**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON, D.C. 20549**

#### **FORM 10-Q**

| **x**                                                                                                                                                                                  |   | **QUARTERLY REPORT  PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF  1934**  |
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|----------------------------------------------------------------------------------------------------------|
|                                                                                                                                                                                   |   |                                                                                                     |
| **FOR THE  QUARTERLY PERIOD ENDED JUNE 30, 2007**                                                                                                                                      |
|                                                                                                                                                                                   |   |                                                                                                     |
| **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 000-23267**

**DEPOMED, INC.**

(EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER)

| **CALIFORNIA**                   |   | **94-3229046**          |
|----------------------------------|--------|-------------------------|
| (STATE OR OTHER  JURISDICTION OF |   | (I.R.S. EMPLOYER        |
| INCORPORATION OR  ORGANIZATION)  |   | IDENTIFICATION  NUMBER) |

 

**1360 O’BRIEN DRIVE**

**MENLO PARK, CALIFORNIA 94025**

(ADDRESS OF PRINCIPAL EXECUTIVE OFFICES, INCLUDING ZIPCODE)

**(650) 462-5900**

(REGISTRANT’S TELEPHONE NUMBER, INCLUDING AREA CODE)

Indicate by check mark whether the registrant(1) has filed all reports required to be filed by Section 13 or15(d) of the Exchange Act during the preceding 12 months (or for suchshorter 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    Noo

Indicate by check mark whether the registrant is alarge accelerated filer, an accelerated filer or a non-accelerated filer, asdefined in Rule 12b-2 of the Exchange Act.

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

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

Yes  o    No  x

Thenumber of issued and outstanding shares of the Registrant’s Common Stock, nopar value, as of August 3, 2007 was 47,630,945.

 

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**DEPOMED, INC.**
|                                                                                                                                | ** ** | **PAGE** |
|--------------------------------------------------------------------------------------------------------------------------------|------------|----------|
| ** **                                                                                                                     |       |     |
| **PART I –  FINANCIAL INFORMATION**                                                                                  |       |     |
|                                                                                                                           |       |     |
| Item 1.  Condensed Consolidated Financial Statements:                                                                          |       |     |
|                                                                                                                           |       |     |
| Condensed  Consolidated Balance Sheets at June 30, 2007 (unaudited) and  December 31, 2006                                |       | 3        |
|                                                                                                                           |       |     |
| Condensed  Consolidated Statements of Operations for the three and six-month periods  ended June 30, 2007 and 2006 (unaudited) |       | 4        |
|                                                                                                                           |       |     |
| Condensed  Consolidated Statements of Cash Flows for the six-month periods ended June  30, 2007 and 2006 (unaudited)           |       | 5        |
|                                                                                                                           |       |     |
| Notes to  Condensed Consolidated Financial Statements                                                                          |       | 6        |
|                                                                                                                           |       |     |
| Item 2.  Management’s Discussion and Analysis of Financial Condition and Results of  Operations                           |       | 13       |
|                                                                                                                           |       |     |
| Item 3.  Quantitative and Qualitative Disclosure About Market Risk                                                             |       | 22       |
|                                                                                                                           |       |     |
| Item 4. Controls and  Procedures                                                                                               |       | 23       |
|                                                                                                                           |       |     |
| **PART II – OTHER  INFORMATION**                                                                                     |       |     |
|                                                                                                                           |       |     |
| Item 1. Legal Proceedings                                                                                                      |       | 24       |
|                                                                                                                           |       |     |
| Item  1A. Risk Factors                                                                                                         |       | 24       |
|                                                                                                                           |       |     |
| Item 2.  Unregistered Sales of Equity Securities and Use of Proceeds                                                           |       | 37       |
|                                                                                                                           |       |     |
| Item 3.  Defaults upon Senior Securities                                                                                       |       | 37       |
|                                                                                                                           |       |     |
| Item 4.  Submission of Matters to a Vote of Security Holders                                                                   |       | 37       |
|                                                                                                                           |       |     |
| Item 5. Other Information                                                                                                      |       | 37       |
|                                                                                                                           |       |     |
| Item  6. Exhibits                                                                                                              |       | 38       |
|                                                                                                                           |       |     |
| Signatures                                                                                                                     |       | 39       |

 

2

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**PART I– FINANCIAL INFORMATION**

###### **ITEM1. CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

**DEPOMED, INC.**

**CONDENSEDCONSOLIDATED BALANCE SHEETS**

** (inthousands, except share and per share amounts)**
| ** **                                                                                                                                                                                                                                                                               | ** ** | **June 30,** | ** ** | **December 31,** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------|------------|-----------------------|------------|
| ** **                                                                                                                                                                                                                                                                               | ** ** | **2007**          | ** ** | **2006**              | ** ** |
| ** **                                                                                                                                                                                                                                                                               | ** ** | **(Unaudited)**   | ** ** | **(1)**               | ** ** |
| **ASSETS**                                                                                                                                                                                                                                                                               | ** ** | ** **        | ** ** | ** **            | ** ** |
| Current assets:                                                                                                                                                                                                                                                                          |       |              |       |                  |       |
| Cash and cash  equivalents                                                                                                                                                                                                                                                               |       | $                 | 9,554      |                  | $          | 14,574 |   |
| Marketable  securities                                                                                                                                                                                                                                                                   |       | 20,711            |       | 16,985                |       |
| Accounts  receivable                                                                                                                                                                                                                                                                     |       | 1,312             |       | 7,127                 |       |
| Unbilled  accounts receivable                                                                                                                                                                                                                                                            |       | 421               |       | 1,955                 |       |
| Inventories                                                                                                                                                                                                                                                                              |       | 4,393             |       | 4,483                 |       |
| Prepaid and  other current assets                                                                                                                                                                                                                                                        |       | 2,003             |       | 2,756                 |       |
| Total current  assets                                                                                                                                                                                                                                                                    |       | 38,394            |       | 47,880                |       |
| Marketable securities                                                                                                                                                                                                                                                                    |       | 5,106             |       | 1,999                 |       |
| Property and equipment,  net                                                                                                                                                                                                                                                             |       | 2,108             |       | 2,541                 |       |
| Other assets                                                                                                                                                                                                                                                                             |       | 197               |       | 197                   |       |
|                                                                                                                                                                                                                                                                                     |       | $                 | 45,805     |                  | $          | 52,617 |   |
| **LIABILITIES  AND SHAREHOLDERS’ DEFICIT**                                                                                                                                                                                                                                          | ** ** | ** **        | ** ** | ** **            | ** ** |
| Current liabilities:                                                                                                                                                                                                                                                                     |       |              |       |                  |       |
| Accounts payable                                                                                                                                                                                                                                                                         |       | $                 | 2,561      |                  | $          | 4,886 |   |
| Accrued  compensation                                                                                                                                                                                                                                                                    |       | 1,295             |       | 1,818                 |       |
| Accrued clinical  trial expense                                                                                                                                                                                                                                                          |       | 1,072             |       | 726                   |       |
| Accrued  promotion fee expense                                                                                                                                                                                                                                                           |       | 663               |       | 2,340                 |       |
| Other accrued  liabilities                                                                                                                                                                                                                                                               |       | 2,722             |       | 3,088                 |       |
| Deferred product  sales                                                                                                                                                                                                                                                                  |       | 3,486             |       | 4,825                 |       |
| Deferred license  revenue                                                                                                                                                                                                                                                                |       | 4,438             |       | 4,600                 |       |
| Other current  liabilities                                                                                                                                                                                                                                                               |       | 56                |       | 56                    |       |
| Total current  liabilities                                                                                                                                                                                                                                                               |       | 16,293            |       | 22,339                |       |
| Deferred license  revenue, non-current portion                                                                                                                                                                                                                                           |       | 54,623            |       | 57,483                |       |
| Other long-term  liabilities                                                                                                                                                                                                                                                             |       | 56                |       | 84                    |       |
| Commitments                                                                                                                                                                                                                                                                              |       |              |       |                  |       |
| Shareholders’ deficit:                                                                                                                                                                                                                                                              |       |              |       |                  |       |
| Preferred stock,  no par value, 5,000,000 shares authorized; Series A convertible  preferred stock, 25,000 shares designated, 18,158 shares issued and  outstanding at June 30, 2007 and December 31, 2006, respectively, with  an aggregate liquidation preference of $18,159 |       | 12,015            |       | 12,015                |       |
| Common stock, no  par value, 100,000,000 shares authorized; 47,630,945 and 42,029,411 shares  issued and outstanding at June 30, 2007 and December 31, 2006,  respectively                                                                                                          |       | 166,767           |       | 144,820               |       |
| Accumulated  deficit                                                                                                                                                                                                                                                                     |       | (203,937          | )          | (184,111              | )          |
| Accumulated  other comprehensive loss                                                                                                                                                                                                                                                    |       | (12               | )          | (13                   | )          |
| Total  shareholders’ deficit                                                                                                                                                                                                                                                        |       | (25,167           | )          | (27,289               | )          |
|                                                                                                                                                                                                                                                                                     |       | $                 | 45,805     |                  | $          | 52,617 |   |

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(1) Derived from the audited consolidated financialstatements included in the Company’s Annual Report on Form 10-K for the yearended December 31, 2006.

See accompanying notes to Condensed ConsolidatedFinancial Statements.

3

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**DEPOMED, INC.**

**CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS**

** (inthousands, except share and per share amounts)**

**(Unaudited)**
| ** **                                                                           | ** ** | **Three Months Ended June 30,** | ** ** | **Six Months Ended June 30,** | ** ** |
|--------------------------------------------------------------------------------------|------------|-----------------------------------------------------|------------|---------------------------------------------------|------------|
| ** **                                                                           | ** ** | **2007**                                            | ** ** | **2006**                                          | ** ** | **2007** | ** ** | **2006** | ** ** |
| Revenue:                                                                             |       |                                                |       |                                              |       |   |   |   |   |
| Product sales                                                                        |       | $                                                   | 2,502      |                                              | $          | 1,165 |   | $ | 3,833 |   | $ | 1,265 |   |
| Royalties                                                                            |       | 45                                                  |       | 80                                                |       | 79 |   | 430 |   |
| License revenue                                                                      |       | 1,059                                               |       | 893                                               |       | 3,523 |   | 1,786 |   |
| Collaborative revenue                                                                |       | 2                                                   |       | 75                                                |       | 2 |   | 75 |   |
| Total revenues                                                                       |       | 3,608                                               |       | 2,213                                             |       | 7,437 |   | 3,556 |   |
|                                                                                 |       |                                                |       |                                              |       |   |   |   |   |
| Costs and  expenses:                                                                 |       |                                                |       |                                              |       |   |   |   |   |
| Cost of sales                                                                        |       | 569                                                 |       | 1,051                                             |       | 874 |   | 1,125 |   |
| Research and development                                                             |       | 6,129                                               |       | 6,768                                             |       | 14,701 |   | 12,452 |   |
| Selling, general and administrative                                                  |       | 6,323                                               |       | 4,898                                             |       | 12,550 |   | 8,830 |   |
| Total costs and  expenses                                                            |       | 13,021                                              |       | 12,717                                            |       | 28,125 |   | 22,407 |   |
|                                                                                 |       |                                                |       |                                              |       |   |   |   |   |
| Loss from  operations                                                                |       | (9,413                                              | )          | (10,504                                           | )          | (20,688 | ) | (18,851 | ) |
|                                                                                 |       |                                                |       |                                              |       |   |   |   |   |
| Interest and  other income                                                           |       | 456                                                 |       | 586                                               |       | 866 |   | 1,181 |   |
|                                                                                 |       |                                                |       |                                              |       |   |   |   |   |
| Net loss before  income taxes                                                        |       | (8,957                                              | )          | (9,918                                            | )          | (19,822 | ) | (17,670 | ) |
|                                                                                 |       |                                                |       |                                              |       |   |   |   |   |
| Provision for  income taxes                                                          |       | (3                                                  | )          | —                                            |       | (4 | ) | — |   |
|                                                                                 |       |                                                |       |                                              |       |   |   |   |   |
| Net loss                                                                             |       | (8,960                                              | )          | (9,918                                            | )          | (19,826 | ) | (17,670 | ) |
|                                                                                 |       |                                                |       |                                              |       |   |   |   |   |
| Deemed dividend  on preferred stock                                                  |       | (170                                                | )          | (162                                              | )          | (337 | ) | (335 | ) |
|                                                                                 |       |                                                |       |                                              |       |   |   |   |   |
| Net loss  applicable to common stock shareholders                                    |       | $                                                   | (9,130     | )                                                 | $          | (10,080 | ) | $ | (20,163 | ) | $ | (18,005 | ) |
|                                                                                 |       |                                                |       |                                              |       |   |   |   |   |
| Basic and  diluted net loss applicable to common stock shareholders per common share |       | $                                                   | (0.20      | )                                                 | $          | (0.24 | ) | $ | (0.46 | ) | $ | (0.44 | ) |
|                                                                                 |       |                                                |       |                                              |       |   |   |   |   |
| Shares used in  computing basic and diluted net loss per common share                |       | 46,233,946                                          |       | 41,517,862                                        |       | 44,166,899 |   | 41,182,550 |   |

 

See accompanying notes to Condensed ConsolidatedFinancial Statements.

4

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**DEPOMED, INC.**

**CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS**

** (inthousands)**

**(Unaudited)**
| ** **                                                                   | ** ** | **Six Months Ended June 30,** | ** ** |
|------------------------------------------------------------------------------|------------|---------------------------------------------------|------------|
| ** **                                                                   | ** ** | **2007**                                          | ** ** | **2006** | ** ** |
| **Operating  Activities**                                                    | ** ** | ** **                                        | ** ** | ** ** | ** ** |
| Net loss                                                                     |       | $                                                 | (19,826    | ) | $ | (17,670 | ) |
| Adjustments to  reconcile net loss to net cash used in operating activities: |       |                                              |       |   |   |
| Depreciation and amortization                                                |       | 469                                               |       | 864 |   |
| Employee and director stock-based compensation                               |       | 1,031                                             |       | 1,217 |   |
| Stock-based compensation related to consultants                              |       | 24                                                |       | — |   |
| Changes in assets and liabilities:                                           |       |                                              |       |   |   |
| Accounts receivable                                                          |       | 7,349                                             |       | 1,182 |   |
| Inventories                                                                  |       | 90                                                |       | (320 | ) |
| Prepaid and other current assets                                             |       | 753                                               |       | (1,166 | ) |
| Other assets                                                                 |       | —                                            |       | 47 |   |
| Accounts payable and other accrued liabilities                               |       | (4,050                                            | )          | 1,865 |   |
| Accrued compensation                                                         |       | (522                                              | )          | (512 | ) |
| Royalty advances                                                             |       | —                                            |       | 626 |   |
| Deferred revenue                                                             |       | (4,361                                            | )          | (1,668 | ) |
| Net cash (used in) operating activities                                      |       | (19,043                                           | )          | (15,535 | ) |
|                                                                         |       |                                              |       |   |   |
| **Investing  Activities**                                                    | ** ** | ** **                                        | ** ** | ** ** | ** ** |
| Purchases of  property and equipment                                         |       | (121                                              | )          | (428 | ) |
| Purchases of  marketable securities                                          |       | (21,594                                           | )          | (20,072 | ) |
| Maturities of  marketable securities                                         |       | 14,846                                            |       | 29,433 |   |
| Sales of  marketable securities                                              |       | —                                            |       | 1,497 |   |
| Net cash (used in) provided by investing activities                          |       | (6,869                                            | )          | 10,430 |   |
|                                                                         |       |                                              |       |   |   |
| **Financing  Activities**                                                    | ** ** | ** **                                        | ** ** | ** ** | ** ** |
| Proceeds from  issuance of common stock                                      |       | 20,892                                            |       | 2,434 |   |
| Net cash provided by financing activities                                    |       | 20,892                                            |       | 2,434 |   |
|                                                                         |       |                                              |       |   |   |
| Net (decrease)  in cash and cash equivalents                                 |       | (5,020                                            | )          | (2,671 | ) |
| Cash and cash  equivalents at beginning of period                            |       | 14,574                                            |       | 7,566 |   |
| Cash and cash  equivalents at end of period                                  |       | $                                                 | 9,554      |   | $ | 4,895 |   |

 

See accompanying notes to Condensed ConsolidatedFinancial Statements.

