Europe. We generally do not
have control over the amount and timing of resources that our business partners
devote to ZADAXIN, and they have not always performed as or when expected. If
they do not perform their obligations as we expect, particularly obligations
regarding clinical trials, our development expenses would increase and the
development and/or sale of our products could be limited or delayed, which
could hurt our business and cause our stock price to decline. In addition, our
relationships with these companies may not be successful. Disputes may arise
with our collaborators, including disputes over ownership rights to
intellectual property, know-how or technologies 20




---



##### Table of Contents



developed with our collaborators. We may not be able to negotiate similar
additional arrangements in the future to develop and commercialize ZADAXIN or
other products. We may lose market share or otherwise fail to compete effectively in the
intensely competitive biopharmaceutical industry. Competition in the biopharmaceutical industry is intense, and we expect
that competition will increase. Our success depends on our ability to compete
in this industry, but we cannot assure you that we will be able to successfully
compete with our competitors. Increased competitive pressure could lead to
intensified price-based competition resulting in lower prices and margins,
which would hurt our operating results. We are focused on developing ZADAXIN as a treatment for HCV and HBV and
certain cancers. Several large biopharmaceutical companies have substantial
commitments to interferon alpha, an approved drug for treating HBV and HCV, and
to lamivudine and adefovir, approved drugs to treat HBV. We cannot assure you
that we will compete successfully against our competitors or that our
competitors, or potential competitors, will not develop drugs or other
treatments for HCV, HBV, cancer and other diseases that will be superior to
ours. If third-party reimbursement is not available or patients cannot otherwise pay
for ZADAXIN, we may not be able to successfully market ZADAXIN. Significant uncertainty exists as to the reimbursement status of new
therapeutic products, such as ZADAXIN. We cannot assure you that third-party
insurance coverage and reimbursement will be available for therapeutic products
we might develop. The failure to obtain third-party reimbursement for our
products, particularly in the United States, Europe and Japan, would harm our
business. Further, we cannot assure you that additional limitations will not be
imposed in the future in the United States on drug coverage and reimbursement
due to proposed health care reforms. In many emerging markets where we have
marketing rights to ZADAXIN, but where government resources and per capita
income may be so low that our products will be prohibitively expensive, we may
not be able to market our products on economically favorable terms, if at all. Efforts by governmental and third-party payors to contain or reduce health
care costs or the announcement of legislative proposals or reforms to implement
government controls could cause us to reduce the prices at which we market our
drugs, which will reduce our gross margins and may harm our business. If we lose key personnel or are unable to attract and retain additional, highly
skilled personnel required for the expansion of our activities, our business
will suffer. We are highly dependent upon our ability to attract and retain qualified
personnel because of the specialized, scientific and worldwide nature of our
business. There is intense competition for qualified management, scientific and
technical personnel in the pharmaceutical industry, and we may not be able to
attract and retain the qualified personnel we need to grow and develop our
business globally. In addition, we assign numerous key responsibilities to a
limited number of individuals, and we would experience difficulty in finding
immediate replacements for any of them. If we were unable to attract and retain
qualified personnel as needed or promptly replace those employees who are
critical to our product development and commercialization, the development and
commercialization of our products would be adversely affected. At this time, we
do not maintain key person life insurance on any of our key personnel. We may be subject to product liability lawsuits, and our insurance may be
inadequate to cover damages. 21




---



##### Table of Contents



Clinical trials or marketing of any of our current and potential products
may expose us to liability claims from the use of these products. We currently
carry product liability insurance. However, we cannot be certain that we will
be able to maintain insurance on acceptable terms, if at all, for clinical and
commercial activities or that the insurance would be sufficient to cover any
potential product liability claim or recall. If we fail to have sufficient
coverage, our business, results of operations and cash flows could be adversely
affected. We depend on international sales, and global conditions could negatively affect
our operating results. A large majority of our sales are in China. Heightened tensions resulting
from the current geopolitical conditions in the Middle East, North Korea and
elsewhere could worsen, causing disruptions in foreign trade, which would harm
our sales. In particular, our commercial product is manufactured in Europe and
distributed by us from our operations in Hong Kong. Any disruption of our
supply and distribution activities due to geopolitical conditions could
decrease our sales and harm our operating results. If we are unable to comply with environmental and other laws and regulations,
our business may be harmed. We are subject to various federal, state and local laws, regulations and
recommendations relating to the use, manufacture, storage, handling and
disposal of hazardous materials and waste products (including radioactive
compounds and infectious disease agents), as well as safe working conditions,
laboratory and manufacturing practices and the experimental use of animals. The
extent of government regulation that might result from future legislation or
administrative action in these areas cannot be accurately predicted. We do not currently maintain hazardous materials at our facilities. While
we outsource our research and development programs involving the controlled use
of biohazardous materials, if in the future we conduct these programs
ourselves, we might be required to incur significant cost to comply with the
environmental laws and regulations. Further, in the event of an accident, we
would be liable for any damages that result, and the liability could exceed our
resources. Our stock price may be volatile, and an investment in our stock could
suffer a decline in value. The market price of our common stock has experienced, and may continue to
experience, substantial volatility due to many factors, some of which we have
no control over, including:  
    
