Table of Contents

 

 

 

**UNITED STATES**

**SECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON, D.C. 20549**

 

**FORM 10-Q**

 

**x****      QUARTERLY REPORT PURSUANT TOSECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**

 

**FOR THE QUARTERLY PERIOD ENDED June 30, 2010**

 

**OR**

 

**o****         TRANSITION REPORTPURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF1934**

 

**FOR THE TRANSITION PERIOD FROM        TO      **

 

**COMMISSION FILE NUMBER 001-13111**

 

**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 ZIP CODE)

 

**(650) 462-5900**

(REGISTRANT’S TELEPHONE NUMBER, INCLUDING AREA CODE)

 

Indicateby check mark whether the registrant (1) has filed all reports required tobe filed by Section 13 or 15(d) of the Exchange Act during thepreceding 12 months (or for such shorter period that the registrant wasrequired to file such reports), and (2) has been subject to such filingrequirements for the past 90 days.  Yes x No o

 

Indicate by check markwhether the registrant has submitted electronically and posted on its corporateWeb site, if any, every Interactive Data File required to be submitted andposted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter)during the preceding 12 months (or for such shorter period that the registrantwas required to submit and post such files). Yes o No o

 

Indicateby check mark whether the registrant is a large accelerated filer, anaccelerated filer, a non-accelerated filer, or a smaller reporting company, asdefined in Rule 12b-2 of the Exchange Act.

 
| Large  accelerated filer o | Accelerated  filer x         |
|----------------------------|------------------------------|
|                       |                         |
| Non-accelerated  filer o   | Smaller  reporting company o |

 

Indicateby check mark whether the registrant is a shell company (as defined inRule 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 5, 2010 was 52,565,189.

 

 

 

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Table ofContents

 

**DEPOMED, INC.**

 
| ** **                                                                                                     | **PAGE** |
|----------------------------------------------------------------------------------------------------------------|----------|
|                                                                                                           |     |
| **PART I — FINANCIAL INFORMATION**                                                                   |
|                                                                                                           |     |
| Item 1. Condensed Financial Statements:                                                                        |     |
|                                                                                                           |     |
| Condensed Balance Sheets at June 30, 2010  (unaudited) and December 31, 2009                         | 3        |
|                                                                                                           |     |
| Condensed Statements of Operations for the three and  six months ended June 30, 2010 and 2009 (unaudited) | 4        |
|                                                                                                           |     |
| Condensed Statements of Cash Flows for the six months  ended June 30, 2010 and 2009 (unaudited)           | 5        |
|                                                                                                           |     |
| Notes to Condensed Financial Statements (unaudited)                                                            | 6        |
|                                                                                                           |     |
| Item 2.  Management’s Discussion and Analysis of Financial Condition and Results of  Operations           | 16       |
|                                                                                                           |     |
| Item 3.  Quantitative and Qualitative Disclosure About Market Risk                                             | 25       |
|                                                                                                           |     |
| Item 4. Controls  and Procedures                                                                               | 25       |
|                                                                                                           |     |
| **PART II  — OTHER INFORMATION**                                                                     |
|                                                                                                           |     |
| Item  1. Legal Proceedings                                                                                     | 27       |
|                                                                                                           |     |
| Item  1A. Risk Factors                                                                                         | 27       |
|                                                                                                           |     |
| Item 2. Unregistered Sales of Equity Securities and  Use of Proceeds                                           | 40       |
|                                                                                                           |     |
| Item 3. Defaults upon Senior Securities                                                                        | 40       |
|                                                                                                           |     |
| Item 4.  Reserved                                                                                              | 40       |
|                                                                                                           |     |
| Item  5. Other Information                                                                                     | 40       |
|                                                                                                           |     |
| Item 6.  Exhibits                                                                                              | 41       |
|                                                                                                           |     |
| Signatures                                                                                                     | 42       |

 

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**PART I — FINANCIAL INFORMATION**

**ITEM 1. CONDENSED FINANCIAL STATEMENTS**

 

**DEPOMED, INC.**

**CONDENSED BALANCE SHEETS**

**(in thousands, except share amounts)**

** **
| ** **                                                                                                                                                                                                                                             | ** ** | **June 30,** | ** ** | **December 31,** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------|------------|-----------------------|------------|
| ** **                                                                                                                                                                                                                                             | ** ** | **2010**          | ** ** | **2009**              | ** ** |
| ** **                                                                                                                                                                                                                                             | ** ** | **(Unaudited)**   | ** ** | **(1)**               | ** ** |
| **ASSETS**                                                                                                                                                                                                                                             | ** ** | ** **        | ** ** | ** **            | ** ** |
| Current assets:                                                                                                                                                                                                                                        |       |              |       |                  |       |
| Cash and cash equivalents                                                                                                                                                                                                                              |       | $                 | 22,245     |                  | $          | 26,821 |   |
| Marketable securities                                                                                                                                                                                                                                  |       | 45,097            |       | 42,922                |       |
| Accounts receivable                                                                                                                                                                                                                                    |       | 4,461             |       | 4,933                 |       |
| Inventories                                                                                                                                                                                                                                            |       | 1,476             |       | 2,565                 |       |
| Prepaid and other current assets                                                                                                                                                                                                                       |       | 1,567             |       | 1,185                 |       |
| Total current assets                                                                                                                                                                                                                                   |       | 74,846            |       | 78,426                |       |
| Marketable securities, long-term                                                                                                                                                                                                                       |       | 9,544             |       | 12,016                |       |
| Property and equipment, net                                                                                                                                                                                                                            |       | 741               |       | 942                   |       |
| Other assets                                                                                                                                                                                                                                           |       | 197               |       | 197                   |       |
|                                                                                                                                                                                                                                                   |       | $                 | 85,328     |                  | $          | 91,581 |   |
| **LIABILITIES AND  SHAREHOLDERS’ EQUITY**                                                                                                                                                                                                         |       |              |       |                  |       |
| Current liabilities:                                                                                                                                                                                                                                   |       |              |       |                  |       |
| Accounts payable and accrued liabilities                                                                                                                                                                                                               |       | 14,230            |       | 15,222                |       |
| Deferred product sales                                                                                                                                                                                                                                 |       | 1,581             |       | 1,635                 |       |
| Deferred license revenue                                                                                                                                                                                                                               |       | 11,132            |       | 11,184                |       |
| Other current liabilities                                                                                                                                                                                                                              |       | 437               |       | 414                   |       |
| Current portion of long-term debt                                                                                                                                                                                                                      |       | 3,978             |       | 3,747                 |       |
| Total current liabilities                                                                                                                                                                                                                              |       | 31,358            |       | 32,202                |       |
| Deferred license revenue, non-current portion                                                                                                                                                                                                          |       | 36,015            |       | 41,306                |       |
| Long-term debt, net of current portion                                                                                                                                                                                                                 |       | 121               |       | 2,170                 |       |
| Other long-term liabilities                                                                                                                                                                                                                            |       | 104               |       | 177                   |       |
| Commitments                                                                                                                                                                                                                                            |       |              |       |                  |       |
| Shareholders’ equity:                                                                                                                                                                                                                             |       |              |       |                  |       |
| Preferred stock, no par value, 5,000,000 shares  authorized; Series A convertible preferred stock, 25,000 shares  designated, 18,158 shares issued and surrendered, and zero shares outstanding  at June 30, 2010 and December 31, 2009 |       | —            |       | —                |       |
| Common stock, no par value, 100,000,000 shares  authorized; 52,546,064 and 52,200,358 shares issued and outstanding at  June 30, 2010 and December 31, 2009, respectively                                                                    |       | 189,556           |       | 187,895               |       |
| Accumulated deficit                                                                                                                                                                                                                                    |       | (171,906          | )          | (172,202              | )          |
| Accumulated other comprehensive gain                                                                                                                                                                                                                   |       | 80                |       | 33                    |       |
| Total shareholders’ equity                                                                                                                                                                                                                        |       | 17,730            |       | 15,726                |       |
|                                                                                                                                                                                                                                                   |       | $                 | 85,328     |                  | $          | 91,581 |   |

 

----

(1) Derivedfrom the audited financial statements included in the Company’s Annual Reporton Form 10-K for the year ended December 31, 2009.

 

See accompanying notes to Condensed Financial Statements.

 

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**DEPOMED, INC.**

**CONDENSED STATEMENTS OFOPERATIONS**

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

**(Unaudited)**

 
| ** **                                                                          | ** ** | **Three Months Ended June 30,** | ** ** | **Six Months Ended June 30,** | ** ** |
|-------------------------------------------------------------------------------------|------------|--------------------------------------|------------|------------------------------------|------------|
| ** **                                                                          | ** ** | **2010**                             | ** ** | **2009**                           | ** ** | **2010** | ** ** | **2009** | ** ** |
| Revenues:                                                                           |       |                                 |       |                               |       |   |   |   |   |
| Product sales                                                                       |       | $                                    | 11,657     |                               | $          | 8,408 |   | $ | 24,257 |   | $ | 15,248 |   |
| Royalties                                                                           |       | 91                                   |       | 529                                |       | 179 |   | 993 |   |
| License and milestone revenue                                                       |       | 12,671                               |       | 2,671                              |       | 15,342 |   | 5,239 |   |
| Total revenues                                                                      |       | 24,419                               |       | 11,608                             |       | 39,778 |   | 21,480 |   |
|                                                                                |       |                                 |       |                               |       |   |   |   |   |
| Costs and expenses:                                                                 |       |                                 |       |                               |       |   |   |   |   |
| Cost of sales                                                                       |       | 2,981                                |       | 1,229                              |       | 4,462 |   | 2,261 |   |
| Research and development expense                                                    |       | 4,570                                |       | 10,024                             |       | 9,758 |   | 20,045 |   |
| Selling, general and administrative expense:                                        |       |                                 |       |                               |       |   |   |   |   |
| Promotion fee expense                                                               |       | 8,099                                |       | 5,640                              |       | 16,978 |   | 10,184 |   |
| Other selling, general and administrative expense                                   |       | 4,541                                |       | 4,305                              |       | 8,091 |   | 8,763 |   |
| Total selling, general and administrative expense                                   |       | 12,640                               |       | 9,945                              |       | 25,069 |   | 18,947 |   |
| Total costs and expenses                                                            |       | 20,191                               |       | 21,198                             |       | 39,289 |   | 41,253 |   |
|                                                                                |       |                                 |       |                               |       |   |   |   |   |
| Income (loss) from operations                                                       |       | 4,228                                |       | (9,590                             | )          | 489 |   | (19,773 | ) |
|                                                                                |       |                                 |       |                               |       |   |   |   |   |
| Other income (expense):                                                             |       |                                 |       |                               |       |   |   |   |   |
| Interest and other income                                                           |       | 56                                   |       | 236                                |       | 150 |   | 550 |   |
| Interest expense                                                                    |       | (157                                 | )          | (263                               | )          | (340 | ) | (548 | ) |
| Total other income (expense)                                                        |       | (101                                 | )          | (27                                | )          | (190 | ) | 2 |   |
|                                                                                |       |                                 |       |                               |       |   |   |   |   |
| Net income (loss) before income taxes                                               |       | 4,127                                |       | (9,617                             | )          | 299 |   | (19,771 | ) |
|                                                                                |       |                                 |       |                               |       |   |   |   |   |
| Provision for income taxes                                                          |       | (1                                   | )          | 2                                  |       | (2 | ) | 1 |   |
|                                                                                |       |                                 |       |                               |       |   |   |   |   |
| Net income (loss)                                                                   |       | $                                    | 4,126      |                               | $          | (9,615 | ) | $ | 297 |   | $ | (19,770 | ) |
|                                                                                |       |                                 |       |                               |       |   |   |   |   |
| Basic net income (loss) applicable to common stock  shareholders per common share   |       | $                                    | 0.08       |                               | $          | (0.19 | ) | $ | 0.01 |   | $ | (0.39 | ) |
| Diluted net income (loss) applicable to common  stock shareholders per common share |       | $                                    | 0.08       |                               | $          | (0.19 | ) | $ | 0.01 |   | $ | (0.39 | ) |
|                                                                                |       |                                 |       |                               |       |   |   |   |   |
| Shares used in computing basic net income (loss)  per common share                  |       | 52,436,681                           |       | 51,263,620                         |       | 52,368,085 |   | 51,235,735 |   |
| Shares used in computing diluted net income (loss)  per common share                |       | 53,103,623                           |       | 51,263,620                         |       | 52,918,507 |   | 51,235,735 |   |

 

See accompanying notes to Condensed Financial Statements.