5

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**DEPOMED, INC.**

**NOTES TO CONDENSED CONSOLIDATED FINANCIALSTATEMENTS**

**(Unaudited)**

**NOTE 1.SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES**

## ***Basis of Presentation***

These unaudited condensedconsolidated financial statements and the related footnote information of Depomed, Inc.(the Company or Depomed) have been prepared pursuant to the requirements of theSecurities and Exchange Commission (SEC) for interim reporting. As permittedunder those rules, certain footnotes or other financial information that arenormally required by U.S. generally accepted accounting principles have beencondensed or omitted pursuant to such rules and regulations. In theopinion of the Company’s management, the accompanying interim unauditedcondensed consolidated financial statements include all adjustments (consistingonly of normal recurring adjustments) necessary for a fair presentation of theinformation for the periods presented. The results for the interim period endedJune 30, 2007 are not necessarily indicative of results to be expected for theentire year ending December 31, 2007 or future operating periods.

The balance sheet as ofDecember 31, 2006 has been derived from the audited financial statementsat that date. The balance sheet does not include all of the information andfootnotes required by U.S. generally accepted accounting principles forcomplete financial statements. For further information, refer to the financialstatements and footnotes thereto included in the Company’s annual report onForm 10-K for the year ended December 31, 2006 filed with the SEC.

***Principles of Consolidation***

The consolidatedfinancial statements for the three and six months ended June 30, 2007 and 2006include the accounts of the Company and Depomed Development, Ltd., or DDL. DDLdoes not have any fixed assets, liabilities or employees and will notperform any further product development on behalf of Depomed or any otherentity. Material intercompany accounts and transactions have been eliminated.DDL was dissolved in April 2007.

***Use of Estimates***

The preparation of financial statements in conformitywith U.S. generally accepted accounting principles requires management to makeestimates and assumptions that affect the amounts reported in the financialstatements and accompanying notes. Actual results could differ from thoseestimates.

***Stock-Based Compensation***

Effective January 1,2006, Depomed implemented the provisions of Statement of Financial AccountingStandards No. 123 (revised 2004), *Share-Based Payment*(FAS 123(R)), as interpreted by SEC Staff Accounting Bulletin No. 107 (SAB107), using the modified prospective transition method. FAS 123(R) is arevision of Statement of Financial Accounting Standards No. 123, *Accounting for Stock-Based Compensation*(FAS 123), andsupercedes APB Opinion No. 25, *Accounting for StockIssued to Employees* (APB No. 25).**FAS123(R) requires companies to recognize the cost of employee and directorservices received in exchange for awards of equity instruments, based on thegrant-date fair value of those awards, in the statement of operations. Usingthe modified prospective transition method of FAS 123(R), Depomed beganrecognizing fair-value compensation expense for stock-based awards, includingstock options granted and purchase rights issued under its employee purchase planafter January 1, 2006. Compensation expense for stock-based awards grantedprior to implementation that were unvested and outstanding as ofJanuary 1, 2006 is recognized over the requisite service period based onthe grant-date fair value of those options and awards as previously calculatedunder FAS 123. The compensation expense for stock-based compensation is basedon the single-option approach, includes an estimate for forfeitures and isrecognized over the vesting term of the options using the straight-line method.FAS 123(R) requires forfeitures to be estimated at the time of grant andrevised, if necessary, in subsequent periods if actual forfeitures differ fromthose estimates. Depomed estimates forfeitures based on historical experience.Under the modified prospective transition method of implementation, norestatement of prior periods has been made. See Note 4 of the Notes toCondensed Consolidated Financial Statements for further information regardingDepomed’s stock-based compensation expense.

6

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***RevenueRecognition***

Revenue arrangements withmultiple elements are divided into separate units of accounting if certaincriteria are met, including whether the delivered element has stand-alone valueto the customer and whether there is objective and reliable evidence of thefair value of the undelivered items. The consideration received is allocatedamong the separate units based on their respective fair values, and theapplicable revenue recognition criteria are applied to each of the separateunits.

Revenue is recognizedwhen there is persuasive evidence that an arrangement exists, delivery hasoccurred and title has passed, the price is fixed or determinable and theCompany is reasonably assured of collecting the resulting receivable.

The Company sells GLUMETZAproduct to wholesalers and retail pharmacies that is subject to rights ofreturn up to twelve months after product expiration.  Given the limited sales history of GLUMETZA,the Company currently cannot reliably estimate expected returns of the productat the time of shipment. Accordingly, the Company defers recognition of revenueon product shipments of GLUMETZA until the right of return no longer exists,which occurs at the earlier of the time GLUMETZA units are dispensed throughpatient prescriptions or expiration of the right of return. The Companyestimates patient prescriptions dispensed using an analysis of third-partyinformation, including third-party market research data, information obtainedfrom wholesalers with respect to inventory levels and out-movement and retailpharmacy re-stocking activity. As a result of this policy, the Company has adeferred revenue balance of $3.5 million at June 30, 2007 related to GLUMETZAproduct shipments that have not been recognized as revenue, which is net ofestimated patient support program discounts, wholesaler fees, stockingallowances, prompt payment discounts, chargebacks and Medicaid rebates. TheCompany will recognize revenue upon the earlier of prescription units dispensedor expiration of the right of return until it can reliably estimate productreturns, at which time the Company will record a one-time increase in netrevenue related to the recognition of revenue previously deferred. In addition,the costs of manufacturing GLUMETZA associated with the deferred revenue arerecorded as deferred costs, which are included in inventory, until such timethe deferred revenue is recognized.

Product sales revenue related to the Company’s supplyagreement with Esprit Pharma, Inc. (Esprit) was recognized after the expirationof a 30-day period in which Esprit was entitled to reject product that did notmeet agreed-upon specifications. The supply agreement with Esprit wasterminated in July 2007.

Royalties are recognized as earned in accordance withthe contract terms when royalties from licensees can be reliably measured andcollectibility is reasonably assured. Royalties received under the Company’sagreements with Biovail Laboratories s.r.l. (Biovail) and LG Life Sciences (LG)are recognized when the royalty payments are received as they are notestimable.

The Company recognized royalties under its licenseagreement with Esprit based on Esprit’s sales of ProQuin XR, net of anyestimated returns, discounts, rebates and chargebacks, subject to minimumannual royalties. The license agreement with Esprit was terminated in July2007.

Revenue from licensearrangements is recognized when the Company has substantially completed itsobligations under the terms of the arrangement and the Company’s remaininginvolvement is inconsequential and perfunctory. If the Company has significantcontinuing involvement under such an arrangement, license fees are deferred andrecognized over the estimated performance period. License fee payments receivedin excess of amounts earned are classified as deferred revenue until earned.

Collaborative revenuerecognized relates to services rendered in connection with collaborativearrangements and the achievements of milestones under such arrangements.Revenue related to collaborative agreements with corporate partners isrecognized as the expenses are incurred under each contract. The Company isrequired to perform services as specified in each respective agreement andthe Company is reimbursed based on the costs incurred on each specific contract.Nonrefundable substantive milestone payments are recognized pursuant tocollaborative agreements upon the achievement of specified milestones where nofurther obligation to perform exists under that milestone provision of thearrangement and when collectibility is reasonably assured.

7

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**NOTE 2.CASH, CASH EQUIVALENTS AND MARKETABLE SECURITIES**

 The Company considers all highly liquidinvestments with an original maturity (at date of purchase) of three months orless to be cash equivalents. Cash and cash equivalents consist of cash ondeposit with banks, money market instruments and commercial paper. The Companyplaces its cash, cash equivalents and marketable securities with high quality,U.S. financial institutions and, to date, has not experienced material losseson any of its balances. The Company records cash and cash equivalents atamortized cost, which approximates the fair value. All marketable securitiesare classified as available-for-sale since these instruments are readilymarketable. These securities are carried at fair value, which is based onreadily available market information, with unrealized gains and losses includedin accumulated other comprehensive income (loss) within shareholders’ equity.The Company uses the specific identification method to determine the amount ofrealized gains or losses on sales of marketable securities. Realized gains orlosses have been insignificant and are included in “interest and other income”in the condensed consolidated statement of operations. As of June 30, 2007, theindividual contractual period for all available-for-sale debt securities isless than two years.

Thefollowing table shows the gross unrealized losses and fair value of the Company’sinvestments with unrealized losses that are not deemed to beother-than-temporarily impaired, aggregated by investment category and lengthof time that individual securities have been in a continuous unrealized lossposition, at June 30, 2007 (in thousands):
| ** **                         | ** ** | **Less than 12 months** | ** ** | **12 months or greater** | ** ** | **Total**           | ** ** |
|------------------------------------|------------|----------------------------------------|------------|-----------------------------------------|------------|---------------------|------------|
| **U.S. Debt Securities** | ** ** | **Fair Value**                    | ** ** | **Gross  Unrealized  Losses**           | ** ** | **Fair Value** | ** ** | **Gross  Unrealized  Losses** | ** ** | **Fair Value** | ** ** | **Gross  Unrealized  Losses** | ** ** |
| U.S. government  debt securities   |       | $                                      | 2,992      |                                    | $          | (1                  | )          | $ | 5,794 |   | $ | (2 | ) | $ | 8,786 |   | $ | (3 | ) |
| U.S. corporate  debt securities    |       | 15,531                                 |       | (9                                      | )          | —              |       | — |   | 15,531 |   | (9 | ) |
| Total  available-for-sale          |       | $                                      | 18,523     |                                    | $          | (10                 | )          | $ | 5,794 |   | $ | (2 | ) | $ | 24,317 |   | $ | (12 | ) |

 

Thegross unrealized losses above were caused by interest rate increases. Nosignificant facts or circumstances have arisen to indicate that there has beenany deterioration in the creditworthiness of the issuers of the Company’ssecurities. Based on the Company’s review of these securities, including theassessment of the duration and severity of the unrealized losses and theCompany’s ability and intent to hold the investments until maturity, there wereno other-than-temporary impairments for these securities at June 30, 2007.

**NOTE 3.NET LOSS PER COMMON SHARE**

Netloss per common share is computed using the weighted-average number of sharesof common stock outstanding. Common stock equivalent shares, which are based onthe number of shares underlying outstanding stock options, warrants and otherconvertible securities, are not included as their effect is antidilutive. AtJune 30, 2007 and 2006, the total number of outstanding common stock equivalentshares excluded from the loss per share computation was 8,576,829 and8,399,008, respectively.

8

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**NOTE4.  STOCK-BASED COMPENSATION**

The Company adopted FAS123(R) on January 1, 2006 as described in Note 1 of the Notes to CondensedConsolidated Financial Statements. The following table presents stock-basedcompensation expense recognized under FAS 123(R) for stock options and theCompany’s employee stock purchase program (ESPP) in the Company’s condensedconsolidated statements of operations (in thousands):
|                                              | ** ** | **Three Months Ended June 30,** | ** ** | **Six Months Ended June 30,** | ** ** |
|----------------------------------------------|------------|-----------------------------------------------------|------------|---------------------------------------------------|------------|
| ** **                                   | ** ** | **2007**                                            | ** ** | **2006**                                          | ** ** | **2007** | ** ** | **2006** | ** ** |
|                                         |       |                                                |       |                                              |       |   |   |   |   |
| Cost of sales                                |       | $                                                   | 5          |                                              | $          | — |   | $ | 9 |   | $ | — |   |
| Research and  development expense            |       | 207                                                 |       | 251                                               |       | 408 |   | 489 |   |
| Selling, general  and administrative expense |       | 350                                                 |       | 418                                               |       | 638 |   | 728 |   |
| Total                                        |       | $                                                   | 562        |                                              | $          | 669 |   | $ | 1,055 |   | $ | 1,217 |   |

 

At June 30, 2007, Depomedhad $5.5 million of total unrecognized compensation expense, net of estimatedforfeitures, related to stock option plans that will be recognized over anaverage vesting period of 2.6 years.

**NOTE5.  COMPREHENSIVE LOSS**

Totalcomprehensive loss for the three and six months ended June 30, 2007 and 2006approximates net loss and includes unrealized gains and losses on marketable securities.

**NOTE6.  COLLABORATIVE ARRANGEMENTS ANDCONTRACTS**

***LG Life Sciences***

InJanuary 2007, the Company and LG Life Sciences further amended the parties’license and distribution agreement, originally entered into in August 2004 andsubsequently amended in November 2006. The amendment grants LG a license tomanufacture the 500mg GLUMETZA in exchange for royalties on net sales ofGLUMETZA in Korea, and to remove the provisions of the original agreementproviding for the supply of 500mg GLUMETZA tablets by the Company to LG. TheCompany received a $0.6 million upfront license fee received in August 2004 anda $0.5 million milestone payment received in November 2006 with respect to LG’sapproval to market GLUMETZA in the Republic of Korea that were originallydeferred and amortized as revenue over the estimated length of time the Companywas obligated to provide assistance in development and manufacturing. Under theamended agreement, the Company no longer has continuing performance obligationsto LG that are other than inconsequential or perfunctory and accordingly, theremaining $0.9 million of previously deferred revenue was recognized as licenserevenue in the first quarter of 2007.

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***Biovail***

In February 2007, the Company entered into a licenseand development agreement with Biovail granting Biovail an option to licensethe AcuForm drug delivery technology to develop and commercialize up to twopharmaceutical products. Pursuant to the agreement, Biovail paid the Company anupfront fee of $0.5 million in February 2007, and is contingently obligated topay the Company additional fees related to the exercise of the license option,the initiation of the first Phase 3 trial for each product and upon receipt ofU.S. regulatory approval for each product. The agreement also requires thatBiovail make royalty payments to the Company on net commercial sales of anyproduct developed under the agreement. As the Company has no continuingobligations to Biovail under the agreement that are other than inconsequentialor perfunctory, the $0.5 million upfront license fee was recognized as licenserevenue in the first quarter of 2007.

Also in February 2007, the Company amended its stockpurchase agreement with Biovail originally entered into in May 2002. Theamended stock purchase agreement removed Biovail’s observer rights at ourCompany’s board of directors meetings and removed the right of firstnegotiation in favor of Biovail with respect to acquisition transactionsinvolving the Company.

**NOTE 7.INVENTORIES**

Inventoriesrelate to the manufacture of the Company’s GLUMETZA and ProQuin XR products.Inventories are stated at the lower of cost or market and consist of thefollowing (in thousands):
|                 | ** ** | **June 30, 2007** | ** ** | **December 31, 2006** | ** ** |
|-----------------|------------|-----------------------------|------------|---------------------------------|------------|
| Raw materials   |       | $                           | 973        |                            | $          | 1,343 |   |
| Work-in-process |       | 392                         |       | 1,387                           |       |
| Finished goods  |       | 2,546                       |       | 970                             |       |
| Deferred costs  |       | 482                         |       | 783                             |       |
| Total           |       | $                           | 4,393      |                            | $          | 4,483 |   |

 

Deferredcosts represent the costs of GLUMETZA product shipped for which recognition ofrevenue has been deferred.