    progress and results of clinical trials involving ZADAXIN;  
    
    progress of ZADAXIN through the regulatory process,
especially regulatory actions in the United States, Europe and
Japan;  
    
    timing and achievement of milestones;  
    
    announcements of technological innovations or new products by
us or our competitors;  
    
    government regulatory action affecting our drug products or
our competitors drug products in both the United States and foreign
countries;  
    
    developments or disputes concerning patent or proprietary
rights;  
    
    changes in company assessments or financial estimates by
securities analysts; 22




---



##### Table of Contents




    
    actual or anticipated fluctuations in our quarterly operating
results;  
    
    general stock market conditions and fluctuations for the
emerging growth and biopharmaceutical market sectors;  
    
    economic conditions in the United States or abroad; and  
    
    broad financial market fluctuations in the United States,
Europe or Asia. In the past, following periods of large price declines in the public
market price of a companys securities, securities class action litigation has
often been initiated against that company. Litigation of this type could result
in substantial costs and diversion of our attention and resources, which would
hurt our business. Any adverse determination in litigation could also subject
us to significant liabilities. Substantial sales of our stock or the exercise or conversion of options or
convertible securities may impact the market price of our common stock. As of March 31, 2004, stock options to purchase 5,894,021 shares of common
stock were outstanding, of which options to purchase 4,078,297 shares were
exercisable. Also outstanding as of the same date were warrants exercisable for
904,760 shares of common stock at $7.00 per share and two notes convertible
into a total of 684,140 shares of common stock. The note holder has the right
to purchase up to $8.3 million of additional convertible notes due on or before
March 2006, which, if fully issued, will be convertible into 684,140 shares of
our common stock. Upon exercise of options or warrants, or conversion of the
notes, these issued shares of common stock will be freely tradable. Future sales of substantial amounts of our common stock could adversely
affect the market price of our common stock. Similarly, if we raise additional
funds through the issuance of common stock or securities convertible into or
exercisable for common stock, the percentage ownership of our stockholders will
be reduced and the price of our common stock may fall. Sales of our common stock by officers and directors could affect our stock
price. Our Board of Directors has approved an amendment to our trading policy
that permits officers and directors to enter into trading plans that comply
with the requirements of Rule 10b5-1 of the Securities and Exchange Act of
1934. Rule 10b5-1 allows corporate officers and directors to adopt written,
pre-arranged stock trading plans when they do not have material, non-public
information. Using these plans, officers and directors can gradually diversify
their investment portfolios, can spread stock trades out over an extended
period of time to reduce any market impact and can avoid concerns about
initiating stock transactions at a time when they might be in possession of
material, non-public information. As of April 28, 2004, only one director has
adopted such a plan, with sales commencing no earlier than May 2004, and other
directors or officers may do so in the future. In general our officers and
directors have rarely sold stock in the Company, though they have held options
or stock for many years. We expect future sales by officers and directors
either under 10b5-1 plans or otherwise as result of personal financial
planning. We do not believe the volume of such sales would affect our trading
price, however, the market could react negatively to sales by our officers and
directors, affecting the trading price of our stock. If our officers, directors and largest stockholders elect to act together, they
may be able to control our management and operations, acting in their best
interests and not necessarily those of other stockholders. As of March 31, 2004 our directors and officers owned or had the right to
acquire approximately 7.7% of the outstanding shares of our common stock. Our
two largest stockholders, Sigma-Tau (and its 23