 

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**DEPOMED, INC.**

**CONDENSED STATEMENTS OF CASHFLOWS**

**(in thousands)**

**(Unaudited)**

 
| ** **                                                                                          | ** ** | **Six Months Ended June 30,** | ** ** |
|-----------------------------------------------------------------------------------------------------|------------|------------------------------------|------------|
| ** **                                                                                          | ** ** | **2010**                           | ** ** | **2009** | ** ** |
| **Operating Activities**                                                                            | ** ** | ** **                         | ** ** | ** ** | ** ** |
| Net income (loss)                                                                                   |       | $                                  | 297        |   | $ | (19,770 | ) |
| Adjustments to reconcile net income (loss) to net  cash (used in) provided by operating activities: |       |                               |       |   |   |
| Depreciation and amortization                                                                       |       | 210                                |       | 520 |   |
| Loss on disposal of property and equipment                                                          |       | 46                                 |       | — |   |
| Stock-based compensation                                                                            |       | 1,061                              |       | 1,353 |   |
| Changes in assets and liabilities:                                                                  |       |                               |       |   |   |
| Accounts receivable                                                                                 |       | 473                                |       | (1,044 | ) |
| Inventories                                                                                         |       | 1,089                              |       | 483 |   |
| Other current assets                                                                                |       | (381                               | )          | 3,425 |   |
| Accounts payable and other accrued liabilities                                                      |       | (58                                | )          | (58 | ) |
| Accrued compensation                                                                                |       | (985                               | )          | (1,043 | ) |
| Deferred revenue                                                                                    |       | (5,395                             | )          | 19,677 |   |
| Net cash (used in) provided by operating  activities                                                |       | (3,643                             | )          | 3,543 |   |
|                                                                                                |       |                               |       |   |   |
| **Investing Activities**                                                                            | ** ** | ** **                         | ** ** | ** ** | ** ** |
| Purchases of property and equipment                                                                 |       | (58                                | )          | (170 | ) |
| Purchases of marketable securities                                                                  |       | (38,579                            | )          | (81,810 | ) |
| Maturities of marketable securities                                                                 |       | 34,490                             |       | 55,812 |   |
| Sales of marketable securities                                                                      |       | 4,482                              |       | 10,008 |   |
| Net cash provided by (used in) investing  activities                                                |       | 335                                |       | (16,160 | ) |
|                                                                                                |       |                               |       |   |   |
| **Financing Activities**                                                                            | ** ** | ** **                         | ** ** | ** ** | ** ** |
| Principal payments on long-term debt                                                                |       | (1,867                             | )          | (1,554 | ) |
| Proceeds from issuance of common stock                                                              |       | 599                                |       | 197 |   |
| Net cash used in financing activities                                                               |       | (1,268                             | )          | (1,357 | ) |
|                                                                                                |       |                               |       |   |   |
| Net decrease in cash and cash equivalents                                                           |       | (4,576                             | )          | (13,974 | ) |
| Cash and cash equivalents at beginning of period                                                    |       | 26,821                             |       | 22,127 |   |
| Cash and cash equivalents at end of period                                                          |       | $                                  | 22,245     |   | $ | 8,153 |   |

 

See accompanying notes to Condensed Financial Statements.

 

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**DEPOMED, INC.**

**NOTES TO CONDENSED FINANCIALSTATEMENTS**

**(Unaudited)**

 

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

 

***Basis of Presentation***

 

Theseunaudited condensed financial statements and the related footnote informationof Depomed, Inc. (the Company or Depomed) have been prepared pursuant tothe requirements of the Securities and Exchange Commission (SEC) for interimreporting. As permitted under those rules and regulations, certain footnotes orother financial information that are normally required by U.S. generallyaccepted accounting principles have been condensed or omitted pursuant to suchrules and regulations. In the opinion of the Company’s management, theaccompanying interim unaudited condensed financial statements include alladjustments (consisting only of normal recurring adjustments) necessary for afair presentation of the information for the periods presented. The results forthe interim period ended June 30, 2010 are not necessarily indicative ofresults to be expected for the entire year ending December 31, 2010 orfuture operating periods.

 

Theaccompanying condensed financial statements and related financial informationshould be read in conjunction with the audited consolidated financialstatements and the related notes thereto for the year ended December 31,2009, included in our Annual Report on Form 10-K filed with the SEC. Thecondensed balance sheet at December 31, 2009 has been derived from auditedconsolidated financial statements at that date.

 

***Use of Estimates***

 

Thepreparation of financial statements in conformity with U.S. generally acceptedaccounting principles requires management to make estimates and assumptionsthat affect the amounts reported in the financial statements and accompanyingnotes. Actual results could differ from those estimates.

 

***Revenue Recognition***

 

TheCompany recognizes revenue from the sale of its products, royalties earned, andon payments received and services performed under contractual arrangements.Revenue arrangements with multiple elements are divided into separate units ofaccounting if applicable criteria are met, including whether the deliveredelement has stand-alone value to the customer and whether there is objectiveand reliable evidence of the fair value of the undelivered items. Theconsideration received is allocated among the separate units based on theirrespective fair values, and the applicable revenue recognition criteria areapplied to each of the separate units.

 

Revenueis recognized when there is persuasive evidence that an arrangement exists,delivery has occurred and title has passed, the price is fixed or determinableand the Company is reasonably assured of collecting the resulting receivable.

 

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**DEPOMED, INC.**

**NOTES TO CONDENSED FINANCIALSTATEMENTS**

**(Unaudited)**

 

·                  Product Sales:

 

·                  *GLUMETZA**®*: The Company sells GLUMETZA*®* (metformin hydrochloride extended releasetablets) to wholesalers and retail pharmacies subject to rights of return sixmonths before expiration and up to twelve months after product expiration. TheCompany recognizes revenue for GLUMETZA sales at the time title transfers toits customers, which occurs at the time product is delivered to its customers.

 

·                  *Proquin**®**XR*: The Companysells Proquin® XR (ciprofloxacin hydrochloride) to wholesalers and retailpharmacies subject to rights of return six months before expiration and up totwelve months after product expiration. Given the Company’s limited history of selling Proquin XR and decliningprescription demand for Proquin XR, the Company currently cannot reliablyestimate expected returns of the product at the time of shipment. Accordingly,the Company defers recognition of revenue on product shipments of Proquin XRuntil the right of return no longer exists, which occurs at the earlier of thetime Proquin XR units are dispensed through patient prescriptions or expirationof the right of return. The Company estimates patient prescriptions dispensedusing an analysis of third-party information, including third-party marketresearch data and information obtained from wholesalers with respect toinventory levels and inventory movement. As a result of this policy, theCompany has a deferred revenue balance of $1.6 million at June 30, 2010 relatedto Proquin XR product shipments that have not been recognized as revenue, whichis net of wholesaler fees, retail pharmacy discounts and prompt paymentdiscounts. The Company will recognize revenue upon the earlier to occur ofprescription units dispensed or the expiration of the right of return until itcan reliably estimate product returns, at which time the Company will record aone-time increase in net revenue related to the recognition of revenuepreviously deferred. In addition, the costs of manufacturing Proquin XRassociated with the deferred revenue are recorded as deferred costs, which areincluded in inventory, until such time the related deferred revenue isrecognized.

 

·                  Product Sales Allowances — The Companyrecognizes product sales allowances as a reduction of product sales in the sameperiod the related revenue is recognized. Product sales allowances are based onamounts owed or to be claimed on the related sales. These estimates take intoconsideration the terms of the Company’s agreements with customers, historicalproduct returns, rebates or discounts taken, estimated levels of inventory inthe distribution channel, the shelf life of the product, and specific known marketevents, such as competitive pricing and new product introductions. If actualfuture results vary from the Company’s estimates, the Company may need toadjust these estimates, which could have an effect on product sales andearnings in the period of adjustment. The Company’s product sales allowancesinclude:

 

·                  Product Returns — TheCompany estimates product returns on sales of GLUMETZA. The Company allowscustomers to return product that is within six months before and up to twelvemonths after its product expiration date. The shelf life of the 500mg GLUMETZA is currently 48 months from thedate of tablet manufacture. On product launch in August 2006 and through thesecond quarter of 2008, the shelf life of 500mg GLUMETZA product shipped was 36months from the date of tablet manufacture. Beginning in March 2010, theCompany began shipping 1000mg GLUMETZA with a shelf life of 36 months from thedate of tablet manufacture.  Prior toMarch 2010, the 1000mg GLUMETZA shelf life on product shipped to customers was24 months from the date of tablet manufacture. The Company monitors actualreturn history on an individual product lot basis since product launch, whichprovides it with a basis to reasonably estimate future product returns, takinginto consideration the shelf life of product, shipment and prescription trendsand estimated distribution channel inventory levels. See Note 4 to the Notes toCondensed Financial Statements for further discussion of returns associatedwith the Company’s 500mg GLUMETZA recall in June 2010.

 

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**DEPOMED, INC.**

**NOTES TO CONDENSED FINANCIALSTATEMENTS**

**(Unaudited)**

 

·                  Managed Care Rebates — TheCompany offers rebates under contracts with certain managed care organizations.The Company establishes an accrual equal to its estimates of future managedcare rebates attributable to sales and recognizes the estimated rebates as areduction of revenue in the same period the related revenue is recognized. TheCompany estimates its managed care rebates based on the terms of eachagreement, estimated levels of inventory in the distribution channel, andhistorical and expected future utilization of product by the managed careorganization.

 

·                  Wholesaler and RetailPharmacy Discounts — The Company offers discounts to certain wholesaledistributors and retail pharmacies based on contractually determined rates. TheCompany accrues the discount on shipment to the respective wholesaledistributors and retail pharmacies and recognizes the discount as a reductionof revenue in the same period the related revenue is recognized.

 

·                  Prompt Pay Discounts - TheCompany offers cash discounts to its customers, generally 2% of the salesprice, as an incentive for prompt payment. Based on the Company’s experience,the Company expects its customers to comply with the payment terms to earn thecash discount. The Company accounts for cash discounts by reducing accountsreceivable by the full amount and recognizes the discount as a reduction ofrevenue in the same period the related revenue is recognized.

 

·                  Medicaid Rebates — TheCompany participates in Medicaid rebate programs, which provide assistance tocertain eligible low-income patients based on each individual state’sguidelines regarding eligibility and services. Under the Medicaid rebateprograms, the Company pays a rebate to each participating state, generally twoto three months after the quarter in which the prescription is filled. TheCompany estimates and accrues Medicaid rebates based on product pricing,current rebates and changes in the level of discounts the Company offers thatmay affect the level of Medicaid discount, historical and estimated futurepercentages of product sold to Medicaid recipients and estimated levels ofinventory in the distribution channel.

 

·                  Chargebacks — The Companyprovides discounts to authorized users of the Federal Supply Schedule (FSS) ofthe General Services Administration under an FSS contract with the Departmentof Veterans Affairs.  These federalentities purchase products from the wholesale distributors at a discountedprice, and the wholesale distributors then charge back to the Company thedifference between the current retail price and the price the federal entitypaid for the product.  The Companyestimates and accrues chargebacks based on estimated wholesaler inventorylevels, current contract prices and historical chargeback activity.

 

·                  Patient Discount Programs —The Company offers loyalty card programs to patients for GLUMETZA in whichpatients receive certain discounts at participating retail pharmacies that arereimbursed by the Company.  The Companyestimates and accrues future redemptions based on historical redemptionactivity.

 

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**DEPOMED, INC.**

**NOTES TO CONDENSED FINANCIALSTATEMENTS**

**(Unaudited)**

 

·                  Royalties — Royalties are recognized asearned in accordance with the contract terms when royalties from licensees canbe reliably measured and collectibility is reasonably assured.

 

InApril 2008, the Company entered into a settlement and license agreement withTeva Pharmaceuticals USA, Inc. (Teva) in which the Company was entitled toreceive royalties from Teva on sales by Teva or its affiliates of genericGlucophage®XR in the United States, subject to a $2.5 million aggregate royaltycap that was met during 2009. The royalties were calculated as a percentage ofsales by Teva of generic Glucophage XR in the United States, as reported by athird-party market research company. The Company accrued royalties from Tevaeach quarter based on Teva’s sales of generic Glucophage XR reported by thethird-party market research company for that quarter. As the $2.5 millionroyalty cap was met in 2009, there were no royalties under this agreement in2010.

 

Royaltiesreceived under the Company’s agreements with Biovail Laboratories s.r.l.(Biovail) and LG Life Sciences (LG) are recognized when the royalty paymentsare received as they cannot reliably be estimated.