**NOTE 8.SHAREHOLDERS’ EQUITY**

***Registered Direct Equity Offering***

In April 2007, the Company completed a registereddirect offering of 5,300,000 shares of common stock with selected institutionalinvestors. The shares were sold at a price of approximately $3.78 per share,with net proceeds totaling approximately $20.0 million.

***Series APreferred Stock***

TheSeries A Preferred Stock accrued a dividend of 7% per annum, compoundedsemi-annually and payable in shares of Series A Preferred Stock. TheSeries A Preferred Stock was convertible at anytime betweenJanuary 2002 and January 2006 into the Company’s common stock. Theoriginal conversion price of the Series A Preferred Stock was $12.00;however, as a result of the Company’s March 2002 and October 2003financings, the conversion price had been adjusted to $9.51 per share. InDecember 2004, the Company entered into an agreement with theSeries A Preferred stockholder to resolve a misunderstanding between theCompany and the stockholder relating primarily to prior adjustments to the conversionprice of the Series A Preferred Stock. Pursuant to the agreement, amongother matters, the Company agreed to adjust the conversion price to $7.50 pershare. The Company and the stockholder also agreed to binding interpretationsof certain other terms related to the Series A Preferred Stock conversionprice.

10

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Prior to December 2004, the amounts calculated asSeries A Preferred stock dividends were accounted for as an adjustment tothe conversion price following EITF Issue No. 98-5, *Accounting for Convertible Securities with BeneficialConversion Features or Contingently Adjustable Conversion Ratios*(IssueNo. 98-5).**As a result ofthe modifications to the preferred stock agreement in December 2004, theCompany determined that a “significant modification” of the agreement had beenmade, and, therefore, a new “commitment date” for accounting purposes had beenestablished on December 10, 2004. The Company measured the differencebetween the carrying value of the preferred stock and the fair value of the modifiedpreferred stock pursuant to EITF Topic No. D-42, *The Effect on the Calculation of Earnings per Sharefor the Redemption or Induced Conversion of Preferred Stock* anddetermined that the fair value of the modified security was less than thecarrying value of the security prior to the modification. The Company alsoevaluated the effective conversion rate, after considering the reset rate of$7.50 per share in addition to the common stock issuable upon conversion of theunpaid, accumulated dividends. The fair value of the underlying common stock onDecember 10, 2004 was $5.06 per share. The Company determined that theconversion rate, after including the effect of the unpaid dividends, did notresult in a beneficial conversion feature, which could have had the effect ofalso providing a deemed dividend to the preferred stockholder. However, an anti-dilution provision of theSeries A Preferred Stock was triggered by the Company’s January 2005financing, which adjusted the conversion price of the Series A PreferredStock to $7.12. As a result of the adjusted conversion price and anincrease in the amount of common stock issuable upon conversion of theSeries A Preferred Stock due to additional accumulated dividends, theSeries A Preferred Stock now contains a “beneficial conversion feature”subject to recognition pursuant to Issue No. 98-5.

In conjunction with the modification of the agreement,the Company issued a warrant to the Series A Preferred stockholder. Thevalue of the warrant was considered in determining the value of the modifiedsecurity. The warrant is convertible into shares of the Company’s common stockduring the period between January 2006 and January 2009. Theconversion price of the warrant initially was $7.12, which was equal to theSeries A Preferred Stock conversion price in effect as of January 20,2006. The conversion price of the warrant decreases by approximately 4.8% peryear during the conversion period, such that the number of shares of theCompany’s common stock issuable upon conversion of the warrant will increase byapproximately 5.1% per year. The conversion of the warrant will be satisfiedonly by surrender of the outstanding shares of Series A Preferred Stock.

The Series A Preferred Stock accrued dividendsthrough January 20, 2006, which is the date the warrant initially becameexercisable. As a result of the issuance of the warrant, the preferred stockmay be surrendered in exchange for common stock for an additional three yearsthrough January 20, 2009. As long as the Series A Preferred Stockremains outstanding, the number of shares into which the warrant can beconverted increases as the conversion price of the warrant decreases resultingin additional deemed dividends on the Series A Preferred Stock. For thethree and six months ended June 30, 2007, the Company recognized Series APreferred Stock deemed dividends of approximately $0.2 and $0.3 million,respectively, attributable to the beneficial conversion feature from theaccrued dividends and decreasing warrant price. The Company will continue torecognize Series A Preferred Stock deemed dividends until the earlier of,the time the Series A Preferred Stock is surrendered or untilJanuary 2009.

As ofJune 30, 2007, there were 18,158 shares of Series A Preferred Stock outstandingwith an aggregate liquidation preference of approximately $18.2 million. Thewarrant was convertible into 2,739,098 shares of the Company’s common stock ata conversion price of $6.63 as of June 30, 2007.

***OptionExercises***

Employees and consultants exercised options topurchase 164,628 and 226,472 shares of the Company’s common stock with netproceeds to the Company of approximately $0.5 and $0.7 million during the threeand six months ended June 30, 2007, respectively.

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***EmployeeStock Purchase Plan***

In May 2007, the Company sold 72,217 shares under the ESPP.The shares were purchased at a weighted average exercise price of $3.09 withproceeds of approximately $0.2 million.

**NOTE 9.INCOME TAXES**

In July 2006, the Financial Accounting StandardsBoard, or FASB, issued FASB Interpretation No. 48, *Accountingfor Uncertainty in Income Taxes - an interpretation of FASB Statement No. 10*(FIN 48). FIN 48 clarifies the accounting for uncertainty in income taxesrecognized in an entity’s financial statements. Tax positions are evaluated forrecognition using a more-likely-than-not threshold, and those tax positionsrequiring recognition are measured as the largest amount of tax benefit that isgreater than 50 percent likely of being realized upon ultimate settlement witha taxing authority that has full knowledge of all relevant information. FIN 48is effective for fiscal years beginning after December 15, 2006.

The Company adopted the provisions of FIN 48 on January 1,2007. As of January 1, 2007 and June 30, 2007, the Company had$2.3 million and $2.7 million of unrecognized tax benefits, which isnetted against deferred tax assets and is fully offset by a valuationallowance. Upon adoption of FIN 48, no adjustment was made to the Company’sliability for uncertain tax positions or the Company’s beginning accumulateddeficit balance. The adoption of FIN 48 did not have a material impact onthe Company’s financial statements, results of operations or cash flows.

All tax years since inception remain open toexamination by the Internal Revenue Service and the California Franchise TaxBoard until such time the Company’s net operating losses and credits are eitherutilized or expire. Interest and penalties, if any, related to unrecognized taxbenefits, would be recognized as income tax expense by the Company. As of thedate of adoption of FIN 48, the Company did not have any accrued interestor penalties associated with unrecognized tax benefits.  The Company does not foresee any materialchanges to unrecognized tax benefits within the next twelve months.

**NOTE 10.SUBSEQUENT EVENTS**

***EspritPharma***

In July 2007, the Companyentered into a termination and assignment agreement with Esprit terminating theexclusive license agreement originally entered into in July 2005 andsubsequently amended in July 2006, in which the Company granted Espritmarketing and distribution rights for in the United States for ProQuin XR. Therelated supply agreement entered into in July 2005 and co-promotion agreemententered into in July 2006 were also terminated.

Upon entering into thetermination and assignment agreement, the marketing and distribution rights inthe United States for ProQuin XR were transferred back to the Company andEsprit paid the Company $17.5 million representing (i) a $10.0 million paymentin respect of the final license payment that would have been due to the Companyin July 2007 under the license agreement; (ii) a $2.5 million payment inrespect to a pro-rated portion of minimum royalties for 2007; and (iii) a $5.0million termination fee. The termination and assignment agreement removedEsprit’s future minimum royalty obligations to the Company.

***WatsonPharmaceuticals***

In July 2007, the Companyentered into a promotion agreement with Watson Pharmaceuticals (Watson)granting Watson a co-exclusive right to promote ProQuin XR to the urologyspecialty and long-term care facilities in the United States.  Watson isrequired to deliver a minimum number of annual sales detail calls to urologistsand to maintain a sales force of a minimum size.  Watson will receive a promotion fee equal toan agreed upon portion of gross margin attributable to the urology specialtyand long-term care facilities above an agreed upon baseline level. The Companywill be responsible for the manufacture and distribution of ProQuin XR and eachparty will bear all of its own personnel and other costs, including marketingexpenses.  The term of the promotionagreement is three years, subject to early termination in certaincircumstances, with up to two additional one-year renewal periods at theelection of Watson. The Company has retained the right to promote ProQuinXR to physicians outside the urology and long-term care markets, either directlyor through third parties.

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**ITEM 2.MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OFOPERATIONS**

### **FORWARD-LOOKINGINFORMATION**

Statements made in this “Management’s Discussion andAnalysis of Financial Condition and Results of Operations” and elsewhere inthis Quarterly Report on Form 10-Q that are not statements of historicalfact are forward-looking statements within the meaning of Section 27A ofthe Securities Act of 1933, as amended (the Securities Act), andSection 21E of the Securities Exchange Act of 1934, as amended. We havebased these forward-looking statements on our current expectations andprojections about future events. Our actual results could differ materiallyfrom those discussed in, or implied by, these forward-looking statements.Forward-looking statements are identified by words such as “believe,” “anticipate,”“expect,” “intend,” “plan,” “will,” “may” and other similar expressions. Inaddition, any statements that refer to expectations, projections or other characterizationsof future events or circumstances are forward-looking statements.Forward-looking statements include, but are not necessarily limited to, thoserelating to:

·    the success of GLUMETZATM andProQuin® XR in the United States;

·    the success of ourcollaborative arrangement with King Pharmaceuticals with respect to GLUMETZA;

·    the success of ourcollaborative arrangement with Watson Pharmaceuticals with respect to ProQuinXR;

·    our ability to obtainmarketing partners for Gabapentin GRTM and other product candidates;

·    market acceptance of GLUMETZAand ProQuin XR;

·    the efforts of Biovail withrespect to the marketing of GLUMETZA in Canada;

·    our collaborative partners’compliance or non-compliance with their obligations under our agreements withthem;

·    results and timing of ourclinical trials, including the results of Gabapentin GR trials and publicationof those results;

·    our ability to raiseadditional capital; and

·    ourplans to develop other product candidates.

Factors that could causeactual results or conditions to differ from those anticipated by these andother forward-looking statements include those more fully described in the “**RISK FACTORS**” section and elsewhere in this QuarterlyReport on Form 10-Q. We disclaim any intent to update or revise theseforward-looking statements to reflect new events or circumstances.

**ABOUT DEPOMED**

Depomed is a specialtypharmaceutical company focused on the development and commercialization ofdifferentiated products that address large and growing markets and are based onproprietary oral drug delivery technologies. We have developed two commercial products.  GLUMETZA (metformin hydrochloride extendedrelease tablets) is a once-daily treatment for adults with type 2 diabetes thatwe jointly commercialize in the United States with King Pharmaceuticals.  ProQuin XR (ciprofloxacin hydrochlorideextended release tablets) is a once-daily treatment for uncomplicated urinarytract infections.

We have a three-prongedapproach to product development designed to optimize the use and value of ourdrug delivery technologies, while managing the costs and risks associated withdeveloping and commercializing pharmaceutical products.  We develop products for our own account thatare designed to compete in large growing markets and that can be highlydifferentiated from immediate release versions of the compounds upon which theyare based.  Second, we selectively enterinto collaborative partnerships with other companies where the uniquecapabilities of our technology can provide superior value to a partner’scompound, resulting in significantly greater value for Depomed than atraditional fee-for-service arrangement. Third, we enter into arrangements that enable our technology to beapplied by other companies to a greater number of compounds than ourinfrastructure can support, so as to derive additional value from ourtechnology.  In the future, we plan to commercializeour proprietary products, relying on partners to cover the large primary careaudiences, while maintaining co-promotion and distribution rights in order tobe in a position to create our own sales force when appropriate, therebyincreasing the value to us of our products, and our control over them.

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Our most advanced productcandidate in development is Gabapentin GR, an extended release form ofgabapentin. In July 2007, we announced that the primary endpoint of our Phase 3clinical trial for the treatment of postherpetic neuralgia (PHN) was notachieved with statistical significance and are currently evaluating thoseresults.****We have also completed and announcedpositive results of a Phase 2 clinical trial for the treatment of diabeticperipheral neuropathy (DPN), and initiated a Phase 2 clinical trial for thetreatment of menopausal hot flashes. Additionally, we have other productcandidates in earlier stages of development, including a treatment forgastroesophageal reflux disease (GERD).

Our intellectual property position includes nineissued patents and fifteen patent applications pending in the United States.

***Significant Developments for theQuarter Ended June 30, 2007***

·    In June 2007, we enrolled ourfirst patient in a Phase 2 clinical trial for Gabapentin GR for the treatmentof menopausal hot flashes;

·    In April 2007, we completed aregistered direct offering of 5,300,000 shares of common stock with selectedinstitutional investors and received net proceeds of approximately $20.0million;

·    In April 2007, we submitted aprior approval supplement to the FDA covering the 1000mg GLUMETZA seekingapproval to market the product in the United States;

·    Revenues for the three monthsended June 30, 2007 were $3.6 million compared to $2.2 million for the threemonths ended June 30, 2006;

·    Operating expenses for thethree months ended June 30, 2007 were $12.5 million compared to $11.7 millionfor the three months ended June 30, 2006;

·    Cash,cash equivalents and marketable securities were $35.4 million as of June 30,2007, compared to $33.6 million as of December 31, 2006.

**RECENT PRODUCT DEVELOPMENTS**

***MARKETED PRODUCTS***

***GLUMETZATM***

In April 2007, we submitted a prior approvalsupplement to the FDA covering the 1000mg GLUMETZA seeking approval to marketthe product in the United States. In August 2007, we received an approvableletter from the FDA in response to the prior approval supplement.  The conditions to approval set forth in theletter relate primarily to manufacturing, and we are working with Biovail toresolve them.  We expect that theconditions will be satisfied, and the 1000mg GLUMETZA to be commerciallyavailable in the first quarter of 2008.

*LG Life Sciences*.  In January 2007, we amended our GLUMETZAlicense agreement with LG covering Korea. We granted LG a license tomanufacture the 500mg GLUMETZA in exchange for royalties on net sales ofGLUMETZA in Korea, and removed the provisions of the original agreementproviding for the supply of 500mg GLUMETZA tablets by the Company to LG.

***ProQuin® XR***

*Esprit Pharma*.  In July 2007, we entered into a terminationand assignment agreement with Esprit terminating the exclusive license andmarketing agreement originally entered into in July 2005 and subsequentlyamended in July 2006, in which we previously granted Esprit ProQuin XRmarketing and distribution rights in the United States. The related supplyagreement entered into in July 2005 and co-promotion agreement entered into inJuly 2006 were also terminated.

Upon entering into thetermination and assignment agreement, the marketing and distribution rights inthe United States for ProQuin XR were transferred back to us and Esprit paid us$17.5 million representing (i) a $10.0 million payment in respect of the finallicense payment that would have been due to us in July 2007 under the exclusivelicense and marketing agreement; (ii) a $2.5 million payment in respect to apro-rated portion minimum royalties for 2007; and (iii) a $5.0 milliontermination fee. The termination and assignment agreement removed Esprit’sfuture minimum royalty obligations to us.