---



##### Table of Contents



affiliates) and Randal J. Kirk, owned in the aggregate approximately 12.9%
of the outstanding shares of our capital stock. As a result, due to their
concentration of stock ownership, our directors, officers and largest
stockholders, if they act together, may be able to influence our management and
operation and may be able to affect or influence all matters requiring a
stockholder vote, including the election of all directors and the amendment of
charter documents or the approval of a merger, sale of assets or other major
corporate transactions. Although they are independent of each other and not part of a group, in
2003 we obtained the support of Sigma-Tau and Mr. Kirk for our proposal to the
stockholders to reincorporate in Delaware, and without that support we would
not have been able to obtain the required stockholder approval for that matter. Anti-takeover provisions in our charter documents and under Delaware law may
make an acquisition of us, which may be beneficial to our stockholders, more
difficult. Certain anti-takeover provisions of Delaware law and our charter documents
as currently in effect may make a change in control of our company more
difficult, even if a change in control would be beneficial to the stockholders.
Prior to our recent reincorporation in Delaware, we had a stockholder rights
plan, also commonly known as a poison pill, which we terminated in connection
with the reincorporation. We currently do not intend to adopt a stockholder
rights plan. However, our charter documents do contain certain anti-takeover
provisions, including provisions in our certificate of incorporation providing
that stockholders may not cumulate votes, stockholders meetings may be called
by stockholders only if they hold 25% or more of our common stock and
provisions in our bylaws providing that the stockholders may not take action by
written consent. Additionally, our board of directors has the authority to
issue 10 million shares of preferred stock and to determine the terms of those
shares of stock without any further action by the stockholders. The rights of
holders of our common stock are subject to the rights of the holders of any
preferred stock that may be issued. The issuance of preferred stock could make
it more difficult for a third-party to acquire a majority of our outstanding
voting stock. Delaware law also prohibits corporations from engaging in a
business combination with any holders of 15% or more of their capital stock
until the holder has held the stock for three years unless, among other
possibilities, the board of directors approves the transaction. Our board of
directors may use these provisions to prevent changes in the management and
control of our company. Also, under applicable Delaware law, our board of
directors may adopt additional anti-takeover measures in the future. We may be subject to currency exchange rate fluctuations, which could adversely
affect our financial performance. Substantially all of our product sales are denominated in U.S. dollars.
Fluctuation in the U.S. dollar exchange rate with local currency directly
affects the customers cost for our product. In particular, a stronger U.S.
dollar vis-à-vis the local currency would tend to have an adverse effect on
sales and potentially on collection of accounts receivable. To date, this
exposure to currency exchange rate fluctuations has been minimal because the
Chinese currency has been pegged to the U.S. dollar. However, the fixed nature
of the Chinese currency in relation to the U.S. dollar may not continue in the
future and, consequently, our foreign operations may expose us to greater risk
of currency exchange rate fluctuations in the future. In addition, we are
subject to currency exchange rate fluctuations as a result of expenses incurred
by our foreign operations. In particular, one of our supply arrangements under
which we purchase finished products is denominated in euros. Consequently,
changes in exchange rates could unpredictably and adversely affect our
operating results and could result in exchange losses. To date, we have not
hedged against the risks associated with fluctuations in exchange rates and,
therefore, exchange rate fluctuations could have a material adverse impact on
our operating results and stock price. 24




---



##### Table of Contents



Item 3. Quantitative and Qualitative Disclosures About Market Risk The primary objective of our investment activities is to preserve
principal while at the same time maximizing yields without significantly
increasing risk. To achieve this objective, we invest solely in U.S. Treasury
or U.S. government agency notes. Our investments in these notes are subject to
interest rate risk. To minimize the exposure due to an adverse shift in
interest rates, we invest in short-term notes and maintain an average maturity
of less than one year. A hypothetical 60 basis point increase in interest
rates would result in an approximate $193,525 decrease (0.6%) in fair value of
our available-for-sale securities. This potential change is based on
sensitivity analyses performed on our financial position at March 31, 2004.
Actual results may differ materially. Substantially all our sales and most of our manufacturing costs to date
have been in U.S. dollars. Our purchases from one of our contract
manufacturers are denominated in euros and this exposes us to foreign currency
rate fluctuations. 
 Item 4. Controls and Procedures Under the supervision and with the participation of our management,
including our Chief Executive Officer and Chief Financial Officer, we evaluated
the effectiveness of our disclosure controls and procedures, as such term is
defined in Rule 13a-15(e) promulgated under the Securities Exchange Act of
1934, as amended. Based on this evaluation, our Chief Executive Officer and
Chief Financial Officer concluded that our disclosure controls and procedures
were effective as of the end of the period covered by this quarterly report. 25




---



##### Table of Contents



PART II. OTHER INFORMATION 
 Item 6. Exhibits and Reports on Form 8-K  (a)
    
    Exhibits Exhibit Number
    
    Description3(i).1(1)
    
    Amended and Restated Certificate of Incorporation.3(ii).1(1)
    
    Bylaws.4.1(2)
    
    Rights Agreement dated as of July 25, 1997 between the
Registrant and Chase Mellon Shareholder Services, LLC.4.2(1)
    
    First Amendment to Rights Agreement dated as of July 17, 2003
between the Registrant and Mellon Investor Services LLC.4.3(3)*
    
    6% Convertible Note dated as of December 7, 2000 by the
Registrant in favor of UBS AG, London Branch.4.4(3)*
    