 

·                  License and Collaborative Arrangements -Revenue from license and collaborative arrangements is recognized when theCompany has substantially completed its obligations under the terms of thearrangement and the Company’s remaining involvement is inconsequential andperfunctory. If the Company has significant continuing involvement under suchan arrangement, license and collaborative fees are recognized over theestimated performance period. The Company recognizes milestone payments uponthe achievement of specified milestones if (1) the milestone issubstantive in nature, and the achievement of the milestone was not reasonablyassured at the inception of the agreement and (2) the fees arenonrefundable. License, milestones and collaborative fee payments received inexcess of amounts earned are classified as deferred revenue until earned.

 

***Recently Issued AccountingStandards***

 

InApril 2010, the Financial Accounting Standards Board issued AccountingStandards Update (ASU) No. 2010-17, *RevenueRecognition — Milestone Method*(ASU 2010-017). ASU 2010-017provides guidance in applying the milestone method of revenue recognition toresearch or development arrangements. Under this guidance, management mayrecognize revenue contingent upon the achievement of a milestone in itsentirety, in the period in which the milestone is achieved, only if themilestone meets all the criteria within the guidance to be consideredsubstantive. This ASU is effective on a prospective basis for research anddevelopment milestones achieved in fiscal years, beginning on or afterJune 15, 2010. The Company does not expect adoption of this standard tohave a material impact on its financial position or results of operations.

 

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**DEPOMED, INC.**

**NOTES TO CONDENSED FINANCIALSTATEMENTS (Continued)**

**(Unaudited)**

 

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

 

Securitiesclassified as available-for-sale as of June 30, 2010 and December 31, 2009are summarized below (in thousands). Estimated fair value is based on quotedmarket prices for these investments.

 
| **June  30, 2010**                                                           | ** ** | **Amortized  Cost** | ** ** | **Gross  Unrealized  Gains** | ** ** | **Gross  Unrealized  Losses** | ** ** | **Fair Value** | ** ** |
|------------------------------------------------------------------------------|------------|---------------------|------------|------------------------------|------------|-------------------------------|------------|----------------|------------|
| U.S. debt securities:                                                        |       |                |       |                         |       |                          |       |           |       |
| Total included in cash and cash equivalents                                  | ** ** | $                   | 16,721     |                         | $          | —                        |       | $              | —     |   | $ | 16,721 |   |
| Total maturing within 1 year and included in  marketable securities:         |       |                |       |                         |       |                          |       |           |       |
| U.S. corporate debt securities                                               |       | 7,050               |       | 1                            |       | (2                            | )          | 7,049          |       |
| U.S. government agency debt securities                                       |       | 22,036              |       | 24                           |       | —                        |       | 22,060         |       |
| U.S. Treasury securities                                                     | ** ** | 15,979              |       | 9                            |       | —                        |       | 15,988         |       |
| Total maturing between 1 and 2 years and included  in marketable securities: |       |                |       |                         |       |                          |       |           |       |
| U.S. government agency debt securities                                       |       | 3,002               |       | 2                            |       | —                        |       | 3,004          |       |
| U.S. Treasury securities                                                     | ** ** | 6,494               |       | 46                           |       | —                        |       | 6,540          |       |
| Total available-for-sale                                                     | ** ** | $                   | 71,282     |                         | $          | 82                            |       | $              | (2         | ) | $ | 71,362 |   |

 
| **December 31, 2009**                                                   | ** ** | **Amortized  Cost** | ** ** | **Gross  Unrealized  Gains** | ** ** | **Gross  Unrealized  Losses** | ** ** | **Fair Value** | ** ** |
|------------------------------------------------------------------------------|------------|---------------------|------------|------------------------------|------------|-------------------------------|------------|----------------|------------|
| U.S.  debt securities:                                                       |       |                |       |                         |       |                          |       |           |       |
| Total included in cash and cash equivalents                                  | ** ** | $                   | 21,186     |                         | $          | —                        |       | $              | —     |   | $ | 21,186 |   |
| Total maturing within 1 year and included in  marketable securities:         |       |                |       |                         |       |                          |       |           |       |
| U.S. corporate debt securities                                               |       | 7,900               |       | 1                            |       | —                        |       | 7,901          |       |
| U.S. government agency debt securities                                       |       | 12,989              |       | 40                           |       | —                        |       | 13,029         |       |
| U.S. Treasury securities                                                     | ** ** | 21,988              |       | 9                            |       | (5                            | )          | 21,992         |       |
| Total maturing between 1 and 2 years and included  in marketable securities: |       |                |       |                         |       |                          |       |           |       |
| U.S. government agency debt securities                                       |       | 12,028              |       | —                       |       | (12                           | )          | 12,016         |       |
| U.S. Treasury securities                                                     | ** ** | —              |       | —                       |       | —                        |       | —         |       |
| Total available-for-sale                                                     | ** ** | $                   | 79,091     |                         | $          | 50                            |       | $              | (17        | ) | $ | 76,124 |   |

 

 TheCompany considers all highly liquid investments with a maturity at date ofpurchase of three months or less to be cash equivalents. Cash and cashequivalents consist of cash on deposit with banks, money market instruments andcommercial paper. The Company places its cash, cash equivalents and marketablesecurities with high quality, U.S. financial institutions and, to date, has notexperienced material losses on any of its balances. All marketable securitiesare classified as available-for-sale since these instruments are readilymarketable. These securities are carried at fair value, which is based on readilyavailable market information, with unrealized gains and losses included inaccumulated other comprehensive gain within shareholders’ equity. The Companyuses the specific identification method to determine the amount of realizedgains or losses on sales of marketable securities. Realized gains or losseshave been insignificant and are included in “interest and other income” in thecondensed statement of operations. As of June 30, 2010, the individualcontractual period for all available-for-sale debt securities is less than twoyears.

 

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**DEPOMED, INC.**

**NOTES TO CONDENSED FINANCIALSTATEMENTS (Continued)**

**(Unaudited)**

 

AtJune 30, 2010, the Company had four securities in an unrealized loss position.The following table shows the gross unrealized losses and fair value of theCompany’s investments 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, 2010 (in thousands):

 
| ** **                     | ** ** | **Less than 12 months** | ** **  | **12 months or greater**      | ** ** | **Total**      | ** ** |
|--------------------------------|------------|-------------------------|-------------|-------------------------------|------------|----------------|------------|
| ** **                     | ** ** | **Fair Value**          | ** **  | **Gross  Unrealized  Losses** | ** ** | **Fair Value** | ** ** | **Gross  Unrealized  Losses** | ** ** | **Fair Value** | ** ** | **Gross  Unrealized  Losses** | ** ** |
| U.S. corporate debt securities |       | 2,025                   |        | (1                            | )          | 2,999          |       | (1 | ) | 5,024 |   | (2 | ) |
| Total available-for-sale       |       | $                       |  2,025 |                          | $          |  (1       | )          | $ |  2,999 |   | $ |  (1 | ) | $ |  5,024 |   | $ |  (2 | ) |
|                                |            |                         |             |                               |            |                |            |  |  |  |  |  |  |  |  |  |  |  |  |

 

The gross unrealized lossesabove were caused by interest rate increases. No significant facts orcircumstances have arisen to indicate that there has been any deterioration inthe creditworthiness of the issuers of the Company’s securities. Based on theCompany’s review of these securities, including the assessment of the durationand severity of the unrealized losses and the Company’s ability and intent tohold the investments until maturity, there were no materialother-than-temporary impairments for these securities at June 30, 2010.

 

Fairvalue is defined as the exchange price that would be received for an asset orpaid to transfer a liability (an exit price) in the principal or mostadvantageous market for the asset or liability in an orderly transactionbetween market participants on the measurement date. Valuation techniques usedto measure fair value must maximize the use of observable inputs and minimizethe use of unobservable inputs.

 

TheCompany utilizes the following fair value hierarchy based on three levels ofinputs:

 

·                  Level 1: Quoted prices in active markets for identical assets orliabilities.

·                  Level 2: Inputs other than Level 1 that are observable, eitherdirectly or indirectly, such as quoted prices for similar assets orliabilities; quoted prices in markets that are not active; or other inputs thatare observable or can be corroborated by observable market data forsubstantially the full term of the assets or liabilities.

·                  Level 3: Unobservable inputs that are supported by little or nomarket activity and that are significant to the fair value of the assets orliabilities.

 

Thefollowing table represents the Company’s fair value hierarchy for its financialassets measured at fair value on a recurring basis as of June 30, 2010 (inthousands):

 
| ** **                             | ** ** | **Level 1** | ** **   | **Level 2** | ** ** | **Level 3**  | ** ** | **Total** | ** **   |
|----------------------------------------|------------|-------------|--------------|-------------|------------|--------------|------------|-----------|--------------|
| Money market funds                     |       | $           |  16,721 |        | $          |  — |       | $         |  — |   | $ |  16,721 |   |
| U.S. corporate debt securities         |       | —      |         | 7,049       |       | —       |       | 7,049     |         |
| U.S. government agency debt securities |       | —      |         | 25,064      |       | —       |       | 25,064    |         |
| U.S. Treasury securities               |       | —      |         | 22,528      |       | —       |       | 22,528    |         |
| Total                                  |       | $           |  16,721 |        | $          |  54,641 |       | $         |  — |   | $ |  71,362 |   |

 

Thefollowing table represents the Company’s fair value hierarchy for its financialassets measured at fair value on a recurring basis as of December 31, 2009 (inthousands):

 
| ** **                             | ** ** | **Level 1** | ** **   | **Level 2** | ** ** | **Level 3**  | ** ** | **Total** | ** **   |
|----------------------------------------|------------|-------------|--------------|-------------|------------|--------------|------------|-----------|--------------|
| Money market funds                     |       | $           |  21,186 |        | $          |  — |       | $         |  — |   | $ |  21,186 |   |
| U.S. corporate debt securities         |       | —      |         | 7,901       |       | —       |       | 7,901     |         |
| U.S. government agency debt securities |       | —      |         | 25,045      |       | —       |       | 25,045    |         |
| U.S. Treasury securities               |       | —      |         | 21,992      |       | —       |       | 21,992    |         |
| Total                                  |       | $           |  21,186 |        | $          |  54,938 |       | $         |  — |   | $ |  76,124 |   |

 

Thereare no financial liabilities measured at fair value on a recurring basis as ofJune 30, 2010 and December 31, 2009.

 

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**DEPOMED, INC.**

**NOTES TO CONDENSED FINANCIALSTATEMENTS (Continued)**

**(Unaudited)**

 

**NOTE3.  NET LOSS PER COMMON SHARE**

 

Basic net loss per commonshare is calculated based on the weighted-average number of shares of commonstock outstanding during the period. Diluted net loss per common share iscalculated based on the weighted-average number of shares of common stockoutstanding and other dilutive securities outstanding during the period, ifdilutive. The potential dilutive shares of common stock resulting from theassumed exercise of outstanding stock options and equivalents and the assumedexercise of the warrants are determined under the treasury stock method. Sharesused in the computation of net loss per common share are as follows:

 
| ** **                                                 | ** ** | **Three Months Ended June 30,** | ** **  | **Six Months Ended June 30,** | ** ** |
|------------------------------------------------------------|------------|---------------------------------|-------------|-------------------------------|------------|
| ** **                                                 | ** ** | **2010**                        | ** **  | **2009**                      | ** ** | **2010** | ** ** | **2009** | ** ** |
| Numerator:                                                 |       |                            |        |                          |       |   |   |   |   |
| Net income (loss) (in thousands)                           |       | $                               |  4,126 |                          | $          |  (9,615 | ) | $ |  297 |   | $ | (19,770 | ) |
|                                                       |       |                            |        |                          |       |   |   |   |   |
| Denominator for basic net income (loss) per  share    |       | 52,436,681                      |        | 51,263,620                    |       | 52,368,085 |   | 51,235,735 |   |
| Net effect of dilutive common stock equivalents            |       | 666,942                         |        | —                        |       | 550,422 |   | — |   |
| Denominator for diluted net income (loss) per  share: |       | 53,103,623                      |        | 51,263,620                    |       | 52,918,507 |   | 51,235,735 |   |
| *** ***                                               |       |                            |        |                          |       |   |   |   |   |
| Net income (loss) per share:                          |       |                            |        |                          |       |   |   |   |   |
| Basic                                                      |       | $                               |  0.08  |                          | $          |  (0.19 | ) | $ |  0.01 |   | $ | (0.39 | ) |
| Diluted                                                    |       | $                               |  0.08  |                          | $          |  (0.19 | ) | $ |  0.01 |   | $ | (0.39 | ) |

 

For the three and six months ended June 30,2010, the total number of antidilutive outstanding common stock equivalentsexcluded from the net income per share computation was 3.2 million and 3.7million, respectively. For the three and six months ended June 30, 2009, thetotal number of antidilutive outstanding common stock equivalents excluded fromthe net loss per share computation was approximately 6.6 million.