Under the termination andassignment agreement, Esprit is responsible for all returns and rebatesassociated with ProQuin XR product distributed by Esprit prior to the effectivedate of the agreement. Esprit is also responsible to continue detailing ProQuinXR to physicians through the earliest to occur of (i) September 15, 2007; (ii)the occurrence of a change in control of Esprit; or (iii) an earlier date asrequested by us.

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As of June 30, 2007, wehave received $40.0 million in license fees under our license agreement withEsprit for ProQuin XR.  We received $30.0million in license fees in July 2005 and an additional $10.0 million inDecember 2006. The final $10.0 installment was due in July 2007. Through June30, 2007, the $40.0 million in license fees received was recognized as revenueratably commencing on our receipt of the fees through June 2020, whichrepresented the length of time we were obligated to manufacture ProQuin XRunder our ProQuin XR supply agreement with Esprit. In July 2007, we and Espritterminated the license and supply agreements and we no longer have continuingperformance obligations to Esprit. Accordingly, we anticipate the remainingdeferred revenue of $36.1 million at June 30, 2007 will be recognized aslicense revenue in the third quarter of 2007.

*Watson Pharmaceuticals*.  In July 2007, we entered into a promotionagreement with Watson granting Watson a co-exclusive right to promote ProQuinXR to the urology specialty and long-term care facilities in the UnitedStates.  Watson is required to deliver a minimum number of annual salesdetail calls to urologists and to maintain a sales force of a minimum size.  Watson will receive a promotion fee equal toan agreed upon portion of gross margin attributable to the urology specialtyand long-term care facilities above an agreed upon baseline level. We will beresponsible for the manufacture and distribution of ProQuin XR. Each party willbear all of its own personnel and other costs, including marketingexpenses.  The term of the PromotionAgreement is three years, subject to early termination in certaincircumstances, with up to two additional one-year renewal periods at theelection of Watson. We have retained the right to promote ProQuin XR tophysicians outside the urology and long-term care markets, either directly orthrough third parties. We expect to re-launch ProQuin XR in the second half of2007.

*Madaus*.  In November 2005, we entered into adistribution and supply agreement for ProQuin XR in Europe with a privatelyowned specialty pharmaceutical company, Madaus S.r.l. Under the terms of theagreement, we granted an exclusive right to Madaus for the commercialization ofProQuin XR in Europe and agreed to supply Madaus with commercial quantities ofProQuin XR tablets in bulk form.  In March 2006, Madaus filed aMarketing Authorization Application for ProQuin XR with the Medical ProductsAgency in Sweden.  We are in the process of assisting Madaus with aresponse to comments and questions on the Marketing Authorization Applicationthat Madaus received in May 2007.  Madaus is required to submit itsresponse to the Swedish Medical Products Agency’s questions and comments inAugust 2007.  We anticipate that the Medical Products Agency will act onthe response submitted by Madaus before the end of the first quarter of 2008.

***PRODUCT CANDIDATES***

## ***Gabapentin GR*****TM**

*Postherpetic Neuralgia*.  In May 2006, we initiated a Phase 3 clinicaltrial for Gabapentin GR for the treatment of PHN.  The study was a randomized, double-blind,placebo-controlled study of approximately 400 PHN patients.  The study was fully enrolled in early March2007.  Patients in the study wererandomized into three treatment arms: placebo, a total daily dose of 1800mg of Gabapentin GR dosed once daily,and a total daily dose of 1800mg of Gabapentin GR dosed twice daily.

The primary objective ofthe study was to assess the efficacy of Gabapentin GR in reducing the painassociated with PHN, measured from baseline pain scores to the end of aten-week treatment period on the basis of the Likert pain scale.  Secondary objectives include an assessment ofchanges from baseline in sleep interference, and additional patient andclinician assessments of pain and quality of life.

In July 2007, weannounced the primary endpoint was not achieved with statistical significancefor either active treatment regimen, as compared to placebo, over the ten-weektreatment period. The mean reductions in average daily pain scores frombaseline to end of study were 1.83 (once-daily), 1.72 (twice-daily) and 1.43(placebo). However, statistical significance relative to placebo was achievedin each of the first six weeks for the once-daily treatment arm and in each ofthe first five weeks for the twice-daily treatment arm. Pain scores in theplacebo group continued to improve in the last four weeks of the study.

The secondary endpointsof sleep interference, Clinical Global Impression of Change (CGIC), a scaleused by physicians for overall assessment of patient improvement, and PatientGlobal Impression of Change (PGIC), a scale used by patients to report theiroverall assessment of change, were all statistically significant for the once-dailytreatment compared to placebo over the ten week study period. Sleepinterference scores were reduced by 2.01 points with Gabapentin GR compared to-1.39 with placebo (p=0.014). Physicians reported that 48.0% of patients takingGabapentin once-daily were “very much improved” or “much improved” compared to27.1% of the patients who received placebo (p<0.001), as measured by theCGIC. Similar results were observed for the PGIC in the once-daily and placeboarms (p=0.009).

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We are currentlyanalyzing the clinical trial data and have not yet determined whether we willconduct one or more additional clinical trials, either alone or with acollaborative partner.

*Menopausal Hot Flashes*.  In April 2007, we commenced a Phase 2 studyof Gabapentin GR for the treatment of menopausal hot flashes assessing therelationship between various doses and dosing schedules of Gabapentin GR andthe safety and efficacy of the formulation of Gabapentin GR for the treatmentof menopausal hot flashes. In June 2007, we enrolled our first patient in thePhase 2 clinical trial. The study is a double-blind, placebo-controlled,multi-center trial of approximately 108 menopausal women experiencing recurrentmoderate to severe hot flashes. The primary endpoint of the trial is the frequencyand severity of hot flashes, relative to baseline. Secondary endpoints include,among others, the efficacy of Gabapentin GR relative to placebo based onchanges from baseline to the end of each treatment period, average dailyfrequency and severity score of hot flashes and sleep quality.

***Gastroesophageal Reflux DiseaseProgram***

In 2006, we conducted a Phase 1 study of the GERDtreatment omeprazole, a generic proton pump inhibitor, designed to provide uswith insight into our formulation strategy for our GERD program.  We have also conducted two proof of conceptstudies related to our GERD program.  Inthe initial study, we determined that our gastric retentive omeprazole tabletcan deliver a pulse of omeprazole 4 to 6 hrs after ingestion.  In the second study, we are investigating theeffect on nighttime stomach acid levels observed when omeprazole is deliveredin two pulses. The first pulse is with the evening meal and the second sometimelater.  Our analysis of the results ofthe second study will be completed in August 2007.

***OTHERRESEARCH AND DEVELOPMENT AND COLLABORATIVE PROGRAMS***

*Supernus*.  In September 2006, we entered into acollaboration agreement with Supernus Pharmaceuticals, Inc. to develop througha Phase 1 study a product candidate leveraging our AcuForm drug deliverytechnology.  The cost and ownership ofthe program will be shared between the parties equally. We continue toparticipate with Supernus on this collaborative program.

*Biovail*.  In February 2007, we entered into a licenseand development agreement with Biovail granting Biovail an option to licenseour AcuForm drug delivery technology to develop and commercialize up to twopharmaceutical products. Pursuant to the agreement, Biovail paid us an upfrontfee of $0.5 million in February 2007, and is contingently obligated to pay usadditional fees related to the exercise of the license option, the initiationof the first Phase 3 trial for each product and upon receipt of U.S. regulatoryapproval for each product.   Theagreement also stipulates that Biovail make royalty payments to us on netcommercial sales of any product developed under the agreement.

Also in February 2007, weamended our stock purchase agreement with Biovail, which was originally enteredinto in May 2002. The amended stock purchase agreement removed Biovail’sobserver rights on our board of directors and removed the right of firstnegotiation in favor of Biovail with respect to any acquisition transactions ofDepomed.

*New River*.* *In June 2005,we entered into a development and license agreement with New RiverPharmaceuticals, Inc. (New River) to develop through the feasibility phase upto three proprietary New River compounds in combination with ourAcuForm technology.  Pursuant to the agreement, New River isobligated to fund any research and development under the agreement, and NewRiver may acquire worldwide rights to use our AcuForm technology in theproduct candidates for agreed-upon milestone payments and royalties. Through January 2007, New River had proposed three product candidates fordevelopment.  In April 2007, Shire Pharmaceuticals, Inc. acquired NewRiver.  We have not commenced any work on any feasibility programs relatedto the proposed product candidates and have received no further informationfrom New River or Shire related to the proposed product candidates since January2007.  We have requested that Shire inform us as to its continuinginterest in the development of the product candidates proposed by New River.

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**CRITICALACCOUNTING POLICIES**

Critical accountingpolicies are those that require significant judgment and/or estimates bymanagement at the time that the financial statements are prepared such thatmaterially different results might have been reported if other assumptions hadbeen made. We consider certain accounting policies related to revenuerecognition, accrued liabilities and stock-based compensation to be criticalpolicies. There have been no changes to our critical accounting policies sincewe filed our 2006 Annual Report on Form 10-K with the Securities andExchange Commission on March 16, 2007. For a description of our criticalaccounting policies, please refer to our 2006 Annual Report on Form 10-K.

### **RESULTSOF OPERATIONS**

*Three and Six Months Ended June 30,2007 and 2006*

### **Revenue**

Totalrevenues are summarized in the following table (in thousands):

|                       | ** ** | **Three Months Ended June 30,** | ** ** | **Six Months Ended June 30,** | ** ** |
|-----------------------|------------|-----------------------------------------------------|------------|---------------------------------------------------|------------|
| ** **            | ** ** | **2007**                                            | ** ** | **2006**                                          | ** ** | **2007** | ** ** | **2006** | ** ** |
| Product sales:        |       |                                                |       |                                              |       |   |   |   |   |
| GLUMETZA              |       | $                                                   | 2,502      |                                              | $          | — |   | $ | 3,833 |   | $ | — |   |
| ProQuin XR            |       | —                                              |       | 1,165                                             |       | — |   | 1,265 |   |
| Total product sales   |       | 2,502                                               |       | 1,165                                             |       | 3,833 |   | 1,265 |   |
|                  |       |                                                |       |                                              |       |   |   |   |   |
| Royalties:            |       |                                                |       |                                              |       |   |   |   |   |
| GLUMETZA              |       | 45                                                  |       | 9                                                 |       | 79 |   | 98 |   |
| ProQuin XR            |       | —                                              |       | 71                                                |       | — |   | 332 |   |
| Total royalties       |       | 45                                                  |       | 80                                                |       | 79 |   | 430 |   |
|                  |       |                                                |       |                                              |       |   |   |   |   |
| License revenue:      |       |                                                |       |                                              |       |   |   |   |   |
| GLUMETZA              |       | 364                                                 |       | 382                                               |       | 1,632 |   | 764 |   |
| ProQuin XR            |       | 695                                                 |       | 511                                               |       | 1,391 |   | 1,022 |   |
| AcuForm  technology   |       | —                                              |       | —                                            |       | 500 |   | — |   |
| Total license revenue |       | 1,059                                               |       | 893                                               |       | 3,523 |   | 1,786 |   |
|                  |       |                                                |       |                                              |       |   |   |   |   |
| Collaborative revenue |       | 2                                                   |       | 75                                                |       | 2 |   | 75 |   |
|                  |       |                                                |       |                                              |       |   |   |   |   |
| Total revenues        |       | $                                                   | 3,608      |                                              | $          | 2,213 |   | $ | 7,437 |   | $ | 3,556 |   |

 

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***Productsales***

The GLUMETZAproduct that we began selling to wholesalers and retail pharmacies in September2006 is subject to rights of return of up to twelve months after productexpiration. Given the limited sales history of GLUMETZA and return privileges,we currently cannot reliably estimate expected returns of the product at thetime of shipment.  We defer recognitionof revenue on product shipments of GLUMETZA until the right of return no longerexists, which occurs at earlier of the time GLUMETZA units are dispensedthrough patient prescriptions or expiration of the right of return. We estimatethe volume of prescription units dispensed by pharmacies based on an analysisof third-party information, including third-party market research data, informationobtained from certain wholesalers with respect to inventory levels andout-movement and retail pharmacy re-stocking activity. For the three and sixmonths ended June 30, 2007, we recognized approximately $2.5 million and $3.8million of product sales of GLUMETZA, respectively, which is net of estimatedpatient support program discounts, wholesaler fees, stocking allowances, promptpayment discounts, chargebacks and Medicaid rebates. We have deferredrecognition of revenue on GLUMETZA product shipments to customers which weestimate have not been dispensed through patient prescriptions. At June 30,2007, we have a deferred revenue balance, which is classified as a liability onthe consolidated balance sheet, of $3.5 million associated with the deferral ofrevenue on GLUMETZA product shipments, which is net of estimated patientsupport program discounts, wholesaler fees, stocking allowances, prompt paymentdiscounts, chargebacks and Medicaid rebates.

ProQuin XR productsales in 2006 relate to our supply agreement with Esprit. We began supplyingEsprit with commercial quantities of ProQuin XR in the fourth quarter of 2005.There were no product sales of ProQuin XR in 2007. The supply agreement wasterminated in July 2007.

***Royalties***

GLUMETZA royaltiesfor the three and six months ended June 30, 2007 relate to royalties wereceived from Biovail based on net sales of GLUMETZA in Canada and royalties wereceived from LG based on net sales of GLUMETZA in Korea. We began receivingroyalties from LG in the first quarter of 2007.

In July 2007, weterminated our license and distribution agreement with Esprit which providedfor royalty payments by Esprit to us on ProQuin XR net sales in the UnitedStates. As a result of returns of product to Esprit, Esprit was not obligatedto pay us any royalties for the three and six months ended June 30, 2007.Accordingly, we recognized no royalty revenue on ProQuin XR for the three andsix months ended June 30, 2007. Under the termination and assignment agreement,Esprit paid us $2.5 million in royalties in July 2007, which we anticipate willbe recognized as royalty revenue in the third quarter of 2007. Esprit will nolonger be obligated to pay us royalties on ProQuin XR sales.

***Licenserevenue***

We received $25.0million in GLUMETZA license fees from Biovail in July 2005. We are recognizingthe $25.0 million license fee payment as revenue ratably until February 2023,which represents the estimated length of time our obligations exist under thearrangement related to royalties we are obligated to pay Biovail on net salesof GLUMETZA in the United States and for our obligation to use Biovail as oursole supplier of the 1000mg GLUMETZA, should the 1000mg GLUMETZA obtainapproval in the United States.

Wealso received a $0.6 million upfront license fee from LG in August 2004 and a$0.5 million milestone payment received in November 2006 with respect to LG’sapproval to market GLUMETZA in the Republic of Korea. These payments wereoriginally deferred and amortized as license revenue over the estimated lengthof time we were obligated to provide assistance in development andmanufacturing. In January 2007, we amended our agreement with LG, granted LG alicense to manufacture the 500mg GLUMETZA in exchange for royalties on netsales of GLUMETZA in Korea, and removed the provisions of the originalagreement providing for the supply of 500mg GLUMETZA tablets by us to LG. Underthe amended agreement, we no longer have continuing performance obligationsthat are other than inconsequential or perfunctory to LG. Accordingly, theremaining $0.9 million of previously deferred revenue was recognized as licenserevenue in the first quarter of 2007.