    Option Agreement dated as of October 26, 2000 by and between
the Registrant and UBS AG, London Branch.4.5(3)*
    
    Amendment No. 1 to Option Agreement dated as of December 19,
2000 by and between the Registrant and UBS AG, London Branch.4.6(4)*
    
    6% Convertible Note dated as of March 21, 2001 by the Company
in favor of UBS AG, London Branch.4.7(4)*
    
    Option Agreement dated as of February 16, 2001 by and between
the Company and UBS AG, London Branch.4.8(4)*
    
    Amendment No.1 to Option Agreement dated as of March 21, 2001
by and between the Company and UBS AG, London Branch.31.1(5)
    
    Rule 13a-14(a) Certification of Chief Executive Officer.31.2(5)
    
    Rule 13a-14(a) Certification of Chief Financial Officer.32.1(5)
    
    Section 1350 Certification of Chief Executive Officer.32.2(5)
    
    Section 1350 Certification of Chief Financial Officer.
 *Certain information in this exhibit has been omitted and filed separately with
the Securities and Exchange Commission pursuant to a confidential treatment
request under 17 C.F.R. Sections 200.80(b)(4), 200.83 and 230.46.  (1)
    
    Incorporated by reference from the Companys Current Report on Form 8-K
filed on July 28, 2003.(2)
    
    Incorporated by reference from the Companys Current Report on Form 8-K
filed on October 14, 1997.(3)
    
    Incorporated by reference from the Companys Annual Report on Form 10-K
for the year ended December 31, 2000.(4)
    
    Incorporated by reference from the Companys Quarterly Report on Form
10-Q filed on May 15, 2001.(5)
    
    Filed herewith. 26




---



##### Table of Contents



(b)
    
    Reports on Form 8-K We filed one Current Report on Form 8-K during the quarterly period
covered by this report. The Current Report was dated February 24, 2004 and was
furnished pursuant to Item 7 and Item 12. 27




---



##### Table of Contents



SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the
Registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized. SCICLONE PHARMACEUTICALS, INC.(Registrant)Date: April 30, 2004
    
    /s/ Richard A. WaldronRichard A. WaldronChief Financial Officer(Principal Financial & Accounting Officer)
 28




---



##### Table of Contents



INDEX TO EXHIBITS SequentiallyExhibit
    
    
    
    NumberedNumber
    
    Exhibit
    
    Page3(i).1(1)
    
    Amended and Restated Certificate of Incorporation.3(ii).1(1)
    
    Bylaws.4.1(2)
    
    Rights Agreement dated as of July 25, 1997 between the
Registrant and Chase Mellon Shareholder Services, LLC.4.2(1)
    
    First Amendment to Rights Agreement dated as of July 17,
2003 between the Registrant and Mellon Investor Services
LLC.4.3(3)*
    
    6% Convertible Note dated as of December 7, 2000 by the
Registrant in favor of UBS AG, London Branch.4.4(3)*
    
    Option Agreement dated as of October 26, 2000 by and
between the Registrant and UBS AG, London Branch.4.5(3)*
    
    Amendment No. 1 to Option Agreement dated as of December
19, 2000 by and between the Registrant and UBS AG,
London Branch.4.6(4)*
    
    6% Convertible Note dated as of March 21, 2001 by the
Company in favor of UBS AG, London Branch.4.7(4)*
    
    Option Agreement dated as of February 16, 2001 by and
between the Company and UBS AG, London Branch.4.8(4)*
    
    Amendment No. 1 to Option Agreement dated as of March
21, 2001 by and between the Company and UBS AG, London
Branch.31.1(5)
    
    Rule 13a-14(a) Certificate of Chief Executive Officer.31.2(5)
    
    Rule 13a-14(a) Certification of Chief Financial Officer.32.1(5)
    
    Section 1350 Certification of Chief Executive Officer.32.2(5)
    
    Section 1350 Certification of Chief Financial Officer.
 * Certain information in this exhibit has been omitted and filed separately
with the Securities and Exchange Commission pursuant to a confidential
treatment request under 17 C.F.R. Sections 200.80(b)(4), 200.83 and 230.46.  (1)
    
    Incorporated by reference from the Companys Current Report on Form 8-K
filed on July 28, 2003.(2)
    
    Incorporated by reference from the Companys Current Report on Form 8-K
filed on October 14, 1997.(3)
    
    Incorporated by reference from the Companys Annual Report on Form 10-K
for the year ended December 31, 2000.(4)
    
    Incorporated by reference from the Companys Quarterly Report on Form
10-Q filed on May 15, 2001.(5)
    
    Filed herewith. 29