 

**NOTE4.  500mg GLUMETZA RECALL**

 

In June 2010, the Companyconducted a voluntary class 2 recall of fifty-two lots of 500mgGLUMETZA tablets from wholesalers due to the presence of trace amounts ofa chemical called 2,4,6-tribromoanisole (TBA) in bottles containing 500mgGLUMETZA tablets. As a result, the Company temporarily suspended productshipments of 500mg GLUMETZA. For the three months ended June 30, 2010, theCompany took an additional return reserve of approximately $1.2 million relatedto estimated credit for returns to be given to its customers on returns ofrecalled product, which had the effect of reducing net product sales for thequarter.  For the three months ended June30, 2010, the Company also incurred a $1.4 million inventory write-off relatedto non-salable inventory resulting from the recall at the Company’s third-partydistribution and manufacturing facilities, which was recorded in cost of goodssold for the quarter.

 

The 1000mg GLUMETZA was notsubject to the recall and is currently being sold to customers.

 

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**DEPOMED, INC.**

**NOTES TO CONDENSED FINANCIALSTATEMENTS (Continued)**

**(Unaudited)**

 

**NOTE 5.LICENSE AND COLLABORATIVE ARRANGEMENTS**

 

***Abbott Products Inc. (formerlySolvay Pharmaceuticals, Inc.)***

 

InMarch 2010, Abbott Products Inc. (Abbott Products) submitted a New DrugApplication (NDA) for DM-1796 to the U.S. Food and Drug Administration (FDA)for the treatment of postherpetic neuralgia. In May 2010, the FDA accepted theNDA filing for DM-1796 for postherpetic neuralgia, which triggered a $10.0million milestone payment from Abbott Products which Depomed received in June2010. As the nonrefundable milestone was substantive in nature, and theachievement of the milestone was not reasonably assured at the inception of theagreement, the Company recognized the entire $10.0 million as milestone revenuein the second quarter of 2010.

 

**NOTE6.  LONG-TERM DEBT**

 

In June 2008, the Companyentered into a loan and security agreement with General Electric CapitalCorporation, as agent (GECC), and Oxford Finance Corporation (Oxford) thatprovided the Company with a $15.0 million credit facility. The credit facilitywas available in up to three tranches. The first tranche of $3.8 million was advanced to the Company upon theclosing of the loan agreement.  Thesecond tranche of $5.6 million was advanced to the Company in July 2008. Thethird tranche of $5.6 million was not drawn and is no longer available to theCompany, and GECC and Oxford waived the 2% unused line fee related to theunused portion of the credit facility.

 

The Company paid interestonly on the first tranche for the first six months at an interest rate of11.59%.  Beginning in January 2009, theCompany began principal payments on the first tranche, plus interest at suchrate, which will be paid in 30 equal monthly installments. The second tranchewas interest-only through December 31, 2008, with principal and interestpayable thereafter in 30 equal monthly installments at an interest rate of11.59%. Interest expense, which includes amortization of debt issuance costs,was $0.2 million and $0.3 million for the three and six months ended June 30,2010, respectively.

 

As of June 30, 2010, theoutstanding balance under the facility was $4.2 million, and the unamortizedportion of the debt issuance costs was approximately $0.1 million. Futurecontractual principal and interest payments are as follows (in thousands):

 
| ** **       | ** ** | **Principal** | ** ** | **Interest** | ** ** |
|------------------|------------|---------------|------------|--------------|------------|
| Less than 1 year |       | $             | 4,076      |         | $          | 282 |   |
| 1-2 years        |       | 145           |       | 1            |       |
| Total            |       | $             | 4,221      |         | $          | 283 |   |

 

The Company has the right tovoluntarily prepay debt outstanding under the facility, in full or in part.Upon any voluntary prepayment of any of the tranches, the Company will berequired to pay the lenders a prepayment premium equal to: (i) 5% on suchprepayment amount, if such prepayment is made within 14 months after theclosing date, (ii) 4% on such prepayment amount, if such prepayment ismade more than 14 months after the closing date but within 29 months after theclosing date, and (ii) 3% on such prepayment amount, if such prepayment ismade more than 29 months after the closing date, but on or before the maturitydate of the respective tranche.

 

The obligations of theCompany under the loan agreement are secured by interests in all of the Company’spersonal property, and proceeds from any intellectual property, but not by theCompany’s intellectual property.

 

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**DEPOMED, INC.**

**NOTES TO CONDENSED FINANCIALSTATEMENTS (Continued)**

**(Unaudited)**

 

The credit facility containsaffirmative and negative covenants with which the Company must comply with, andimposes restrictions with regards to additional indebtedness, liens, variousfundamental changes (including mergers and acquisitions), payments,investments, transactions with affiliates, and other limitations customary insecured credit facilities. The Company was in compliance with such covenants asof June 30, 2010.

 

**NOTE7.  STOCK-BASED COMPENSATION**

 

The following table presentsstock-based compensation expense recognized for stock options, stock awards andthe Company’s employee stock purchase program (ESPP) in the Company’sstatements of operations (in thousands):

 
| ** **                                  | ** ** | **Three Months Ended June 30,** | ** ** | **Six Months Ended June 30,** | ** ** |
|---------------------------------------------|------------|---------------------------------|------------|-------------------------------|------------|
| ** **                                  | ** ** | **2010**                        | ** ** | **2009**                      | ** ** | **2010** | ** ** | **2009** | ** ** |
|                                        |       |                            |       |                          |       |   |   |   |   |
| Cost of sales                               |       | $                               | 3          |                          | $          | 7 |   | $ | 6 |   | $ | 16 |   |
| Research and development expense            |       | 143                             |       | 228                           |       | 309 |   | 436 |   |
| Selling, general and administrative expense |       | 371                             |       | 424                           |       | 746 |   | 901 |   |
| Total                                       |       | $                               |  517  |                          | $          |  659 |   | $ | 1,061 |   | $ |  1,353 |   |

 

AtJune 30, 2010, the Company had $2.7 million of total unrecognized compensationexpense, net of estimated forfeitures, related to stock option grants that willbe recognized over an average vesting period of 2.2 years.

 

**NOTE8.  COMPREHENSIVE INCOME (LOSS)**

 

Thefollowing table summarizes components of total comprehensive income (loss) (inthousands):

 
| ** **                                               | ** ** | **Three Months Ended June 30,** | ** **  | **Six Months Ended June 30,** | ** ** |
|----------------------------------------------------------|------------|---------------------------------|-------------|-------------------------------|------------|
| ** **                                               | ** ** | **2010**                        | ** **  | **2009**                      | ** ** | **2010** | ** ** | **2009** | ** ** |
| Net income (loss)                                        |       | $                               |  4,126 |                          | $          |  (9,615 | ) | $ |  297 |   | $ |  (19,770 | ) |
| Unrealized gain (loss) on available-for-sale  securities |       | 46                              |        | 37                            |       | 47 |   | (29 | ) |
| Total comprehensive income (loss)                        |       | $                               |  4,172 |                          | $          |  (9,578 | ) | $ |  344 |   | $ |  (19,799 | ) |

 

**NOTE9.  INVENTORIES**

 

Inventories relate to themanufacture of the Company’s GLUMETZA and Proquin XR products. Inventories arestated at the lower of cost or market and consist of the following (inthousands):

 
| ** **      | ** ** | **June 30, 2010** | ** ** | **December 31, 2009** | ** ** |
|-----------------|------------|-------------------|------------|-----------------------|------------|
| Raw materials   |       | $                 | 107        |                  | $          | 49 |   |
| Work-in-process |       | 204               |       | —                |       |
| Finished goods  |       | 1,104             |       | 2,453                 |       |
| Deferred costs  |       | 61                |       | 63                    |       |
| Total           |       | $                 | 1,476      |                  | $          | 2,565 |   |

 

Deferred costs represent thecosts of Proquin XR product shipped for which recognition of revenue has beendeferred. See Note 4 to the Notes to Condensed Financial Statements for furtherdiscussion on inventory write-offs related to the Company’s 500mg GLUMETZArecall in June 2010.

 

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**DEPOMED, INC.**

**NOTES TO CONDENSED FINANCIALSTATEMENTS (Continued)**

**(Unaudited)**

 

**NOTE10.   ACCOUNTS PAYABLE AND ACCRUEDLIABILITIES**

 

Accountspayable and accrued liabilities consist of the following (in thousands):

 
| ** **                                     | ** ** | **June 30, 2010** | ** ** | **December 31, 2009** | ** ** |
|------------------------------------------------|------------|-------------------|------------|-----------------------|------------|
| Accounts payable                               |       | $                 | 587        |                  | $          | 709 |   |
| Accrued compensation                           |       | 1,419             |       | 2,404                 |       |
| Accrued clinical trial expense                 |       | 84                |       | 221                   |       |
| Accrued rebates and sales discounts            |       | 2,557             |       | 4,396                 |       |
| Allowance for product returns                  |       | 4,698             |       | 3,364                 |       |
| Accrued promotion fee                          |       | 2,483             |       | 1,752                 |       |
| Other accrued liabilities                      |       | 2,402             |       | 2,376                 |       |
| Total accounts payable and accrued liabilities |       | $                 | 14,230     |                  | $          | 15,222 |   |

 

**NOTE11.  SHAREHOLDERS’ EQUITY**

 

***Option Exercises***

 

Forthe three and six months ended June 30, 2010, employees and consultantsexercised options to purchase 40,401 and 194,445 shares of the Company’s commonstock with net proceeds to the Company of approximately $0.1 million and $0.4million, respectively.

 

***Employee Stock Purchase Plan***

 

In May 2010, the Company sold 151,261shares under the ESPP. The shares were purchased at a weighted average purchaseprice of $1.27 per share with proceeds of approximately $0.2 million.

 

**NOTE 12.  INCOME TAXES**

 

Asof December 31, 2009 and June 30, 2010, the Company had $3.2 million ofunrecognized tax benefits, which is netted against deferred tax assets and theremainder of which are fully offset by a valuation allowance.  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. The Companydoes not have any accrued interest or penalties associated with unrecognizedtax benefits.  The Company does notforesee any material changes to unrecognized tax benefits within the nexttwelve months.

 

**NOTE13.  SUBSEQUENT EVENTS**

 

In August 2010,the Company entered into a non-exclusive license agreement with JanssenPharmaceutica N.V. (Janssen) granting Janssen a license to certain patentsrelated to the Company’s Acuform drug delivery technology to be used indeveloping fixed dose combinations of canagliflozin and extended releasemetformin.

 

Under the terms of theagreement, Janssen was also granted a right of reference to the New DrugApplication covering the Company’s GLUMETZA product in Janssen’s regulatoryfilings covering fixed dose combinations of canagliflozin and extended releasemetformin. Depomed will be responsible for providing formulation workassociated with the fixed dose combination product.  In exchange, Depomed will receive a $5.0million upfront license fee, plus reimbursement for its formulation work on theproject and an additional $5.0 million milestone payment following completionof the Company’s formulation work.  TheCompany’s formulation obligations are expected to be completed in 2011.  The Company is also eligible to receiveadditional milestones plus a royalty on potential future net sales.

 

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

 

**FORWARD-LOOKING INFORMATION**

 

Statements made in this “Management’s Discussionand Analysis 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 have based these forward-lookingstatements on our current expectations and projections about futureevents.  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.  In addition, any statements that refer toexpectations, projections or other characterizations of future events orcircumstances are forward-looking statements. Forward-looking statementsinclude, but are not necessarily limited to, those relating to:

 

·                  regulatory filings and approval of DM-1796for postherpetic neuralgia;

·                  the commercial success and market acceptanceof DM-1796 if it is approved for marketing in the United States, and theefforts of Abbott Products Inc. (a wholly-owned subsidiary of Abbott Laboratories,or Abbott Products) with respect to the commercialization of DM-1796;

·                  results and timing of our clinical trials,including the results of our Serada® Phase 3 trialfor menopausal hot flashes;

·                  the commercial success and market acceptanceof Serada if we receive approval to market Serada in the United States;

·                  any patent infringement or other litigationthat may be instituted against us related to Serada under the Hatch-Waxman Act;

·                  the commercial success of GLUMETZA® (metformin hydrochloride extended releasetablets) in the United States, and the efforts of Santarus, Inc.(Santarus) with respect to the commercialization of GLUMETZA;

·                  the results of our ongoing litigation againstLupin Limited (Lupin) related to Lupin’s abbreviated New Drug Application(ANDA) to market generic GLUMETZA in the United States;

·                  our ability to timely resupply the marketwith 500mg tablets of GLUMETZA;

·                  the results of our research and developmentefforts;

·                  submission, acceptance and approval ofregulatory filings;

·                  our need for, and ability to raise additionalcapital;

·                  our and our collaborative partners’compliance or non-compliance with obligations under our collaborationagreements; and

·                  our plans to develop other productcandidates.