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As of June 30,2007, we have received $40.0 million in license fees under our licenseagreement with Esprit for ProQuin XR.  Wereceived $30.0 million in license fees in July 2005 and an additional $10.0million in December 2006. The final $10.0 installment was due in July 2007.Through June 30, 2007, the $40.0 million in license fees received wasrecognized as revenue ratably commencing on our receipt of the fees throughJune 2020, which represented the length of time we were obligated tomanufacture ProQuin XR under our ProQuin XR supply agreement with Esprit. InJuly 2007, we and Esprit terminated the license and supply agreements and we nolonger have continuing performance obligations to Esprit. Accordingly, weanticipate the remaining deferred revenue of $36.1 million at June 30, 2007will be recognized as license revenue in the third quarter of 2007. In July 2007,we received the final $10.0 million installment as part of the terminationagreement, which we anticipate will be recognized as license revenue in July2007.

InFebruary 2007, we received $0.5 million from Biovail upon entering into alicense and development agreement with Biovail granting Biovail an option tolicense our AcuForm drug delivery technology to develop and commercialize up totwo pharmaceutical products. We have no continuing performance obligations thatare other than inconsequential or perfunctory under the agreement. Accordingly,we have recognized the entire upfront license fee as revenue in the firstquarter of 2007.

**Cost ofSales**

Cost of sales consists ofcosts of the active pharmaceutical ingredient, contract manufacturing andpackaging costs, product quality testing, internal employee costs related tothe manufacturing process, distribution costs and shipping costs related to ourproduct sales. Total cost of sales for the three and six months ended June 30,2007, as compared to the prior year, was as follows (in thousands):
|               | ** ** | **Three Months Ended June 30,** | ** ** | **Six Months Ended June 30,** | ** ** |
|---------------|------------|-----------------------------------------------------|------------|---------------------------------------------------|------------|
| ** **    | ** ** | **2007**                                            | ** ** | **2006**                                          | ** ** | **2007** | ** ** | **2006** | ** ** |
| Cost of sales |       | $                                                   | 569        |                                              | $          | 1,051 |   | $ | 874 |   | $ | 1,125 |   |
|               |            |                                                     |            |                                                   |            |  |  |  |  |  |  |  |  |

 

Cost of sales for thethree and six months ended June 30, 2007 relates primarily to costs associatedwith the sale of GLUMETZA.  Costs ofsales for the three and six months ended June 30, 2006 relates primarily tocosts associated with the supply of ProQuin XR to Esprit. The costs ofmanufacturing associated with deferred revenue on GLUMETZA product shipmentsare recorded as deferred costs, which are included in inventory, until suchtime the deferred revenue is recognized.

**Researchand Development Expense**

Our research anddevelopment expenses currently include costs for scientific personnel,supplies, equipment, outsourced clinical and other research activities,consultants, depreciation, facilities and utilities. The scope and magnitude offuture research and development expenses cannot be predicted at this time forour product candidates in the early phases of research and development, as itis not possible to determine the nature, timing and extent of clinical trialsand studies, the FDA’s requirements for a particular drug and the requirementsand level of participation, if any, by potential partners. As potentialproducts proceed through the development process, each step is typically moreextensive, and therefore more expensive, than the previous step. Success indevelopment therefore, generally results in increasing expenditures untilactual product launch. Furthermore, our business strategy involves licensingcertain of our drug candidates to collaborative partners. Depending upon whensuch collaborative arrangements are executed, the amount of costs incurredsolely by us will be impacted. Total research and development expense for thethree and six months ended June 30, 2007, as compared to the prior year, was asfollows (in thousands):
|                                    | ** ** | **Three Months Ended June 30,** | ** ** | **Six Months Ended June 30,** | ** ** |
|------------------------------------|------------|-----------------------------------------------------|------------|---------------------------------------------------|------------|
| ** **                         | ** ** | **2007**                                            | ** ** | **2006**                                          | ** ** | **2007** | ** ** | **2006** | ** ** |
| Research and  development expense  |       | $                                                   | 6,129      |                                              | $          | 6,768 |   | $ | 14,701 |   | $ | 12,452 |   |
| Dollar change  from prior year     |       | (639                                                | )          |                                              |       | 2,249 |   |   |   |
| Percentage change from  prior year |       | (9.4                                                | )%         |                                              |       | 18.1 | % |   |   |
|                                    |            |                                                     |            |                                                   |            |  |  |  |  |  |  |  |  |

 

The decrease in researchand development expense for the three months ended June 30, 2007 as compared tothe three months ended June 30, 2006 was primarily due to lower outsidecontract service expenses for our clinical trial expenses related to thecompletion of the Phase 3 clinical trial for Gabapentin GR for the treatment ofpostherpetic neuralgia. The decrease was partially offset by outside contractservice expenses for our clinical trial expenses associated with our Phase 2clinical trial for Gabapentin GR for the treatment of menopausal hot flashes.

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The increase in researchand development expense for the six months ended June 30, 2007 as compared tothe six months ended June 30, 2006 was primarily due to higher outside contractservice expenses for our clinical trial expenses related to our Phase 2clinical trial for Gabapentin GR for the treatment of menopausal hot flashesand costs associated with our Phase 2a proof-of-concept GERD formulationstudies.

We are currentlyanalyzing the clinical trial data results of our Phase 3 clinical trial forGabapentin GR for the treatment of postherpetic neuralgia which did not meetits primary endpoint. We may decide to commence one or more additional Phase 3trials for Gabapentin GR for the treatment of postherpetic neuralgia eitheralone or with a collaborative partner, which may result in increased researchand development expense in future periods.

**Selling,General and Administrative Expense**

Selling,general and administrative expenses primarily consist of personnel expenses tosupport our operating activities, marketing and promotion expenses associatedwith GLUMETZA, facility costs and professional expenses, such as legal andaccounting fees. Total selling, general and administrative expenses, ascompared to the prior year, were as follows (in thousands):
|                                      | ** ** | **Three Months Ended June 30,** | ** ** | **Six Months Ended June 30,** | ** ** |
|--------------------------------------|------------|-----------------------------------------------------|------------|---------------------------------------------------|------------|
| ** **                           | ** ** | **2007**                                            | ** ** | **2006**                                          | ** ** | **2007** | ** ** | **2006** | ** ** |
| Selling, general  and administrative |       | $                                                   | 6,323      |                                              | $          | 4,898 |   | $ | 12,550 |   | $ | 8,830 |   |
| Dollar change  from prior year       |       | 1,425                                               |       |                                              |       | 3,720 |   |   |   |
| Percentage change from  prior year   |       | 29.1                                                | %          |                                              |       | 42.1 | % |   |   |
|                                      |            |                                                     |            |                                                   |            |  |  |  |  |  |  |  |  |

 

The increase in selling,general and administrative expense for the three months ended June 30, 2007 ascompared to the three months ended June 30, 2006 was primarily due to $0.7million in promotion fees due to King under the promotion agreement forGLUMETZA, which was launched in September 2006, and $0.6 million in marketingcosts associated with GLUMETZA.

The increase in selling,general and administrative expense for the six months ended June 30, 2007 ascompared to the six months ended June 30, 2006 was primarily due to an increaseof $1.2 million in marketing costs associated with GLUMETZA, a $1.3 millionincrease in legal fees resulting from our patent infringement case againstIVAX, $0.9 million in promotion fees due to King under the promotion agreementfor GLUMETZA, and a $0.6 million increase in consulting expenses.

**Interestand Other Income**
|                                    | ** ** | **Three Months Ended June 30,** | ** ** | **Six Months Ended June 30,** | ** ** |
|------------------------------------|------------|-----------------------------------------------------|------------|---------------------------------------------------|------------|
| ** **                         | ** ** | **2007**                                            | ** ** | **2006**                                          | ** ** | **2007** | ** ** | **2006** | ** ** |
| Interest and  other income         |       | $                                                   | 456        |                                              | $          | 586 |   | $ | 866 |   | $ | 1,181 |   |
| Dollar change  from prior year     |       | (130                                                | )          |                                              |       | (315 | ) |   |   |
| Percentage change from  prior year |       | (22.2                                               | )%         |                                              |       | (26.7 | )% |   |   |
|                                    |            |                                                     |            |                                                   |            |  |  |  |  |  |  |  |  |

 

Interest and other income decreased during the threeand six months ended June 30, 2007 as compared to the corresponding periods in2006 as a result of lower investment balances in 2007.

**LIQUIDITYAND CAPITAL RESOURCES**
| (in thousands)                               | ** ** | **June 30,  2007** | ** ** | **December 31,  2006** | ** ** |
|---------------------------------------------------|------------|-------------------------|------------|-----------------------------|------------|
| Cash, cash  equivalents and marketable securities |       | $                       | 35,371     |                        | $          | 33,558 |   |
|                                                   |            |                         |            |                             |            |  |  |

 

Since inception through June 30, 2007, we havefinanced our product development efforts and operations primarily from privateand public sales of equity securities and receipts of upfront license fees fromcollaborative and license partners. InJuly 2005, we received $25.0 million under our license agreement with Biovailand $30.0 million under our license agreement with Esprit. In December 2006, wereceived an additional $10.0 million from Esprit.

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In December 2006, we entered into a common stockpurchase agreement with Azimuth Opportunity, Ltd., pursuant to which Azimuth iscommitted to purchase, from time to time and at our sole discretion, up to thelesser of (a) $30.0 million of our common stock, or (b) 8,399,654 shares ofcommon stock. Sales to Azimuth under the agreement, if any, will occur over a24-month term and will be made at a price equal to the average closing price ofour common stock over a given pricing period, minus a discount ranging fromapproximately 3.8% to 6.4%, which varies based on a threshold price set by us.Upon each sale of the our common stock to Azimuth under the agreement, we havealso agreed to pay Reedland Capital Partners a placement fee equal toapproximately 1.1% of the aggregate dollar amount of common stock purchased byAzimuth. Azimuth is not required to purchase our common stock when the price ofour common stock is below $2 per share. As of June 30, 2007, we have not soldany common stock to Azimuth under this common stock purchase agreement.

In April 2007, we completed a registered directoffering of 5,300,000 shares of common stock with institutional investors. Theshares were sold at a price of approximately $3.78 per share, with net proceedstotaling approximately $20.0 million.

In July 2007, Esprit paid us $17.5 million inconnection with the termination of the license and supply agreement.

As of June 30, 2007, we have accumulated net losses of$203.9 million. We expect to continue to incur operating losses for at leastthe next year. We anticipate that our existing capital resources will permit usto meet our capital and operational requirements through at least the secondquarter of 2008. We base this expectation on our current operating plan, whichmay change as a result of many factors.

Our cash needs may also vary materially from ourcurrent expectations because of numerous factors, including:

·   expenditures related to ourcommercialization and development efforts;

·   results of research anddevelopment efforts;

·   financial terms of definitivelicense agreements or other commercial agreements we enter into, if any;

·   results of our litigationagainst IVAX;

·   changes in the focus anddirection of our research and development programs;

·   technological advances;

·   results of clinical testing,requirements of the FDA and comparable foreign regulatory agencies; and

·   acquisitionsor investment in complimentary businesses, products or technologies.

We will needsubstantial funds of our own or from third parties to:

·   conduct research anddevelopment programs;

·   conduct preclinical andclinical testing; and

·   manufacture(or have manufactured) and market (or have marketed) potential products usingthe AcuForm technology.

Our existingcapital resources may not be sufficient to fund our operations until suchtime as we may be able to generate sufficient revenues to support ouroperations. We have limited credit facilities and, except for the common stockpurchase agreement with Azimuth, we have no other committed sources of capital.To the extent that our capital resources are insufficient to meet our futurecapital requirements, we will have to raise additional funds through the saleof our equity securities or from development and licensing arrangements tocontinue our development programs. We may be unable to raise suchadditional capital on favorable terms, or at all. If we raise additionalcapital by selling our equity or convertible debt securities, the issuance ofsuch securities could result in dilution of our shareholders’ equity positions.If adequate funds are not available we may have to:

·   delay, postpone or terminateclinical trials;

·   curtail other operationssignificantly; and/or

·   obtainfunds through entering into collaboration agreements on unattractive terms.

The inability toraise additional capital would have a material adverse effect on our company.

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### **CashFlows from Operating Activities**

Cash used in operatingactivities for the six months ended June 30, 2007 was approximately $19.0million, compared to cash used in operating activities of approximately $15.5million for the six months ended June 30, 2006. During the six months endedJune 30, 2007 and 2006, cash used in operating activities was primarily due toour net loss adjusted for stock-based compensation, depreciation expense andmovements in working capital. The increase in cash used in operating activitiesfor the six months ended June 30, 2007 as compared to the prior year wasprimarily due to an increase in net loss and a decrease in accounts payable andother accrued liabilities.

**Cash Flows from Investing Activities**

Cash used in investingactivities in the six months ended June 30, 2007 was approximately $6.9 millionand consisted of a net increase in marketable securities. Net cash provided byinvesting activities in the six months ended June 30, 2006 totaledapproximately $10.4 million and consisted of a $10.8 million net decrease inmarketable securities offset by $0.4 million in purchases of laboratory andoffice equipment.

**CashFlows from Financing Activities**

Cash provided by financing activities in thesix months ended June 30, 2007 was approximately$20.9 million compared to cash provided by financing activities ofapproximately $2.4 million for the same period in 2006. In the sixmonths ended June 30, 2007, the amount consistedof $20.0 million in proceeds from our registered direct offering inApril 2007 and $0.9 million in cash proceedsfrom exercises of stock options and our ESPP. In the six months endedJune 30, 2006, the amount consisted primarilyof cash proceeds from the exercises of warrants and stock options.

**Contractual Obligations**

As of June 30, 2007, our aggregate contractualobligations are as shown in the following table (in thousands):
|                    | ** ** | **Less than  1 year** | ** ** | **1-3 years** | ** ** | **More than 3  years** | ** ** | **Total** | ** ** |
|--------------------|------------|---------------------------------|------------|--------------------|------------|----------------------------------|------------|-----------|------------|
| Operating leases   |       | $                               | 1,307      |               | $          | 1,604                            |       | $         | 40         |   | $ | 2,951 |   |
| Other  commitments |       | 60                              |       | —             |       | —                           |       | 60        |       |
|               |       | $                               | 1,367      |               | $          | 1,604                            |       | $         | 40         |   | $ | 3,011 |   |

 

The contractualobligations reflected in this table exclude $3.5 million of contingentmilestone payments we may be obligated to pay in the future under oursublicense agreement with PharmaNova. These payments relate to variousmilestones for the product candidate under the sublicense agreement, includingdosing of the first patient in any Phase 3 trial, submission to the FDA of an NDA,and FDA approval of an NDA. The table above also excludes any future royaltypayments we may be required to pay on products we have licensed or anypromotion fees associated with our promotion agreements with King or Watson.

We are also contractuallyobligated to pay PharmaNova consultancy fees of $30,000 per month throughAugust 2007 under a consulting agreement related to our Gabapentin GR productcandidate for the treatment of menopausal hot flashes.

**ITEM 3.QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK**

Therehave been no significant changes in our market risk compared to the disclosuresin Item 7A of our Annual Report on Form 10-K for the year endedDecember 31, 2006.