 

Factorsthat could cause actual results or conditions to differ from those anticipatedby these and other forward-looking statements include those more fullydescribed in the “**RISK FACTORS**”section and elsewhere in this Quarterly Report on Form 10-Q. Wedisclaim any intent to update or revise these forward-looking statements toreflect new events or circumstances.

 

**ABOUT DEPOMED**

 

Depomed is a specialty pharmaceutical companyfocused on the development and commercialization of differentiated productsthat address large and growing markets and are based on proprietary oral drugdelivery technologies.  In 2009, we completed Phase 3 clinical trials fortwo product candidates.  In October 2009, we announced that DM-1796,an extended release formulation of gabapentin for the treatment of postherpeticneuralgia that we have licensed to Abbott Products met its Phase 3 clinicaltrial primary endpoint with statistical significance.  A New DrugApplication (NDA) for DM-1796 was filed with the FDA in March 2010 andaccepted for review by the FDA in May 2010. Also in October 2009, weannounced the results of Breeze 1 and Breeze 2, our Phase 3 clinical trials forSerada, our proprietary extended release formulation of gabapentin for thetreatment of menopausal hot flashes.  The higher dose formulation ofSerada evaluated in the studies met five of eight co-primary endpoints acrossthe two studies, while the lower dose formulation evaluated met four of eightco-primary endpoints. In December 2009, we met with the FDA to discuss theresults of the Breeze 1 and Breeze 2 studies and 

 

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any additional clinical development that may be required to obtainapproval to market Serada in the United States. We expect to initiate oneadditional Phase 3 trial for Serada after we reach an agreement with the FDA ona Special Protocol Assessment (SPA) for the trial.

 

Weseek to optimize the use and value of our product candidates and drug deliverytechnologies in three ways.  First, weare seeking to assemble a number of pharmaceutical products that can be highlydifferentiated from immediate release versions of the compounds upon which theyare based and may be promoted together within a specialty pharmaceutical field,such as women’s health care providers. Our development of Serada, and ourretention of co-promotion rights within the obstetrics/gynecology field in ourcommercialization arrangements with Covidien, Ltd. (Covidien) and Santarus, Inc.(Santarus), are examples of this aspect of our business strategy.  Second, we out-license product candidatesafter we have increased their value through our formulation and clinicaldevelopment efforts. Our DM-1796 license and development arrangement withAbbott Products is an example of this strategy. Third, we enter into collaborative partnerships with other companieswhere the unique capabilities of our technology can provide superior value to apartner’s product candidate, resulting in greater value for Depomed thantraditional fee-for-service arrangements. Our license and development arrangement with Covidien and our licenseagreement with Merck & Co., Inc. (Merck) are examples of thisstrategy.

 

Wehave developed two products which have been approved by the FDA and arecurrently being sold. GLUMETZA is a once-daily treatment for adults with type 2diabetes that we commercialize in the United States with Santarus. Proquin® XR (ciprofloxacin hydrochloride) is aonce-daily treatment for uncomplicated urinary tract infections.

 

Thefollowing table summarizes our product pipeline and marketed products.

 

**Product Pipeline**

 
| **Product**  | ** ** | **Indication**                   | ** ** | **Status**                                                                                                                                                                                  |
|--------------|------------|----------------------------------|------------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|         |       |                             |       |                                                                                                                                                                                        |
| DM-1796      |       | Postherpetic  neuralgia          |       | Phase  3 study completed.

NDA  submitted to the FDA in March 2010 and accepted for review in  May 2010.

*Licensed  to Abbott Products in the United States, Mexico and Canada.* |
|         |       |                             |       |                                                                                                                                                                                        |
| Serada® |       | Menopausal  hot flashes          |       | Phase  3 studies completed (Breeze 1 and Breeze 2).

One  additional Phase 3 study (Breeze 3) expected to be initiated in Q3 2010.                                                          |
|         |       |                             |       |                                                                                                                                                                                        |
| DM-3458      |       | Gastroesophageal  reflux disease |       | Proof  of concept studies completed.                                                                                                                                                        |
|         |       |                             |       |                                                                                                                                                                                        |
| DM-1992      |       | Parkinson’s  disease        |       | Phase  1 study completed.

Second  Phase 1 study expected to be initiated in Q3 2010.                                                                                                       |

 

**MarketedProducts**

 
| **Product**           | ** ** | **Indication**                         | ** ** | **Status**                                                                                                                                                                            |
|-----------------------|------------|----------------------------------------|------------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| ** **            | ** ** | ** **                             | ** ** | ** **                                                                                                                                                                            |
| GLUMETZA®        |       | Type  2 diabetes                       |       | Currently  sold in the United States and Canada.

*Co-promoted  in the United States with Santarus.*

*Canadian rights held by Biovail.*

*Korean  rights held by LG Life**Sciences.* |
|                  |       |                                   |       |                                                                                                                                                                                  |
| Proquin® XR |       | Uncomplicated  urinary tract infection |       | Currently  sold in the United States.

Regulatory  application approved in Sweden*.*

*European  rights held by Rottapharm/Madaus*.                                                   |

 

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***Significant Developments and Highlights for the QuarterEnded June 30, 2010***

 

·                  In May 2010, the FDA accepted the NDAfiling for DM-1796 for postherpetic neuralgia, which triggered a $10.0 millionmilestone payment from Abbott Products to us in June 2010.

·                  Revenue for the three months ended June 30,2010 was $24.4 million, compared to $11.6 million for the three months ended June 30,2009. Revenue for the three months ended June 30, 2010 includedrecognition of the $10.0 million milestone payment received from AbbottProducts.

·                  In June 2010, we conducted a voluntaryrecall of fifty-two lots of 500mg GLUMETZA from wholesalers due to the presenceof trace amounts of a chemical called 2,4,6-tribromoanisole in bottlescontaining 500mg GLUMETZA tablets. Additionally, we temporarily suspendedshipments of the 500mg GLUMETZA to our customers until such time we are able toremedy the situation.

·                  Operating expenses for the three months endedJune 30, 2010 were $17.2 million, compared to $20.0 million for the threemonths ended June 30, 2009.

·                  Cash, cash equivalents and marketablesecurities were $76.9 million as of June 30, 2010, compared to $81.8million as of December 31, 2009.

 

***RECENT PRODUCT DEVELOPMENTS ANDTRANSACTIONS***

 

***DM-1796 for Postherpetic Neuralgia***

 

*Abbott Products Inc.* In November 2008, we entered into an exclusive license agreementwith Solvay Pharmaceuticals, Inc. (Solvay) granting Solvay exclusiverights to develop and commercialize DM-1796 in the United States, Canada andMexico for pain indications. In February 2010, Abbott Laboratoriesacquired the pharmaceutical business of Solvay.

 

In March 2010, Abbott Products, asubsidiary of Abbott Laboratories, submitted a New Drug Application (NDA) forDM-1796 to the U.S. Food and Drug Administration (FDA) for the management ofpostherpetic neuralgia.  In May 2010,the FDA accepted the NDA for DM-1796 for the management of postherpetic neuralgia,which triggered a $10 million milestone payment from Abbott Products to us in June 2010.

 

Weare also eligible to receive aggregate milestone payments of up to $60 millionon FDA approval of the New Drug Application for DM-1796 for postherpetic neuralgia,and up to $300 million in potential sales milestone payments. AbbottProducts will pay us royalties of 14 to 20 percent of net product sales,depending on the level of net product sales.

 

TheNDA for DM-1796 was submitted under Section 505(b)(2) of the Food,Drug and Cosmetic Act (FDCA) as it relies on the FDA’s prior approval ofNeurontin® (gabapentin), the immediate release formulation of gabapentininitially approved by the FDA.  In accordance with the Hatch-Waxman Act,the DM-1796 NDA includes certifications, known as Paragraph IV certifications,that certify the patents listed with Neurontin in the FDA’s Orange Bookpublication (Orange Book), U.S. Patent Nos. 7,256,216 and 6,054,482(collectively, the Orange Book Patents), are invalid, unenforceable, and/orwill not be infringed by the manufacture, use, or sale of DM-1796.

 

InJune 2010, following the FDA’s acceptance for filing of the DM-1796 NDA,Abbott Products provided a notice (Paragraph IV Notice) to Pfizer, Inc.(Pfizer), the Neurontin NDA holder listed in the FDA’s Orange Book that(a) states, among other things, that the DM-1796 NDA has been submittedand (b) provides the factual and legal basis for the applicant’s opinionthat Pfizer’s Neurontin Orange Book Patents are invalid, unenforceable, and/orwill not be infringed by the manufacture, use, or sale of DM-1796.  In August 2010, the 45-day period for filing a patentinfringement suit by Pfizer against Abbott Products expired. The filing of asuit could have initiated a 30-month stay on the FDA’s ability to approve theDM-1796 NDA under the Hatch-Waxman Act.

 

TheFDA has set the Prescription Drug User Fee (PDUFA) goal date in the firstquarter of 2011 for action on the DM-1796 NDA.

 

***Serada****®** ****for Menopausal Hot Flashes***

 

*Phase 3Study-Breeze 3 Clinical Trial**. * InDecember 2009, we met with the FDA regarding Serada for the treatment ofmenopausal hot flashes. Based on guidance reflected in the meeting minutes, weplan to conduct a single additional pivotal Phase 3 trial evaluating Serada forthe treatment of menopausal hot flashes. We expect to initiate the trial, whichwill be known as Breeze 3, after we reach agreement with the FDA on a SpecialProtocol Assessment (SPA) for the trial.

 

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The Breeze 3 protocol has been reviewed bythe FDA under the FDA’s special protocol assessment procedures.  An SPA isan agreement with the FDA that a proposed trial protocol design, clinicalendpoints and statistical analyses are acceptable to support a productcandidate’s regulatory approval.  We received an initial assessment of theBreeze 3 protocol in March 2010, and resubmitted the protocol for afurther assessment after modifying the protocol to address the FDA’s guidancereflected in the initial assessment. In April 2010, we received theFDA’s further guidance on the protocol.  The guidance included three minorcomments related to the statistical analysis of a secondary endpoint, thePatient Global Impression of Change (PGIC).  The PGIC will be used inconjunction with a “responder analysis” that may be required to assess theclinical meaningfulness of any reduction in the frequency of hot flashes in theactive arm relative to the placebo arm.

 

In June 2010, we held a meeting with theFDA to discuss the FDA’s further guidance received in April 2010. Following the meeting, we resubmitted the protocol for Breeze 3 to the FDApursuant to the SPA program.  Because the resubmitted Breeze 3 protocolreflects the FDA’s two prior reviews of the Breeze 3 protocol under the SPAprogram and guidance from the FDA received at the meeting, we do not anticipateany further comments from the FDA on the Breeze 3 protocol.  Accordingly,we expect to receive a final assessment of the Breeze 3 protocol in August 2010and expect to begin enrolling patients in the Breeze 3 trial in September 2010.

 

*StudyDesign. *Breeze 3 will be a randomized, double-blind,placebo-controlled study of up to 600 patients. Patients will be randomizedinto one of two treatment arms, with patients receiving either placebo or atotal dose of 1800mg of Serada dosed 600mg in the morning and 1200mg in theevening. The co-primary efficacy endpoints in the study will be reductions inthe mean frequency of moderate-to-severe hot flashes, and the average severityof hot flashes, measured after four and 12 weeks of stable treatment. As in theprior Breeze 1 trial, the treatment duration of the study will be 24 weeks, toaddress the FDA’s view that an effective drug should also show statisticallysignificant persistence of efficacy at 24 weeks. The trial will also include aresponder analysis to assess the clinical meaningfulness of any reduction inthe frequency of hot flashes in the active arm relative to the placebo arm.

 

Modifications to the design of Breeze 3relative to Breeze 1 and 2 include: (i) a single active arm rather thantwo arms, and therefore a required statistical p value of .05 rather than .025to achieve statistical significance; (ii) up to 65% more patients in theactive treatment arm than in Breeze 1 and 2 (iii) a two-week run in periodto prior to randomization, rather than one week, which is designed to reducethe regression to the mean observed in Breeze 1 and 2, resulting in a morestable baseline, and thereby potentially reducing the placebo effect; and(iv) an alternative statistical analysis method, known as a non-parametricanalysis, that is designed to reduce the influence significant outliers canhave on the achievement of efficacy endpoints.