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**ITEM 4.CONTROLS AND PROCEDURES**

***Evaluation of DisclosureControls and Procedures***

Anevaluation was performed under the supervision and with the participation ofour management, including the President and Chief Executive Officer along withthe Chief Financial Officer, of the effectiveness of the design and operationof our disclosure controls and procedures as of the end of the period coveredby this quarterly report. Based on that evaluation, our management, includingthe President and Chief Executive Officer along with the Chief Financial Officer,concluded that our disclosure controls and procedures were effective.

Wereview and evaluate the design and effectiveness of our disclosure controls andprocedures on an ongoing basis and to improve our controls and procedures overtime and to correct any deficiencies that we may discover in the future.Our goal is to ensure that our senior management has timely access to allmaterial financial and non-financial information concerning our business. Whilewe believe the present design of our disclosure controls and procedures iseffective to achieve our goal, future events affecting our businessmay cause us to significantly modify our disclosure controls andprocedures.

***Changes in InternalControls***

Therewere no changes in our internal controls over financial reporting during thequarter ended June 30, 2007 that have materially affected, or are reasonablylikely to materially affect, our internal control over financial reporting.

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**PART II – OTHER INFORMATION**

**ITEM 1. LEGAL PROCEEDINGS**

We are involved in legalproceedings relating to some of our intellectual property rights.  InJanuary 2006, we filed a complaint against IVAX Corporation in the U.S.District Court for the Northern District of California for infringement of U.S.Patent Nos. 6,340,475 and 6,635,280, both of which we own.  The patentsrelate to our AcuForm delivery technology. The complaint alleges infringementof our patents by IVAX’s extended release metformin hydrochloridetablets.  In April 2006, IVAX filed an answer and counterclaim, in whichit alleged that the patents in the suit are not infringed by IVAX and areinvalid and unenforceable. In December 2006, the court issued an orderconstruing certain of the claim terms appearing in the patents.  Factdiscovery in the case was completed in July 2007.  Expert discovery isongoing, and the court has set a deadline for the completion of expertdiscovery of September 12, 2007.  The court has also set deadline for thesubmission of summary judgment motions of October 5, 2007.  A trial datehas not yet been set by the court.

**ITEM 1A. RISK FACTORS**

Therisk factors presented below amend and restate the risk factors previouslydisclosed in our Annual Report on Form 10-K for the year ended December 31,2006.

Thefollowing factors, along with those set described above under **“MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIALCONDITION AND RESULTS OF OPERATIONS – LIQUIDITY AND CAPITAL RESOURCES”**should be reviewed carefully, in conjunction with the other informationcontained in this Report and our consolidated financial statements. Thesefactors, among others, could cause actual results to differ materially fromthose currently anticipated and contained in forward-looking statements made inthis Form 10-Q and presented elsewhere by our management from time to time. See“Part I, Item 2—Forward-Looking Information.”

**Our recent Phase 3 trial for Gabapentin GR failedto meet the primary efficacy endpoint and there can be no assurance this drugcandidate will be approved.**

InJuly 2007, we announced that our drug candidate Gabapentin GR failed to meetthe primary efficacy endpoint in a Phase 3 trial for the treatment ofpostherpetic neuralgia (PHN).  We arecurrently analyzing the clinical trial data from this trial and have not yetdetermined whether we will conduct one or more additional clinical trials,either alone or with a marketing partner, or whether we will abandon thefurther development of the drug for this indication.

Ifwe conduct additional trials, we will incur significant additional expenses andwill not know for at least one to two years whether the drug is safe andeffective such that it could be approved for marketing.  Even if these trials are successful, theapproval date for the drug is likely to be significantly delayed, which meansthat we would not receive revenue from drug sales for a number of years, if atall.  If we decide to abandon the furtherdevelopment of Gabapentin GR for PHN, our commercial prospects may be adverselyaffected.

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**We depend heavily on KingPharmaceuticals for the successful commercialization of GLUMETZA in the UnitedStates.**

In June 2006, we enteredinto a promotion agreement with King Pharmaceuticals pursuant to which Kingpromotes GLUMETZA in the United States through its sales force.  Under theagreement, in exchange for promotion fees, King is required to promote GLUMETZAto physicians in the United States, to deliver a minimum number of annualdetail calls to potential GLUMETZA prescribers, and to maintain a sales forceof a minimum size.  Although we haveretained rights to promote GLUMETZA to certain physicians and to retainrevenues from incremental sales generated by physicians we call upon, we havenot yet established a sales force, or contracted with a third party to act asour sales force, and we do not have immediate plans to do so.  Accordingly, the success of the initialcommercialization of GLUMETZA will depend in large part on the efforts of King’ssales force in the promotion of the product. Factors that may affect the success of our promotion arrangement withKing include the following:

·      King may acquire or developalternative products;

·      King may pursuehigher-priority programs, or change the focus of its marketing programs;

·      King may in the futurechoose to devote fewer resources to GLUMETZA;

·      GLUMETZA may fail to achievemarket acceptance; and

·      Kingmay fail to comply with its obligations under our promotion agreement.

Any of the precedingfactors could affect King’s commitment to the collaboration, which, in turn,could adversely affect the commercial success of GLUMETZA.  Any failure to successfully commercializeGLUMETZA could have a material adverse effect on our business, financialconditions, results of operations and cash flows.

**We are responsible for thedistribution of GLUMETZA, and we have limited experience with distribution ofpharmaceutical products.**

We are responsible forthe distribution of GLUMETZA, which is the first product that we havedistributed ourselves.  Although we haveenhanced our in-house commercial operations and distribution capabilities inconnection with the commercial launch of GLUMETZA, our internal resourcesremain limited.  In addition, we haveentered into distribution arrangements with third parties related to GLUMETZA,including Cardinal Health, AmeriSource Bergen and McKesson, and we will dependon them to ensure that GLUMETZA is widely available to support its commercialavailability.  To continue to support ourcommercialization effort related to GLUMETZA and any other product we choose tomarket and distribute, we must continue to enhance our internal commercialinfrastructure, and continue to contract with capable third parties to assistus in our commercialization efforts.  Thedevelopment of that infrastructure will also require substantial resources,which may divert the attention of our management and key personnel.  The efforts of third parties with whom wecontract for distribution of our products may not be successful.  Any failure on our part to successfullydevelop distribution capabilities could cause delays in product sales and incurincreased costs.

**We have limited in-house sales andmarketing resources, which we will require in order to successfully co-promoteGLUMETZA and ProQuin XR through our own sales force.**

Although we have theright to co-promote GLUMETZA and ProQuin XR through our own sales force, orthrough third parties, we have no sales force and limited marketing and salesstaff.  The success of our own promotion effortsfor GLUMETZA, ProQuin XR and any other product candidates that receiveregulatory approval that we choose to market or co-market will require that wesubstantially enhance our in-house marketing and sales force with technicalexpertise, or make arrangements with third parties to perform theseservices for us.  The development of theinfrastructure associated with these activities involves substantial resources,and considerable attention of our management and key personnel. To the extentthat we enter into marketing and sales arrangements with other companies, ourrevenues will depend on the efforts of others. These efforts may not be successful.  If we fail to fully develop marketing andsales capabilities, or enter into arrangements with third parties, our revenuesmay suffer.

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**We****depend on Watson Pharmaceuticalsfor the successful commercialization of ProQuin XR in the United States.**

In July 2007, we grantedWatson Pharmaceuticals the co-exclusive marketing rights to ProQuin XR in theUnited States for urology specialty andlong-term care sales channels.  Asdescribed above, we do not have a commercial sales force and do not, for theforeseeable future, expect to have the resources to successfully promote ProQuinXR on our own.  Accordingly, we willdepend on Watson to successfully promote this drug.  Our prior marketing partner for ProQuin XR,Esprit Pharma, was unable to successfully commercialize ProQuin XR followingits initial launch in November 2005.  Asa result, we and Esprit agreed to terminate the license in July 2007.  It is possible that Watson could also havesimilar difficulties commercializing ProQuin XR.  If Watson fails to successfullycommercialize ProQuin XR, our business, financial condition and results ofoperations may be materially and adversely affected.

**We depend on our marketing partnersfor the successful commercialization of GLUMETZA in Canada and Korea, and ofProQuin XR in Europe.**

We have licensedexclusive marketing rights to the 500mg GLUMETZA in Canada to Biovail, and inKorea to LG Life Sciences.  Biovaillaunched the 500mg GLUMETZA in Canada in November 2005, and LG launchedthe 500mg GLUMETZA in Korea in 2006 under the trade name Novamet GR.  We have also entered into a supply anddistribution agreement with Madaus related to the commercialization of ProQuinXR in Europe.  If Biovail fails tosuccessfully commercialize GLUMETZA in Canada and/or LG fails to successfullycommercialize Novamet GR in Korea, our business and future revenues may beadversely affected.

**The development of drug candidates is inherentlyuncertain and we cannot be certain that any of our product candidates will beapproved for marketing or, if approved, will achieve market acceptance.**

We have the following programs in clinical development: Gabapentin GR for postherpetic neuralgia, Gabapentin GRfor diabetic peripheral neuropathy, Gabapentin GR for the treatment ofhot flashes associated with menopause and a compound for the treatment of gastroesophageal reflux disease.  Wealso have other product candidatesin earlier stages of development.

Our own productcandidates and those of our collaborative partners are subject to the risk thatany or all of them are found to be ineffective or unsafe, or otherwisemay fail to receive necessary regulatory clearances.  Additionally,clinical trial results in earlier trials may not be indicative of results thatwill be obtained in subsequent larger trials, as was the case with our recentlycompleted Phase 3 trial for Gabapentin GR for the treatment of postherpeticneuralgia.

We are unable to predictwhether any of these product candidates will receive regulatory clearances orbe successfully manufactured or marketed. Further, due to the extended testing and regulatory review process requiredbefore marketing clearance can be obtained, the time frames forcommercialization of any products are long and uncertain.  Even if these other product candidatesreceive regulatory clearance, our products may not achieve or maintainmarket acceptance. Also, substantially all of our product candidates use theAcuForm technology.  If it isdiscovered that the AcuForm technology could have adverse effects or othercharacteristics that indicate it is unlikely to be effective as a deliverysystem for drugs or therapeutics, our product development efforts and ourbusiness would be significantly harmed.

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**We are expecting operating losses in the future.**

To date, we have recordedlimited revenues from license fees, product sales, royalties, collaborativeresearch and development arrangements and feasibility studies. For the sixmonths ended June 30, 2007, we recorded total revenues of $7.4 million, and forthe years ended December 31, 2006, 2005 and 2004, we recorded totalrevenue of $9.6 million, $4.4 million and $0.2 million, respectively. For thesix months ended June 30, 2007, we incurred a net loss of $19.8 million, andfor the years ended December 31, 2006, 2005 and 2004 we incurred netlosses of $39.7 million, $24.5 million and $26.9 million, respectively. Weexpect the termination of our license agreement with Esprit in July 2007 andaccelerated recognition of previously deferred revenue under the arrangementwill allow us to be profitable for the third quarter of 2007. As we incurexpenses related to the commercialization of GLUMETZA and continue our researchand development efforts, preclinical testing and clinical trial activities, weanticipate that we will incur operating losses in the fourth quarter of 2007and at least through fiscal year 2008. Therefore, we expect our cumulativelosses to increase. These losses, among other things, have had, and we expectthat they will continue to have, an adverse impact on our total assets,shareholders’ equity and working capital.

**Our operating resultsmay fluctuate and affect our stock price.**

The following factorswill affect our operating results and may result in a material adverseeffect on our stock price:

·      results of clinical trialsfor our product candidates;

·      announcements regardingdevelopment plans for our drug candidates, including Gabapentin GR;

·      the degree of commercialsuccess of ProQuin XR and GLUMETZA;

·      regulatory actions;

·      results of litigation,including our pending litigation against IVAX Corporation;

·      developments concerningproprietary rights, including patents, infringement allegations and litigationmatters;

·      variations in revenuesobtained from collaborative agreements, including milestone payments,royalties, license fees and other contract revenues;

·      decisions by collaborativepartners to proceed or not to proceed with subsequent phases of a collaborationor program;

·      market acceptance of theAcuForm technology;

·      adoption of new technologiesby us or our competitors;

·      the introduction of newproducts by our competitors;

·      manufacturing costs anddifficulties;

·      changes in governmentfunding;

·      third-party reimbursementpolicies; and

·      the status of our compliancewith the provisions of the Sarbanes-Oxley Act of 2002.

As a result of these factors, our stock price maycontinue to be volatile and investors may be unable to sell their shares at aprice equal to, or above, the price paid. Additionally, any significant dropsin our stock price, such as the one we experienced following the announcementof our Gabapentin GR Phase 3 trial results, could give rise to shareholderlawsuits, which are costly and time consuming to defend against and which mayadversely affect our ability to raise capital while the suits are pending, evenif the suits are ultimately resolved in our favor.

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**Our collaborative arrangementsmay give rise to disputes over commercial terms, contract interpretationand ownership of our intellectual property and may adversely affect thecommercial success of our products.**

We currently have a collaboration agreement fordevelopment of product candidates through the feasibility phase with New RiverPharmaceuticals, who was acquired by Shire Pharmaceuticals, Inc., and we have acollaboration arrangement with Patheon, Inc. related to the potentialdevelopment of product candidates for third parties.  We also have a collaboration agreement withSupernus, Inc. providing for the development of a product candidate throughfeasibility, with the possibility to enter into a definitive agreementproviding for the further development of the product candidate, by either orboth parties.  In addition, we have inthe past and may in the future enter into other collaborativearrangements, some of which have been based on less definitive agreements, suchas memoranda of understanding, material transfer agreements, options orfeasibility agreements.  We may notexecute definitive agreements formalizing these arrangements.  Collaborative relationships are generallycomplex and may give rise to disputes regarding the relative rights,obligations and revenues of the parties, including the ownership ofintellectual property and associated rights and obligations, especially whenthe applicable collaborative provisions have not been fully negotiated anddocumented. Such disputes can delay collaborative research, development orcommercialization of potential products, and can lead to lengthy, expensivelitigation or arbitration. The terms of collaborative arrangementsmay also limit or preclude us from developing products or technologiesdeveloped pursuant to such collaborations. Additionally, the collaboratorsunder these arrangements might breach the terms of their respective agreementsor fail to prevent infringement of the licensed patents by third parties.Moreover, negotiating collaborative arrangements often takes considerablylonger to conclude than the parties initially anticipate, which could cause usto agree to less favorable agreement terms that delay or defer recovery of ourdevelopment costs and reduce the funding available to support key programs.

We may be unable to enter into futurecollaborative arrangements on acceptable terms, which would harm our ability todevelop and commercialize our current and potential future products. Further,even if we do enter into collaboration arrangements, it is possible that ourcollaborative partners may not choose to develop and commercializeproducts using the AcuForm technology. Other factors relating tocollaborations that may adversely affect the commercial success of ourproducts include:

·      any parallel development bya collaborative partner of competitive technologies or products;

·      arrangements withcollaborative partners that limit or preclude us from developing products ortechnologies;

·      premature termination of acollaboration agreement; or

·      failureby a collaborative partner to devote sufficient resources to the developmentand commercial sales of products using the AcuForm technology.

Generally, our collaborative arrangements do notrestrict our collaborative partners from competing with us or restrict theirability to market or sell competitive products. Our current and any futurecollaborative partners may pursue existing or other development-stageproducts or alternative technologies in preference to those being developed incollaboration with us. Our collaborative partners may also terminate theircollaborative relationships with us or otherwise decide not to proceed withdevelopment and commercialization of our products.