 

***GLUMETZA for Type 2 Diabetes***

 

*500mg GLUMETZA Recall**.** * In June 2010, we conducted a voluntary class 2 recall offifty-two lots of 500mg GLUMETZA product from wholesalers due to thepresence of trace amounts of a chemical called 2,4,6-tribromoanisole (TBA) inbottles containing 500mg GLUMETZA tablets. We believe the presence of TBAin 500mg GLUMETZA bottles may have resulted from the breakdown of a chemicalsometimes applied to wood in pallets previously used to transport 500mgGLUMETZA bottles to our contract manufacturer in Puerto Rico. The healtheffects of TBA have not been well studied, but TBA has been found in foodproducts (such as wine and milk) at levels greater than those detected in theGLUMETZA tablet bottles and no serious events associated with TBA have beendocumented in the medical literature. We are cooperating with the FDA and ourcontract manufacturer on this recall. As a result, we temporarily suspendedproduct shipments of 500mg GLUMETZA product in June 2010 to our customers.

 

Based on preliminary testresults we recently received and are evaluating in connection with our ongoinginvestigation into the source of trace amounts of TBA found in 500mg Glumetzabottles, we have determined that additional testing and analysis isrequired.  We expect to provide an updateon the 500mg Glumetza supply situation in mid-August, after we determinewhether the corrective actions we have taken have been successful. If thoseactions have been successful, we expect to be in a position to resupply themarket in mid-August.  If not, we expectto experience a further period of supply disruption as we address the issue.

 

1000mg GLUMETZA product wasnot subject to the recall and is currently being sold to customers.

 

***Janssen Pharmaceutica N.V.***

 

InAugust 2010, we entered into a non-exclusive license agreement with JanssenPharmaceutica N.V. (Janssen) granting Janssen a license to certain patentsrelated to our Acuform drug delivery technology to be used in developing fixeddose combinations of canagliflozin, a Sodium Glucose Transport 2 (SGLT2)inhibitor, and extended release metformin.

 

Underthe terms of the agreement, Janssen was also granted a right of reference tothe New Drug Application covering our GLUMETZA product in Janssen’s regulatoryfilings covering fixed dose combinations of canagliflozin and extended releasemetformin. We are responsible for providing formulation work associated withthe fixed dose combination product.  Inexchange, we will receive a $5.0 million upfront license fee, plusreimbursement for our formulation work on the project and an additional $5.0million milestone payment following completion of our formulation work.  Our formulation obligations are expected tobe completed in 2011.  We are alsoeligible to receive additional milestones plus a royalty on potential futurenet sales.

 

**CRITICAL ACCOUNTING POLICIES**

 

Criticalaccounting policies are those that require significant judgment and/orestimates by management at the time that the financial statements are preparedsuch that materially different results might have been reported if otherassumptions had been made. We consider certain accounting policies related torevenue recognition, accrued liabilities and stock-based compensation to becritical policies. There have been no changes to our critical accountingpolicies since we filed our 2009 Annual Report on Form 10-K with theSecurities and Exchange Commission on March 9, 2010. For a description ofour critical accounting policies, please refer to our 2009 Annual Report onForm 10-K.

 

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**RESULTS OF OPERATIONS**

 

*Three and Six Months Ended June 30, 2010 and 2009*

 

**Revenue**

 

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

 
| ** **                          | ** ** | **Three Months Ended June 30,** | ** ** | **Six Months Ended June 30,** | ** ** |
|-------------------------------------|------------|--------------------------------------|------------|------------------------------------|------------|
| ** **                          | ** ** | **2010**                             | ** ** | **2009**                           | ** ** | **2010** | ** ** | **2009** | ** ** |
| Product sales:                      |       |                                 |       |                               |       |   |   |   |   |
| GLUMETZA                            |       | $                                    | 11,625     |                               | $          | 8,245 |   | $ | 24,169 |   | $ | 14,888 |   |
| Proquin XR                          |       | 32                                   |       | 163                                |       | 88 |   | 360 |   |
| Total product sales                 |       | 11,657                               |       | 8,408                              |       | 24,257 |   | 15,248 |   |
|                                |       |                                 |       |                               |       |   |   |   |   |
| Royalties:                          |       |                                 |       |                               |       |   |   |   |   |
| GLUMETZA                            |       | 91                                   |       | 65                                 |       | 179 |   | 101 |   |
| Teva                                |       | —                               |       | 464                                |       | — |   | 892 |   |
| Total royalties                     |       | 91                                   |       | 529                                |       | 179 |   | 993 |   |
|                                |       |                                 |       |                               |       |   |   |   |   |
| License and milestone revenue:      |       |                                 |       |                               |       |   |   |   |   |
| DM-1796                             |       | 11,561                               |       | 1,561                              |       | 13,123 |   | 3,038 |   |
| GLUMETZA                            |       | 626                                  |       | 626                                |       | 1,251 |   | 1,252 |   |
| Acuform technology                  |       | 458                                  |       | 458                                |       | 917 |   | 916 |   |
| Proquin XR                          |       | 26                                   |       | 26                                 |       | 51 |   | 33 |   |
| Total license and milestone revenue |       | 12,671                               |       | 2,671                              |       | 15,342 |   | 5,239 |   |
|                                |       |                                 |       |                               |       |   |   |   |   |
| Total revenues                      |       | $                                    | 24,419     |                               | $          | 11,608 |   | $ | 39,778 |   | $ | 21,480 |   |

 

***Product sales***

 

*GLUMETZA**.*The increase in GLUMETZAproduct sales in the three and six months ended June 30, 2010 as comparedto the three and six months ended June 30, 2009 is primarily driven byincreased penetration in the metformin prescription market resulting from thepromotion efforts by our promotion partner, Santarus, as well price increases.

 

GLUMETZAproduct sales in the three and six months ended June 30, 2010 alsoincluded a return reserve of $1.2 million related to estimated credit forreturns to be given to customers on returns of recalled 500mg GLUMETZA product,which had the effect of reducing product sales. As a result of the recall, wetemporarily suspended product shipments of 500mg GLUMETZA product in June 2010to our customers until such time we are able to remedy the situation. Any delayin resupplying the market with 500mg GLUMETZA product could adverselyaffect our GLUMETZA product sales.

 

The1000mg GLUMETZA product was not subject to the recall and is currently beingsold to customers.

 

Productsales for GLUMETZA relative to its current runrate will depend in part on thesuccess of our promotion partner, Santarus, price adjustments, the timing ofmarket re-introduction of 500mg GLUMETZA product, and our ability to continuesupplying 1000mg GLUMETZA product.

 

*Proquin XR*.  Wedefer recognition of revenue on product shipments of Proquin XR until the rightof return no longer exists, which occurs at the earlier of the time Proquin XRunits are dispensed through patient prescriptions or expiration of the right ofreturn. At June 30, 2010, we have a deferred revenue balance, which isclassified as a liability on the balance sheet, of $1.6 million associatedwith the deferral of revenue on Proquin XR product shipments, which is net ofestimated wholesaler fees, retail pharmacy discounts, stocking allowances andprompt payment discounts.

 

InFebruary 2009, we amended our promotion agreement with Watson, pursuant towhich Watson performed a specified number of details in the first quarter of2009.  The agreement with Watsonterminated effective December 31, 2009, and we currently have no salesforce or promotion partner promoting Proquin XR to physicians.

 

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***Royalties***

 

*GLUMETZA**.* GLUMETZA royalties relateto royalties we received from Biovail based on net sales of GLUMETZA in Canadaand royalties we received from LG based on net sales of LG’s version ofGLUMETZA, Novamet GR, in Korea. We began receiving royalties from Biovail inthe first quarter of 2006 and from LG in the first quarter of 2007.

 

*Teva*.  In April 2008,we entered into a settlement and license agreement with Teva PharmaceuticalsUSA, Inc. (Teva) associated with our patent infringement lawsuit againstTeva affiliates IVAX Corporation and IVAX Pharmaceuticals, Inc. related toTeva’s generic Glucophage XR tablets. In connection with the settlement andlicense agreement we were entitled to receive up to a total of $2.5 million infuture royalties on Teva’s generic Glucophage XR product in the United States.The $2.5 million cap in royalties was met in 2009.

 

***License and milestone revenue***

 

*DM-1796**.*The increase in**DM-1796 license and milestone revenue for the three and sixmonths ended June 30, 2010 as compared to the corresponding periods in2009 relates to the $10.0 million milestone payment received from AbbottProducts in June 2010 on FDA acceptance of the NDA for DM-1796 for thetreatment of postherpetic neuralgia. Because the milestone was substantive innature, achieved and based on past performance, the entire $10.0 million wasrecognized as license revenue in the second quarter of 2010. In the fourthquarter of 2008, the Company received a $25.0 million upfront license paymentfrom Abbott Products under our license agreement granting Abbott Productsexclusive rights to develop and commercialize DM-1796 in the United States,Canada and Mexico for pain indications. We are recognizing the $25.0 millionupfront payment received from Abbott Products as revenue ratably until January 2013,which represents the expected maximum length of time our development and supplyobligations exist under the agreement.

 

*GLUMETZA**.*GLUMETZA license revenue forthe three and six months ended June 30, 2010 and 2009 consisted of licenserevenue recognized from the $25.0 million upfront license fee received fromBiovail in July 2005 and the $12.0 million upfront fee received fromSantarus in July 2008.

 

Weare recognizing the $25.0 million upfront license fee payment from Biovail asrevenue ratably until October 2021, which represents the estimated lengthof time our obligations exist under the arrangement related to royalties we areobligated to pay Biovail on net sales of GLUMETZA in the United States and forour obligation to use Biovail as our sole supplier of the 1000mg GLUMETZA. Weare recognizing the $12.0 million upfront payment from Santarus as revenueratably until October 2021, which represents the estimated length of timeour obligations exist under the arrangement related to promotion fees we areobligated to pay Santarus on gross margin of GLUMETZA in the United States.

 

*Acuform Technology**.*In November 2008,we entered into a license agreement with Covidien granting Covidien worldwiderights to utilize our Acuform technology for the exclusive development of fourproducts containing acetaminophen in combination with opiates. Through November 2008,Covidien paid us a total of $5.5 million in upfront fees, representing a $4.0million upfront license fee and a $1.5 million upfront payment for formulationwork to be performed by Depomed under the agreement. The entire $5.5 million isbeing accounted for as a single unit of accounting and being amortized ratablythrough November 2011, which is the length of time Depomed is obligated toperform formulation work under the agreement.

 

**Cost ofSales**

 

Costof sales consists of costs of the active pharmaceutical ingredient, contractmanufacturing and packaging costs, inventory write-downs, product qualitytesting, internal employee costs related to the manufacturing process,distribution costs and shipping costs related to our product sales of GLUMETZAand Proquin XR. Total cost of sales for the three and six months ended June 30,2010, as compared to the prior year, was as follows (in thousands):

 
| ** **    | ** ** | **Three Months Ended June 30,** | ** ** | **Six Months Ended June 30,** | ** ** |
|---------------|------------|--------------------------------------|------------|------------------------------------|------------|
| ** **    | ** ** | **2010**                             | ** ** | **2009**                           | ** ** | **2010** | ** ** | **2009** | ** ** |
| Cost of sales |       | $                                    | 2,981      |                               | $          | 1,229 |   | $ | 4,462 |   | $ | 2,261 |   |
|               |            |                                      |            |                                    |            |  |  |  |  |  |  |  |  |

 

Costof sales increased in 2010 as compared to the corresponding period in 2009,mainly as a result of $1.4M inventory write off for unsalable inventory relatedto the 500mg GLUMETZA product recall in June 2010 as well as increases in1000mg GLUMETZA product sales.

 

Thecosts of manufacturing associated with deferred revenue on Proquin XR productshipments are recorded as deferred costs, which are included in inventory,until such time the related deferred revenue is recognized.

 

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**Researchand Development Expense**

 

Ourresearch and development expenses currently include costs for scientificpersonnel, supplies, equipment, outsourced clinical and other researchactivities, consultants, depreciation, facilities and utilities. The scope andmagnitude of future research and development expenses cannot be predicted atthis time for our product candidates in the early phases of research anddevelopment, as it is not possible to determine the nature, timing and extentof clinical trials and studies, the FDA’s requirements for a particular drugand the requirements and level of participation, if any, by potential partners.As potential products proceed through the development process, each step istypically more extensive, and therefore more expensive, than the previous step.Success in development therefore, generally results in increasing expendituresuntil actual product launch.

 

Totalresearch and development expense for the three and six months ended June 30,2010, as compared to the prior year, was as follows (in thousands):

 

 
| ** **                        | ** ** | **Three Months Ended June 30,** | ** ** | **Six Months Ended June 30,** | ** ** |
|-----------------------------------|------------|--------------------------------------|------------|------------------------------------|------------|
| ** **                        | ** ** | **2010**                             | ** ** | **2009**                           | ** ** | **2010** | ** ** | **2009** | ** ** |
| Research and development expense  |       | $                                    | 4,570      |                               | $          | 10,024 |   | $ | 9,758 |   | $ | 20,045 |   |
| Dollar change from prior year     |       | (5,454                               | )          |                               |       | (10,287 | ) |   |   |
| Percentage change from prior year |       | (54.4                                | )%         |                               |       | (51.3 | )% |   |   |
|                                   |            |                                      |            |                                    |            |  |  |  |  |  |  |  |  |

 

Thedecrease in research and development expense for the three and six months endedJune 30, 2010 as compared to the three and six months ended June 30,2009 was primarily due to lower clinical research organization expenses relatedto the completion of our DM-1796 Phase 3 and Serada Breeze 1 and Breeze 2 Phase3 programs in 2009.

 

Weplan to conduct a single additional pivotal Phase 3 trial evaluating Serada forthe treatment of menopausal hot flashes. The company expects to initiate thetrial, which will be known as Breeze 3 in September 2010. As such, weexpect research and development expense to increase in the second half of 2010relative to the first half of 2010. While we expect to continue to incursignificant research and development expenses resulting from the progress ofBreeze 3, we expect total research and development expenses to decrease in 2010from 2009 as a result of completion of the DM-1796 Phase 3 clinical trialduring 2009.

 

Wecategorize our research and development expense by project. The table belowshows research and development costs for our major clinical development programs,as well as the expenses associated with all other projects in our productpipeline.

 
| ** **                             | ** ** | **Three Months Ended June 30,** | ** ** | **Six Months Ended June 30,** | ** ** |
|----------------------------------------|------------|--------------------------------------|------------|------------------------------------|------------|
| **(In thousands)**                     | ** ** | **2010**                             | ** ** | **2009**                           | ** ** | **2010** | ** ** | **2009** | ** ** |
| DM-1796                                |       | $                                    | 869        |                               | $          | 2,645 |   | $ | 2,246 |   | $ | 6,726 |   |
| Serada                                 |       | 2,062                                |       | 5,279                              |       | 4,010 |   | 8,854 |   |
| Other projects                         |       | 1,639                                |       | 2,100                              |       | 3,502 |   | 4,465 |   |
| Total research and development expense |       | $                                    | 4,570      |                               | $          | 10,024 |   | $ | 9,758 |   | $ | 20,045 |   |

 

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**Selling, General and Administrative Expense**

 

Selling, general and administrative expenseprimarily consists of personnel expenses to support our administrative andoperating activities, marketing and promotion expenses associated with Serada,GLUMETZA and Proquin XR, facility costs and professional expenses, such aslegal and accounting fees. Total selling, general and administrative expense,as compared to the prior year, were as follows (in thousands):

 
| ** **                                        | ** ** | **Three Months Ended June 30,** | ** ** | **Six Months Ended June 30,** | ** ** |
|---------------------------------------------------|------------|--------------------------------------|------------|------------------------------------|------------|
| ** **                                        | ** ** | **2010**                             | ** ** | **2009**                           | ** ** | **2010** | ** ** | **2009** | ** ** |
| Selling, general and administrative expense:      |       |                                 |       |                               |       |   |   |   |   |
| Promotion fee expense                             |       | $                                    | 8,099      |                               | $          | 5,640 |   | $ | 16,978 |   | $ | 10,184 |   |
| Other selling, general and administrative expense |       | 4,541                                |       | 4,305                              |       | 8,091 |   | 8,763 |   |
| Total selling, general and administrative expense |       | $                                    | 12,640     |                               | $          | 9,945 |   | $ | 25,069 |   | $ | 18,947 |   |
| Dollar change from prior year                     |       | 2,695                                |       |                               |       | 6,122 |   |   |   |
| Percentage change from prior year                 |       | 27.1                                 | %          |                               |       | 32.3 | % |   |   |

 

Theincrease in selling, general and administrative expense was primarily due to anincrease in GLUMETZA promotion fees to Santarus which was driven by an increasein GLUMETZA product sales.

 

**Interest Income and Expense**

 
| ** **                    | ** ** | **Three Months Ended June 30,** | ** ** | **Six Months Ended June 30,** | ** ** |
|-------------------------------|------------|--------------------------------------|------------|------------------------------------|------------|
| **(in  thousands)**           | ** ** | **2010**                             | ** ** | **2009**                           | ** ** | **2010** | ** ** | **2009** | ** ** |
| Interest and other income     |       | $                                    | 56         |                               | $          | 236 |   | $ | 150 |   | $ | 550 |   |
| Interest expense              |       | (157                                 | )          | (263                               | )          | (340 | ) | (548 | ) |
| Net interest income (expense) |       | (101                                 | )          | (27                                | )          | (190 | ) | 2 |   |
|                               |            |                                      |            |                                    |            |  |  |  |  |  |  |  |  |

 

Interestand other income decreased during the three and six months ended June 30,2010 as compared to the corresponding period in 2009 as a result of lowerinterest rates on our investments.

 

Interestexpense relates to interest on the credit facility we entered into in June 2008with General Electric Capital Corporation and Oxford Finance Corporation.

 

**LIQUIDITYAND CAPITAL RESOURCES**

 
| **(in  thousands)**                              | ** ** | **June 30,********2010** | ** ** | **December 31,  2009** | ** ** |
|--------------------------------------------------|------------|-------------------------------|------------|-----------------------------|------------|
| Cash, cash equivalents and marketable securities |       | $                             | 76,886     |                        | $          | 81,759 |   |
|                                                  |            |                               |            |                             |            |  |  |

 

InJune 2010, we received a $10.0 million milestone payment from AbbottProducts related to the FDA’s acceptance for review of the NDA for DM-1796 forthe treatment of postherpetic neuralgia.

 

Sinceinception through June 30, 2010, we have financed our product developmentefforts and operations primarily from private and public sales of equitysecurities and from license and termination fees from collaborative and licensepartners.

 

In December 2006, weentered into a common stock purchase agreement with Azimuth Opportunity, Ltd.,pursuant to which Azimuth is committed to purchase, from time to time and atour sole discretion, up to the lesser of (a) $30.0 million of our commonstock, or (b) 8,399,654 shares of common stock. In August 2008, theagreement was amended and the term of the agreement was extended until December 2010.Sales to Azimuth under the agreement, if any, will be made at a price equal tothe average closing price of our common stock over a given pricing period,minus a discount ranging from approximately 3.8% to 6.4%, which varies based ona threshold price set by us. Upon each sale of the our common stock to Azimuthunder the agreement, we have also agreed to pay Reedland Capital Partners aplacement fee equal to approximately 1.1% of the aggregate dollar amount ofcommon stock purchased by Azimuth. Azimuth is not required to purchase ourcommon stock when the price of our common stock is below $2 per share. As of June 30,2010, we have not sold any common stock to Azimuth under this common stockpurchase agreement.

 

InJune 2008, we entered into a credit facility with GECC and Oxford. Thecredit facility was available in up to three tranches.  The first tranche of $3.8 million wasadvanced to us upon the closing of the loan agreement.  In July 2008, we received the secondtranche of $5.6 million. The third tranche of $5.6 million was not drawn and itis no longer available to us, and GECC and Oxford waived the 2% unused line feerelated to the third tranche.

 

We paid interest only on thefirst tranche for the first six months at an interest rate of 11.59%.  Thereafter we are required to pay principalon the first tranche, plus interest at such rate, in 30 equal monthlyinstallments. The second tranche

 

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was interest-only through December 31,2008, with principal and interest payable thereafter in 30 equal monthlyinstallments with an interest rate of 11.59%. Asof June 30, 2010, the entire outstanding balance on the credit facilitywas $4.2 million at an interest rate of 11.59%.

 

Our obligations under the loan agreement aresecured by interests in all of our personal property, and proceeds from anyintellectual property, but not by our intellectual property.  The loan agreement contains conditionsprecedent that must be satisfied prior to any borrowing and affirmative andnegative covenants with which we must comply.  The loan agreement imposesrestrictions with regards to additional indebtedness, liens, variousfundamental changes (including mergers and acquisitions), payments,investments, transactions with affiliates, and other limitations customary insecured credit facilities.  As of June 30,2010, we were in compliance with such covenants. The loan agreement providesthat events of default will exist in certain circumstances, including failureto make payment of principal or interest on the loans when required, failure toperform certain obligations under the loan agreement and related documents,defaults in certain other indebtedness and certain other events.  Upon anevent of default, the principal amount of the loan may become due immediately.

 

Asof June 30, 2010, we have accumulated net losses of $171.9 million. Weexpect to incur operating losses for the remainder of 2010. We anticipate thatour existing capital resources will permit us to meet our capital andoperational requirements through at least the end of 2011. We base thisexpectation on our current operating plan, which may change as a result ofmany factors.

 

Ourcash needs may also vary materially from our current expectations becauseof numerous factors, including:

 

·          sales of ourmarketed products;

·          expendituresrelated to our commercialization and development efforts, includingarrangements we make for the commercialization of Serada, if the product isapproved for marketing;

·          financial termsof definitive license agreements or other commercial agreements we enter into,if any;

·          results ofresearch and development efforts;

·          changes in thefocus and direction of our research and development programs;

·          technologicaladvances;

·          results ofclinical testing, requirements of the FDA and comparable foreign regulatoryagencies; and

·          acquisitions orinvestment in complimentary businesses, products or technologies.

 

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

 

·          conductresearch and development programs;

·          commercializeany products we market;

·          conductpreclinical and clinical testing; and

·          manufacture (or have manufactured) and market (orhave marketed) our marketed products and product candidates.

 

Our existing capital resources may not be sufficient to fund ouroperations until such time as we may be able to generate sufficientrevenues to support our operations. We have limited credit facilities and,except for the common stock purchase agreement with Azimuth, we have no othercommitted sources of capital. To the extent that our capital resources areinsufficient to meet our future capital requirements, we will have to raiseadditional funds through the sale of our equity securities or from developmentand licensing arrangements to continue our development programs. We may beunable to raise such additional capital on favorable terms, or at all. If weraise additional capital by selling our equity or convertible debt securities,the issuance of such securities could result in dilution of our shareholders’equity positions. If adequate funds are not available we may have to:

 

·          delay, postponeor terminate clinical trials;

·          significantlycurtail commercialization of our marketed products or other operations; and/or

·          obtain fundsthrough entering into collaboration agreements on unattractive terms.

 

Theinability to raise additional capital required to fund our operations couldhave a material adverse effect on our company.

 

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**Cash Flows from Operating Activities**

 

Cashused in operating activities during the six months ended June 30, 2010 wasapproximately $3.6 million, compared to cash provided by operating activitiesof approximately $3.5 million for the six months ended June 30, 2009. Cashused in operating activities during the six months ended June 30, 2010 wasprimarily due to our net income adjusted for movements in working capital,stock-based compensation and depreciation expense. Cash provided by operatingactivities for the six months ended June 30, 2009 was primarily as aresult of the $25.0 million upfront payment received from Solvay in February 2009,offset by a net loss for the six months ended June 30, 2009.

 

**Cash Flows from Investing Activities**

 

Netcash provided by investing activities during the six months ended June 30,2010 was approximately $0.3 million and consisted primarily of a slightdecrease in marketable securities for use in operating activities. Net cashused in investing activities during the six months ended June 30, 2009 wasapproximately $16.2 million and consisted primarily of a net increase inmarketable securities resulting from investment of the upfront payment receivedfrom Solvay in February 2009.

 

**Cash Flows from Financing Activities**

 

Cashused in financing activities during the six months ended June 30, 2010 wasapproximately $1.3 million compared to $1.4 million for the same period in2009, and consisted of repayments of principal on our credit facility offset byproceeds from employee and consultant option exercises.