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**We may be unable to protect our intellectual propertyand may be liable for infringing the intellectual property of others.**

Our success will depend in part on our ability toobtain and maintain patent protection for our technologies and to preserve ourtrade secrets. Our policy is to seek to protect our proprietary rights, byamong other methods, filing patent applications in the United States andforeign jurisdictions to cover certain aspects of our technology. We currentlyhold nine issued patents, and have fourteen patent applications pending in theUnited States.  In addition, we arepreparing patent applications relating to our expanding technology for filingin the United States and abroad.  We havealso applied for patents in numerous foreign countries. Some of those countrieshave granted our applications and other applications are still pending. Ourpending patent applications may lack priority over others’ applications or maynot result in the issuance of patents. Even if issued, our patents may not besufficiently broad to provide protection against competitors with similartechnologies and may be challenged, invalidated or circumvented, which couldlimit our ability to stop competitors from marketing related products or maynot provide us with competitive advantages against competing products. We alsorely on trade secrets and proprietary know-how, which are difficult to protect.We seek to protect such information, in part, through entering intoconfidentiality agreements with employees, consultants, collaborative partnersand others before such persons or entities have access to our proprietary tradesecrets and know-how. These confidentiality agreements may not be effective incertain cases, due to, among other things, the lack of an adequate remedy forbreach of an agreement or a finding that an agreement is unenforceable. Inaddition, our trade secrets may otherwise become known or be independentlydeveloped by competitors.

Our ability to develop our technologies and to makecommercial sales of products using our technologies also depends on notinfringing others’ patents or other intellectual property rights. We are notaware of any intellectual property claims against us.  However, the pharmaceutical industry hasexperienced extensive litigation regarding patents and other intellectualproperty rights. For example, we areaware that patents issued to third parties relating to sustained release drugformulations or particular pharmaceutical compounds could in the future beasserted against us, although we believe that we do not infringe any validclaim of any patents.  If claimsconcerning any of our products were to arise and it was determined that theseproducts infringe a third party’s proprietary rights, we could be subject tosubstantial damages for past infringement or be forced to stop or delay ouractivities with respect to any infringing product, unless we can obtain alicense, or we may have to redesign our product so that it does not infringeupon others’ patent rights, which may not be possible or could requiresubstantial funds or time.  Such alicense may not be available on acceptable terms, or at all.  Even if we, our collaborators or ourlicensors were able to obtain a license, the rights may be nonexclusive, whichwould give our competitors access to the same intellectual property.  In addition, any public announcements relatedto litigation or interference proceedings initiated or threatened against us,even if such claims are without merit, could cause our stock price to decline.

From time to time, we maybecome aware of activities by third parties that may infringe our patents.  Infringement by others of our patents mayreduce our market shares (if a related product is approved) and, consequently,our potential future revenues and adversely affect our patent rights if we donot take appropriate enforcement action. We may need to engage in litigation in the future to enforce any patentsissued or licensed to us or to determine the scope and validity of third-party proprietary rights.  Our issued or licensed patents may not beheld valid by a court of competent jurisdiction. Whether or not the outcome oflitigation is favorable to us, defending a lawsuit takes significant time, maybe expensive and may divert management attention from other business concerns.We may also be required to participate in interference proceedings declared bythe United States Patent and Trademark Office for the purpose of determiningthe priority of inventions in connection with our patent applications or otherparties’ patent applications. Adverse determinations in litigation orinterference proceedings could require us to seek licenses which may not beavailable on commercially reasonable terms, or at all, or subject us tosignificant liabilities to third parties. If we need but cannot obtain a license, we may be prevented frommarketing the affected product.

In January 2006, wefiled a complaint against IVAX Corporation in federal court for infringement oftwo of our U.S. patents related to the AcuForm delivery technology.  The complaint alleged infringement of ourpatents by IVAX’s extended release metformin hydrochloride tablet. Although weintend to vigorously enforce our intellectual property rights, there can be noassurance that we will be successful in our litigation against IVAX. If one ormore of our patents is declared invalid or key claims are disallowed, thepatent protection for our products and product candidates could be substantiallyweakened and our business and business prospects could be severely impacted.

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**Our licensed patent covering the useof gabapentin to treat hot flashes associated with menopause is a method-of-usepatent, which increases the risk that prescriptions for gabapentin to treat hotflashes in menopausal women could be written for, or filled with, genericgabapentin.**

We have an exclusive sublicense from PharmaNova, Inc.to a patent held by the University of Rochester to develop and commercialize inthe United States a gabapentin product for the treatment of hot flashesassociated with menopause in women. Because a method-of-use patent, such as the patent we have sublicensedfrom PharmaNova, covers only a specified use of a particular compound, not aparticular composition of matter, we cannot prevent others from commercializinggabapentin.  Accordingly, physicianscould prescribe another manufacturer’s gabapentin to treat hot flashes inmenopausal women rather than Gabapentin GR, or pharmacists could seek to fillprescriptions for Gabapentin GR with another manufacturer’s gabapentin.  Although any such “off-label” use wouldviolate our licensed patent, effectively monitoring compliance with ourlicensed patent may be difficult and costly.

**It is difficult to develop a successful product. If we do notdevelop a successful product we may not be able to raise additional funds.**

The drug developmentprocess is costly, time-consuming and subject to unpredictable delays andfailures. Before we or others make commercial sales of products using theAcuForm technology, other than GLUMETZA and ProQuin XR, we, our currentand any future collaborative partners will need to:

·      conduct preclinical andclinical tests showing that these products are safe and effective; and

·      obtain regulatory approvalfrom the FDA or foreign regulatory authorities.

We will have to curtail,redirect or eliminate our product development programs if we or ourcollaborative partners find that:

·      the AcuForm technologyhas unintended or undesirable side effects; or

·      product candidates thatappear promising in preclinical or early-stage clinical studies do notdemonstrate efficacy in later-stage, larger scale clinical trials.

Even when or if ourproducts obtain regulatory approval, successful commercialization requires:

·      market acceptance;

·      cost-effective commercialscale production; and

·      reimbursement under privateor governmental health plans.

Any material delay orfailure in the governmental approval process and/or the successfulcommercialization of our potential products would adversely impact ourfinancial position and liquidity and would make it difficult for us to raisefinancing on favorable terms, if at all.

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**If we do not achieve our projecteddevelopment and commercialization goals in the timeframes we announce andexpect, the commercialization of our product candidates may be delayed and ourbusiness will be harmed and our stock price may decline.**

For planning purposes, weestimate the timing of the accomplishment of various scientific, clinical, regulatoryand other product development and commercialization goals.  These milestones may include our expectationsregarding the commercial launchof our products by us or our licensees, and the commencement or completion ofscientific studies and clinical trials and the submission of regulatoryfilings.  From time to time, we maypublicly announce the expected timing of some of these milestones, such as thecompletion of an ongoing clinical trial, or the initiation of other clinicalprograms. All of these milestones are based on a variety of assumptions.  The actual timing of these milestones canvary considerably from our estimates depending on numerous factors, some ofwhich are beyond our control, including:

·      our available capitalresources;

·      the efforts of our marketingpartners with respect to the commercialization of our products;

·      the rate of progress, costsand results of our clinical trial and research and development activities,including the extent of scheduling conflicts with participating clinicians andclinical institutions and our ability to identify and enroll patients who meetclinical trial eligibility criteria;

·      our receipt of approvals bythe FDA and other regulatory agencies and the timing thereof;

·      other actions by regulators;

·      our ability to accesssufficient, reliable and affordable supplies of components used in themanufacture of our product candidates, including insulin and materials for ourAcuForm technology; and

·      thecosts of ramping up and maintaining manufacturing operations, as necessary.

If we fail to achieve ourannounced milestones in the timeframes we announce and expect, our business andresults of operations may be harmed and the price of our stock may decline.

**We depend on clinical investigatorsand clinical sites to enroll patients in our clinical trials and other thirdparties to manage the trials and to perform related data collection andanalysis, and, as a result, we may face costs and delays outside of ourcontrol.**

We rely on clinicalinvestigators and clinical sites to enroll patients and other third parties tomanage our trials and to perform related data collection and analysis. However,we may be unable to control the amount and timing of resources that theclinical sites that conduct the clinical testing may devote to our clinicaltrials.  If our clinical investigatorsand clinical sites fail to enroll a sufficient number of patients in ourclinical trials or fail to enroll them on our planned schedule, we will be unableto complete these trials or to complete them as planned, which could delay orprevent us from obtaining regulatory approvals for our product candidates.

Our agreements withclinical investigators and clinical sites for clinical testing and for trialmanagement services place substantial responsibilities on these parties, whichcould result in delays in, or termination of, our clinical trials if theseparties fail to perform as expected. For example, if any of our clinical trialsites fail to comply with FDA-approved good clinical practices, we may beunable to use the data gathered at those sites. If these clinicalinvestigators, clinical sites or other third parties do not carry out theircontractual duties or obligations or fail to meet expected deadlines, or if thequality or accuracy of the clinical data they obtain is compromised due totheir failure to adhere to our clinical protocols or for other reasons, ourclinical trials may be extended, delayed or terminated, and we may be unable toobtain regulatory approval for, or successfully commercialize, our productcandidates.

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**If we are unable to obtain or maintain regulatoryapproval, we will be limited in our ability to commercialize our products, andour business will be harmed.**

The regulatory process is expensive and timeconsuming. Even after investing significant time and expenditures on clinicaltrials, we may not obtain regulatory approval of our product candidates. Dataobtained from clinical trials are susceptible to varying interpretations, whichcould delay, limit or prevent regulatory approval, and the FDA may not agreewith our methods of clinical data analysis or our conclusions regarding safetyand/or efficacy. Significant clinical trial delays would impair our ability tocommercialize our products and could allow our competitors to bring products tomarket before we do. In addition, changes in regulatory policy for productapproval during the period of product development and regulatory agency reviewof each submitted new application may cause delays or rejections. Even if we receiveregulatory approval, this approval may entail limitations on the indicated usesfor which we can market a product.

Further, with respect to our approved products, onceregulatory approval is obtained, a marketed product and its manufacturer aresubject to continual review. The discovery of previously unknown problems witha product or manufacturer may result in restrictions on the product,manufacturer or manufacturing facility, including withdrawal of the productfrom the market. Manufacturers of approved products are also subject to ongoingregulation, including compliance with FDA regulations governing current GoodManufacturing Practices (cGMP). Failure to comply with manufacturingregulations can result in, among other things, warning letters, fines,injunctions, civil penalties, recall or seizure of products, total or partialsuspension of production, refusal of the government to renew marketingapplications and criminal prosecution.

**Pharmaceuticalmarketing is subject to substantial regulation in the United States.**

All marketing activities associated with ProQuin XRand GLUMETZA, as well as marketing activities related to any other products forwhich we obtain regulatory approval, will be subject to numerous federal andstate laws governing the marketing and promotion of pharmaceutical products.The FDA regulates post-approval promotional labeling and advertising to ensurethat they conform to statutory and regulatory requirements. In addition toFDA restrictions, the marketing of prescription drugs is subject to laws andregulations prohibiting fraud and abuse under government healthcare programs.For example, the federal healthcare program antikickback statute prohibitsgiving things of value to induce the prescribing or purchase of products thatare reimbursed by federal healthcare programs, such as Medicare and Medicaid.In addition, federal false claims laws prohibit any person from knowinglypresenting, or causing to be presented, a false claim for payment to thefederal government. Under this law, the federal government in recent years hasbrought claims against drug manufacturers alleging that certain marketingactivities caused false claims for prescription drugs to be submitted tofederal programs. Many states have similar statutes or regulations, which applyto items and services reimbursed under Medicaid and other state programs, or,in some states, regardless of the payer. If we, or our collaborative partners,fail to comply with applicable FDA regulations or other laws or regulations relatingto the marketing of our products, we could be subject to criminal prosecution,civil penalties, seizure of products, injunction, and exclusion of our productsfrom reimbursement under government programs, as well as other regulatoryactions against our product candidates, our collaborative partners or us.

**The approval process outside theUnited States is uncertain and may limit our ability to develop, manufactureand sell our products internationally.**

To market any of our products outside of the UnitedStates, we and our collaborative partners, including Madaus, are subject tonumerous and varying foreign regulatory requirements, implemented by foreignhealth authorities, governing the design and conduct of human clinical trialsand marketing approval for drug products. The approval procedure varies amongcountries and can involve additional testing, and the time required to obtainapproval may differ from that required to obtain FDA approval. The foreignregulatory approval process includes all of the risks associated with obtainingFDA approval set forth above, and approval by the FDA does not ensure approvalby the health authorities of any other country, nor does the approval byforeign health authorities ensure approval by the FDA.

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**If we or our marketing partners areunable to obtain acceptable prices or adequate reimbursement for our productsfrom third-party payers, we will be unable to generate significant revenues.**

In both domestic and foreign markets, sales of ourproduct candidates will depend in part on the availability of adequatereimbursement from third-party payers such as:

·      government healthadministration authorities;

·      private health insurers;

·      health maintenanceorganizations;

·      pharmacy benefit managementcompanies; and

·      otherhealthcare-related organizations.

If reimbursement is not available for our products orproduct candidates, demand for these products may be limited. Further, anydelay in receiving approval for reimbursement from third-party payers wouldhave an adverse effect on our future revenues. Third-party payers areincreasingly challenging the price and cost-effectiveness of medical productsand services. Significant uncertainty exists as to the reimbursement status ofnewly approved healthcare products, including pharmaceuticals. Our products maynot be considered cost effective, and adequate third-party reimbursement may beunavailable to enable us to maintain price levels sufficient to realize anacceptable return on our investment.

Federal and state governments in the United States andforeign governments continue to propose and pass new legislation designed tocontain or reduce the cost of healthcare. Existing regulations affectingpricing may also change before many of our product candidates are approved formarketing. Cost control initiatives could decrease the price that we receivefor any product we may develop.

**We may be unable to compete successfully in thepharmaceutical product and drug delivery system industries.**

Other companies that have oral drug deliverytechnologies competitive with the AcuForm technology include Bristol-MyersSquibb, IVAX Corporation (a subsidiary of TEVA Pharmaceutical Industries,Ltd.), ALZA Corporation (a subsidiary of Johnson & Johnson),SkyePharma plc, Biovail Corporation, Flamel Technologies S.A., RanbaxyLaboratories, Ltd., Kos Pharmaceuticals, Inc., Intec Pharma andAlpharma, Inc., all of which develop oral tablet products designed torelease the incorporated drugs over time. Each of these companies has patentedtechnologies with attributes different from ours, and in some cases withdifferent sites of delivery to the gastrointestinal tract.

Bristol-Myers Squibb is currently marketing asustained release formulation of metformin, Glucophage XR, with whichGLUMETZA competes. The limited license that Bristol-Myers Squibb obtained fromus under our November 2002 settlement agreement extends to certain currentand internally-developed future compounds, which may increase thelikelihood that we will face competition from Bristol-Myers Squibb in thefuture on products in addition to GLUMETZA. Several other companies, includingBarr Pharmaceuticals, Inc., Mylan Laboratories, Inc. and TevaPharmaceutical Industries, Ltd. have received FDA approval for and are sellinga controlled-release metformin product. Flamel Technologies has acontrolled-release microparticle-based formulation of metformin product inPhase 2 clinical trials.

Bayer Corporation developed a once-daily ciprofloxacinproduct for the treatment of urinary tract infections, which is currentlymarketed by Schering-Plough Corporation. There may be other companiesdeveloping products competitive with GLUMETZA and ProQuin XR of which we areunaware.

Gabapentin is currently marketed by Pfizer asNeurontin for adjunctive therapy for epileptic seizures and for postherpeticpain. Pfizer’s basic U.S. patents relating to Neurontin have expired, and atleast seven companies have received approval to market generic versions of theimmediate release product. In addition, Pfizer has developed a new product,LyricaTM (pregabalin), which has been approved for marketing in the U.S. and theEuropean Union.

Competition in pharmaceutical products and drugdelivery systems is intense. We expect competition to increase. Competingtechnologies or products developed in the future may prove superior to theAcuForm technology or products using the AcuForm technology, eithergenerally or in particular market segments. These developments could make theAcuForm technology or products using the AcuForm technologynoncompetitive or obsolete.

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Most of our principal competitors have substantiallygreater financial, sales, marketing, personnel and research and developmentresources than we do. In addition, many of our potential collaborative partnershave devoted, and continue to devote, significant resources to the developmentof their own drug delivery systems and technologies.

**We depend on third parties who aresingle source suppliers to manufacture ProQuin XR, GLUMETZA and our otherproduct candidates.  If these suppliersare unable to manufacture ProQuin XR, GLUMETZA or our product candidates, ourbusiness will be harmed.**

We are responsible for the supply and distribution ofGLUMETZA, and MOVA Pharmaceuticals, a subsidiary of Patheon, Inc., is our solesupplier for tablets of the 500mg strength of GLUMETZA pursuant to a supplyagreement we entered into with MOVA Pharmaceuticals in December 2006. Ifapproved, Biovail will be our sole supplier for the new formulation of 1000mgGLUMETZA.  We will be unable tomanufacture GLUMETZA in a timely manner if we are unable to obtain GLUMETZA500mg tablets from our contract manufacturer or active pharmaceuticalingredient from suppliers, or GLUMETZA 1000mg tablets from Biovail.

We are also responsible for supply and distribution ofProQuin XR.  For the manufacture ofProQuin XR tablets, we have entered into an agreement with MOVAPharmaceuticals, as our sole supplier. We purchase the active ingredient forProQuin XR from Uquifa Mexico, S.A., a sole supplier to us, on a purchase orderbasis. We will also be responsible for the manufacture of bulk ProQuin XRtablets to Madaus for the European market, if the product is approved formarketing in European jurisdictions.  Weintend to purchase ProQuin XR tablets from MOVA Pharmaceuticals for thatpurpose. If we are unable, for whatever reason, to obtain the activepharmaceutical ingredient or ProQuin XR tablets from our contractmanufacturers, we may be unable to manufacture ProQuin XR in a timely manner,if at all.

Although we have obtained clinical batches ofGabapentin GR from a contract manufacturer, we currently have no long-termsupply arrangement with respect to Gabapentin GR.  Any failure to obtain clinical supplies ofGabapentin GR could adversely affect our Gabapentin GR clinical developmentprograms.

**We could become subject to product liability litigation andmay not have adequate insurance to cover product liability claims.**

Our business involves exposure to potential productliability risks that are inherent in the development and production ofpharmaceutical products. We have obtained product liability insurance forclinical trials currently underway and forecasted 2007 sales of our products,but:

·      we may be unable toobtain product liability insurance for future trials;

·      we may be unable toobtain product liability insurance for future products;

·      we may be unable tomaintain product liability insurance on acceptable terms;

·      we may be unable tosecure increased coverage as the commercialization of the AcuForm technologyproceeds; or

·      our insurance may notprovide adequate protection against potential liabilities.

Our inability to obtain adequate insurance coverage atan acceptable cost could prevent or inhibit the commercialization of ourproducts. Defending a lawsuit would be costly and significantly divertmanagement’s attention from conducting our business. If third parties were tobring a successful product liability claim or series of claims against usfor uninsured liabilities or in excess of insured liability limits, ourbusiness, financial condition and results of operations could be materiallyharmed.

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**If we choose to acquire new and complementarybusinesses, products or technologies, we may be unable to complete theseacquisitions or to successfully integrate them in a cost effective andnon-disruptive manner.**

Our success depends on our ability to continuallyenhance and broaden our product offerings in response to changing customerdemands, competitive pressures and technologies. Accordingly, we may in thefuture pursue the acquisition of complementary businesses, products ortechnologies instead of developing them ourselves. We have no currentcommitments with respect to any acquisition or such investment. We do not knowif we would be able to successfully complete any acquisitions, or whether wewould be able to successfully integrate any acquired business, product ortechnology or retain any key employees. Integrating any business, product ortechnology we acquire could be expensive and time consuming, disrupt ourongoing business and distract our management. If we were to be unable tointegrate any acquired businesses, products or technologies effectively, ourbusiness would suffer. In addition, any amortization or charges resulting fromthe costs of acquisitions could harm our operating results.

**If we lose our key personnel or are unable toattract and retain key management and operating personnel, we may beunable to pursue our product development and commercialization efforts.**

Our success is dependent in large part upon thecontinued services of John W. Fara, Ph.D., our Chairman, President and ChiefExecutive Officer, Carl A. Pelzel, our Executive Vice President and ChiefOperating Officer, and other members of our executive management team, and onour ability to attract and retain key management and operating personnel. We donot have agreements with Dr. Fara, Mr. Pelzel or any of our otherexecutive officers that provide for their continued employment with us and we may be at increased risk of losing keyemployees following the Phase 3 results from our recent Gabapentin GR trial forPHN. Management, scientific and operating personnel are in high demandin our industry and are often subject to competing offers. The loss of theservices of one or more members of management or key employees or the inabilityto hire additional personnel as needed could result in delays in the research,development and commercialization of our products and potential productcandidates.

**We have implemented certainanti-takeover provisions.**

Certain provisions of our articles of incorporationand the California General Corporation Law could discourage a third party fromacquiring, or make it more difficult for a third party to acquire, control ofour company without approval of our board of directors. These provisions couldalso limit the price that certain investors might be willing to pay in thefuture for shares of our common stock. Certain provisions allow the board ofdirectors to authorize the issuance of preferred stock with rights superior tothose of the common stock. We are also subject to the provisions ofSection 1203 of the California General Corporation Law which requires afairness opinion to be provided to our shareholders in connection with theirconsideration of any proposed “interested party” reorganization transaction.

We have adopted a shareholder rights plan, commonlyknown as a “poison pill”. The provisions described above, our poison pill andprovisions of the California General Corporation Law may discourage, delay orprevent a third party from acquiring us.

**Increased costs associated withcorporate governance compliance may significantly impact our results ofoperations.**

Changing laws, regulationsand standards relating to corporate governance, public disclosure andcompliance practices, including the Sarbanes-Oxley Act of 2002, new SECregulations and Nasdaq Global Market rules, are creating uncertainty forcompanies such as ours in understanding and complying with these laws,regulations and standards.  As a resultof this uncertainty and other factors, devoting the necessary resources tocomply with evolving corporate governance and public disclosure standards has resulted in andmay in the future result in increased general and administrative expenses and adiversion of management time and attention to compliance activities.  We also expect these developments to increase our legal compliance andfinancial reporting costs.  In addition,these developments may make it more difficult and more expensive for us toobtain director and officer liability insurance, and we may be required toaccept reduced coverage or incur substantially higher costs to obtaincoverage.  Moreover, we may be unable tocomply with these new rules and regulations on a timely basis.

These developments couldmake it more difficult for us to attract and retain qualified members of ourboard of directors, or qualified executive officers.  We are presently evaluating and monitoringregulatory developments and cannot estimate the timing or magnitude ofadditional costs we may incur as a result. To the extent these costs are significant, our selling, general andadministrative expenses are likely to increase.

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**If we sell shares of our common stock under ourequity line of credit arrangement or in other future financings, existingcommon shareholders will experience immediate dilution and, as a result, ourstock price may go down.**

We may from time to time issue additional shares ofcommon stock at a discount from the current trading price of our commonstock.  As a result, our existing commonshareholders will experience immediate dilution upon the purchase of any sharesof our common stock sold at such discount. For example, in December 2006, we entered into a common stock purchaseagreement with Azimuth Opportunity Ltd., pursuant to which we may sell sharesof common stock at a discount to the prevailing market price ranging fromapproximately 3.8% to 6.4%, excluding an additional placement agent fee ofapproximately 1.1% payable by us on the gross offering proceeds. In addition,as other capital raising opportunities present themselves, we may enter intofinancing or similar arrangements in the future, including the issuance of debtsecurities, preferred stock or common stock. If we issue common stock orsecurities convertible into common stock, our common shareholders willexperience dilution and this dilution will be greater if we find it necessaryto sell securities at a discount to prevailing market prices.

**If we are unable to satisfy regulatoryrequirements relating to internal controls, our stock price could suffer.**

Section 404 of the Sarbanes-Oxley Act of 2002 requirescompanies to conduct a comprehensive evaluation of their internal control over financial reporting.  At the end of each fiscal year, we mustperform an evaluation of our internal control over financial reporting, includein our annual report the results of the evaluation, and have our externalauditors publicly attest to such evaluation. If material weaknesses were found in our internal controls in thefuture, if we fail to complete future evaluations on time, or if our externalauditors cannot attest to our future evaluations, we could fail to meet ourregulatory reporting requirements and be subject to regulatory scrutiny and aloss of public confidence in our internal controls, which could have an adverseeffect on our stock price.

**Businessinterruptions could limit our ability to operate our business.**

Our operations are vulnerable to damage orinterruption from computer viruses, human error, natural disasters,telecommunications failures, intentional acts of vandalism and similar events.In particular, our corporate headquarters are located in the San Francisco Bay area, which has a history ofseismic activity. We have not established a formal disaster recovery plan, andour back-up operations and our business interruption insurance may not beadequate to compensate us for losses that occur. A significant businessinterruption could result in losses or damages incurred by us and require us tocease or curtail our operations.

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**ITEM 2.****                        UNREGISTEREDSALES OF EQUITY SECURITIES AND USE OF PROCEEDS**

Notapplicable.

**ITEM 3.****                        DEFAULTSUPON SENIOR SECURITIES**

Notapplicable.

**ITEM 4.****                        SUBMISSIONOF MATTERS TO A VOTE OF SECURITY HOLDERS**

TheCompany held its annual meeting of shareholders on May 31, 2007 to consider andvote on the following proposals: (i) the election of directors until the nextannual meeting of shareholders (Proposal 1); (ii) an amendment of the 2004Equity Incentive Plan (the 2004 Plan) to increase the number of shares of commonstock issuable under the 2004 Plan by an additional 1,500,000 shares to anaggregate of 5,000,000 shares (Proposal 2); (iii) an amendment of the 2004Employee Stock Purchase Plan (the ESPP) to increase the number of sharesissuable under the ESPP by an additional 500,000 shares to an aggregate of1,000,000 shares (Proposal 3); and (iv) the ratification of Ernst & YoungLLP as the independent registered public accounting firm of the Company for thefiscal year ending December 31, 2007 (Proposal 4).

Proposal1:   The shareholders of Depomed elected sevendirectors to serve until the next annual meeting of shareholders.  The votes regarding the election of directorswere as follows:
|                         | ** ** | **Shares Voted For** | ** ** | **Votes Withheld** | ** ** |
|-------------------------|------------|--------------------------------|------------|-------------------------|------------|
| John W. Fara,  Ph.D.    |       | 34,418,103                     |       | 5,110,020               |       |
| G. Steven  Burrill      |       | 36,471,883                     |       | 3,056,240               |       |
| John W. Shell,  Ph.D    |       | 36,241,543                     |       | 3,286,580               |       |
| Craig R. Smith,  M.D    |       | 36,818,263                     |       | 2,709,860               |       |
| Peter D. Staple         |       | 37,090,132                     |       | 2,447,991               |       |
| Julian N. Stern         |       | 31,612,292                     |       | 7,915,831               |       |
| David B. Zenoff, D.B.A. |       | 36,825,158                     |       | 2,702,965               |       |

 

Proposal2:  The shareholders of Depomed approved theamendment of the 2004 Plan to increase the number of shares of common stockissuable under the 2004 Plan by an additional 1,500,000 shares to an aggregateof 5,000,000 shares with the following votes:
| For     |   | 19,153,372 |   |
|---------|--------|------------|--------|
| Against |   | 4,519,248  |   |
| Abstain |   | 94,411     |   |

 

Proposal3:  The shareholders of Depomed approved theamendment of the ESPP to increase the number of shares issuable under the ESPP byan additional 500,000 shares to an aggregate of 1,000,000 shares with thefollowing votes:
| For     |   | 20,900,638 |   |
|---------|--------|------------|--------|
| Against |   | 2,784,057  |   |
| Abstain |   | 82,336     |   |

 

Proposal4:  The shareholders of Depomed approved theappointment of Ernst & Young LLP as the independent registered publicaccounting firm of the Company for the fiscal year ending December 31, 2007with the following votes:
| For     |   | 39,312,635 |   |
|---------|--------|------------|--------|
| Against |   | 190,105    |   |
| Abstain |   | 25,383     |   |

 

**ITEM 5.****                     OTHERINFORMATION**

InJune 2007, the Company amended its supply agreement with Biovail originallyentered into in December 2005. The amendment extends the period of time theCompany is required to launch the 1000mg GLUMETZA to up to 180 days afterregulatory approval, provided that Biovail is in compliance with its supplyobligations.

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**ITEM 6. EXHIBITS**
|        | (a)    | Exhibits |
|--------|--------|----------|
|        |   | 10.1 (1) |   | Form of Common Stock Purchase Agreement between  Depomed, Inc. and institutional investors dated April 20, 2007 |
|   |   | 10.2     |   | 2004 Equity Incentive Plan |
|   |   | 10.3     |   | 2004 Employee Stock Purchase Plan |
|   |   | 10.4     |   | Amendment to the Supply Agreement between the  Company and Biovail Laboratories International SRL dated June 30, 2007 |
|   |   | 31.1     |   | Certification pursuant to  Rule 13a-14(a) under the Securities Exchange Act of 1934 of John W.  Fara, Ph.D |
|   |   | 31.2     |   | Certification pursuant to  Rule 13a-14(a) under the Securities Exchange Act of 1934 of John F.  Hamilton |
|   |   | 32.1     |   | Certification pursuant to 18 U.S.C.  Section 1350 of John W. Fara, Ph.D. |
|   |   | 32.2     |   | Certification pursuant to 18 U.S.C.  Section 1350 of John F. Hamilton |

 

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(1)          Incorporatedby reference to the Company’s Form 8-K filed with the SEC on April 23, 2007.

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##### **SIGNATURES**

Pursuant to the requirements of the SecuritiesExchange Act of 1934, the Registrant has duly caused this report to be signedon its behalf by the undersigned thereunto duly authorized.
| Date: August 7, 2007 |   | DEPOMED, INC.      |
|----------------------|--------|-------------------------|
|                 |   |                    |
|                 |   |                    |
|                 |   | /s/ John F. Hamilton    |   |
|                 |   | John F. Hamilton        |
|                 |   | Vice President and      |
|                 |   | Chief Financial Officer |
|                 |   | (Authorized Officer and |
|                 |   | Principal Accounting    |
|                 |   | and Financial Officer)  |
|                 |   |                    |
|                 |   |                    |
|                 |   | /s/ John W. Fara, Ph.D. |   |
|                 |   | John W. Fara, Ph.D.     |
|                 |   | President, Chairman and |
|                 |   | Chief Executive Officer |

 

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