 

**Contractual Obligations**

 

Asof June 30, 2010, our aggregate contractual obligations are as shown inthe following table (in thousands):

 
| ** **                 | ** ** | **Less than  1 year** | ** ** | **1-3 years** | ** ** | **3-5 years** | ** ** | **Total** | ** ** |
|----------------------------|------------|-----------------------|------------|---------------|------------|---------------|------------|-----------|------------|
| Operating leases           |       | $                     | 1,618      |          | $          | 961           |       | $         | —     |   | $ | 2,579 |   |
| Long-term debt (principal) |       | 4,075                 |       | 146           |       | —        |       | 4,221     |       |
| Long-term debt (interest)  |       | 282                   |       | 1             |       | —        |       | 283       |       |
| Purchase commitments       |       | 3,023                 |       | —        |       | —        |       | 3,023     |       |
|                       |       | $                     | 8,998      |          | $          | 1,108         |       | $         | —     |   | $ | 10,106 |   |

 

AtJune 30, 2010, we had non-cancelable purchase orders and minimum purchaseobligations of approximately $1.9 million under our manufacturing agreementwith Patheon Puerto Rico, Inc. for the manufacture of 500mg GLUMETZAproduct, and $1.1 million under our supply agreement with Biovail for thesupply of 1000mg GLUMETZA product. The amounts disclosed only represent minimumpurchase requirements. Actual purchases are expected to exceed these amounts.

 

Thecontractual obligations reflected in this table exclude $3.0 million ofcontingent milestone payments we may be obligated to pay in the future underour sublicense agreement with PharmaNova related to the development of Serada.The payments relate to various milestones for the product candidate under thesublicense agreement, including submission to the FDA of an NDA, and FDAapproval of an NDA. The above table also excludes any future royalty paymentswe may be required to pay on products we have licensed or any promotion feesassociated with our promotion agreement with Santarus.

 

**ITEM 3. QUANTITATIVE ANDQUALITATIVE 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, 2009.

 

**ITEM 4. CONTROLS ANDPROCEDURES**

 

***Evaluation of Disclosure Controls and Procedures***

 

An evaluation was performedunder the supervision and with the participation of our management, includingthe Company’s Chief Executive Officer and Vice President, Finance, of theeffectiveness of the design and operation of our disclosure controls andprocedures as of the end of the period covered by this quarterly report. Basedon that evaluation, our management, including the Company’s Chief ExecutiveOfficer and Vice President, Finance, concluded that our disclosure controls andprocedures were effective.

 

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We review and evaluate the design and effectivenessof our disclosure controls and procedures on an ongoing basis to improve ourcontrols and procedures over time and to correct any deficiencies that wemay discover in the future. Our goal is to ensure that our seniormanagement has timely access to all material financial and non-financialinformation concerning our business. While we believe the present design of ourdisclosure controls and procedures is effective to achieve our goal, futureevents affecting our business may cause us to significantly modify ourdisclosure controls and procedures.

 

***Changes in Internal Controls***

 

There were no changes in our internal controls overfinancial reporting during the quarter ended June 30, 2010 that havematerially affected, or are reasonably likely to materially affect, ourinternal control over financial reporting.

 

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**PART II — OTHER INFORMATION**

 

**ITEM 1. LEGAL PROCEEDINGS**

 

***Depomed v. Lupin (U.S.  GenericGLUMETZA Litigation)***

 

In November 2009, we filed a lawsuit in theUnited States District Court for the Northern District of California againstLupin Limited and its wholly-owned subsidiary, Lupin Pharmaceutical, Inc.(Lupin), for infringement of the patents listed in the Orange Book forGLUMETZA.  The lawsuit is in response to an Abbreviated New DrugApplication filed by Lupin with the FDA regarding Lupin’s intent to marketgeneric versions of 500mg and 1000mg dosage strengths of GLUMETZA prior to theexpiration of the four listed patents (U.S. Patent Nos. 6,340,475; 6,488,962; 6,635,280;and 6,723,340). The Company has commenced the lawsuit within the 45 daysrequired to automatically stay, or bar, the FDA from approving Lupin’s ANDA for30 months or until a district court decision that is adverse to thepatents, whichever may occur earlier. Absent a court decision, the 30-monthstay is expected to expire in May 2012. Lupin has prepared and filed ananswer in the case, principally asserting non-infringement and invalidity ofthe Orange Book patents, and has also filed counterclaims.  Discovery iscurrently underway and a hearing for claim construction, or Markman hearing, isscheduled for January 2011. An adverse outcome in this matter couldsubstantially weaken our U.S. intellectual property.

 

***Biovail and Depomed v. Apotex (Canadian Generic GLUMETZA Litigation)***

 

InDecember 2007, Apotex, Inc. (Apotex) filed the Canadian equivalent ofan Abbreviated New Drug Application in Canada seeking approval to market ageneric version of the 500mg formulation of GLUMETZA in Canada.

 

InFebruary 2010, Apotex received clearance from the Minister of Health inCanada to market the generic version of the 500mg formulation of GLUMETZA.  Also in February 2010, Biovail andDepomed filed a complaint in the Federal Court in Canada against Apotex forinfringement of the Company’s Canadian Patent No. 2,290,624.

 

Anadverse outcome in this matter could substantially weaken our Canadianintellectual property.

 

**ITEM 1A. RISK FACTORS**

 

The risk factors presented below amend and restatethe risk factors previously disclosed in our Annual Report on Form 10-Kfor the year ended December 31, 2009.

 

The following factors, along with those describedabove under **“MANAGEMENT’S DISCUSSION ANDANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS — LIQUIDITY ANDCAPITAL RESOURCES”** should be reviewed carefully, in conjunction withthe other information contained in this Report and our financial statements.These factors, among others, could cause actual results to differ materiallyfrom those currently anticipated and contained in forward-looking statementsmade in this Form 10-Q and presented elsewhere by our management from timeto time. See “Part I, Item 2—Forward-Looking Information.”

 

**We depend on Abbott Products forcertain aspects of the development and commercialization of DM-1796, whichsubjects us to risks related to Abbott Products and its business that areoutside our control.**

 

Our license agreement withAbbott Products grants Abbott Products exclusive rights to develop andcommercialize DM-1796 in the United States, Canada and Mexico for painindications.  We depend on AbbottProducts to obtain regulatory approval and complete any further development ofDM-1796, and to commercialize the product in the licensed territories, whichsubjects us to a number of risks, including the following:

 

·                  we may not be able to control the amount and timing ofresources that Abbott Products devotes to the development or commercializationof DM-1796;

·                  we and Abbott Products may not be successful in our effortsto obtain regulatory approval of DM-1796 in a timely manner, or at all;

·                  Abbott Products may experience financial difficulties; or

·                  Abbott Products may change its business strategy, due to acombination with another company or for another reason unrelated to the DM-1796commercial opportunity, in a manner that adversely affects the development orcommercialization of DM-1796.

 

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AbbottProducts completed its acquisition ofSolvay’s pharmaceutical business in February 2010.  Accordingly, Abbott Products is nowresponsible for the DM-1796 license arrangement through a subsidiary.  We do not yet know whether Abbott Productswill be as committed to the development and commercialization of DM-1796 asSolvay, and we are not likely to know until some time following the completionof the acquisition.  However, it ispossible that Abbott Products’s acquisition of Solvay’s pharmaceutical businessmay adversely affect the development or commercialization of DM-1796.

 

**Our prior clinical trials evaluating S****erada****for menopausal hot flashes failed to meet all of their primary endpointsand there can be no assurance this product will be approved for marketing.**

 

InOctober 2009, our Phase 3 trials evaluating Serada for menopausal hotflashes failed to meet all of their primary endpoints.  In December 2009, we met and discussedwith the FDA the results of the trials and any additional clinical developmentthat may be required to complete the program and obtain regulatory approval tomarket Serada in the United States. Based on the guidance from the meeting withthe FDA, we expect to initiate an additional Phase 3 trial for Serada by September 2010.  The trial will be known as Breeze 3.   There can be no assurance the results of theBreeze 3 trial will demonstrate the product candidate is sufficiently safe andeffective to obtain approval for marketing.

 

Wewill incur significant additional expenses and will not know for at least oneto two years whether the drug is safe and effective such that it could beapproved for marketing. Clinical development is a long, expensive and uncertainprocess and is subject to delays.  Thepositive or encouraging results of prior clinical trial are not necessarilyindicative of the results we will obtain in later clinical trials.  Accordingly, our additional Phase 3 trial maynot demonstrate that Serada is effective for menopausal hot flashes.  In addition, data obtained from pivotalclinical trials are susceptible to varying interpretations, which could delay,limit or prevent regulatory approval.

 

Manyother factors could delay or result in termination of our clinical trials,including:

 

·                  negative or inconclusive results;

·                  patient noncompliance with the protocol;

·                  adverse medical events or side effects amongpatients during the clinical trials;

·                  FDA inspections of our clinical operations;and

·                  real or perceived lack of effectiveness orsafety of the product candidate.

 

**We depend heavily on Santarus, Inc. for thesuccessful commercialization of GLUMETZA in the United States.**

 

InJuly 2008, we entered into a promotion agreement with Santarus, Inc.pursuant to which Santarus will promote GLUMETZA in the United States throughits sales force beginning in the fourth quarter of 2008. Under the agreement,in exchange for promotion fees, Santarus is required to market and promoteGLUMETZA to physicians in the United States, to deliver annual detail calls topotential GLUMETZA prescribers, and to maintain a sales force of a minimumsize.  Although we have retained rights to promote GLUMETZA toobstetricians/gynecologists, or ob/gyns, and to retain revenues fromincremental sales generated by ob/gyns we call upon, ob/gyns generally do notprescribe significant amounts of metformin products.  In addition, we do not have any immediateplans to establish a sales force, or contract with a third party to act as oursales force, for the purpose of exercising our GLUMETZA co-promotion rights.Accordingly, the success of the commercialization of GLUMETZA will depend inlarge part on Santarus’ marketing and promotion efforts.  Other factors that may affect the success ofour promotion arrangement with Santarus include the following:

 

·                  Santarus mayacquire or develop alternative products;

·                  Santarus maypursue higher-priority programs, or change the focus of its marketing programs;

·                  Santarus may inthe future choose to devote fewer resources to GLUMETZA;

·                  GLUMETZA mayfail to achieve greater market acceptance;

·                  The outcome ofour ongoing litigation against Lupin Limited seeking to prevent Lupin frommarketing a generic version of GLUMETZA in the United States;

·                  Santarus mayexperience financial difficulties; and

·                  Santarus mayfail to comply with its obligations under our promotion agreement.

 

Inaddition to the factors described above, Santarus’ business and product revenuehave been adversely affected by the introduction of a generic version of itsZegerid® (omeprazole/sodium bicarbonate) prescription products in the thirdquarter of 2010.

 

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Any of the preceding factors could affectSantarus’ commitment to the collaboration, which, in turn, could adverselyaffect the commercial success of GLUMETZA.  Any failure to successfullycommercialize GLUMETZA could have a material adverse effect on our business,financial conditions, results of operations and cash flows.

 

**Therecent recall of GLUMETZA and the related ongoing supply interruption mayadversely affect our product revenue.**

 

Weare conducting a voluntary class 2 recall of 52 lots of 500mg GLUMETZA productdue to the presence of trace amounts of a chemical called2,4,6-tribromoanisole, or TBA, in bottles containing 500mg GLUMETZAtablets.  In connection with the recall, we have temporarily suspendedproduct shipments of 500mg GLUMETZA product.  We currently expect todetermine by mid-August 2010 whether corrective actions we have taken toremedy the matter have been successful.  If those actions have beensuccessful, we will resume shipments of 500mg GLUMETZA product in mid-August 2010. If those actions have not been successful, we expect to experience a furtherperiod of supply disruption.

 

Wecannot be sure we will be able to begin resupplying 500mg GLUMETZA product in atimely manner or whether additional recall activities will be required,including activities at the pharmacy level in addition to the activitiescurrently underway at the wholesaler level. In addition, if we are not able toestablish resupply at the manufacturing facility currently utilized for 500mgGLUMETZA product, we may move the manufacturing of 500mg GLUMETZA product to analternate site, which could result in an extended delay before the productwould be available for commercial sale.

 

Thesupply disruption for 500mg GLUMETZA product described above may adverselyimpact our product revenue and profitability of GLUMETZA.

 

Inaddition, Biovail, our sole supplier for the 1000mg formulation of GLUMETZA,has moved its GLUMETZA tablet manufacturing operation to a Biovail site inCanada.  We expect FDA approval to begin manufacturing at that site in October 2010. However, if that approval is delayed, we may also experience a supplydisruption of the 1000mg formulation of GLUMETZA, which could adversely impactproduct revenue and profitability of GLUMETZA.

 

**The timing and any potentialnegative outcome in the ongoing patent litigation with Lupin could adverselyaffect our financial condition and results of operations as it could result inthe introduction of generic products prior to the expiration of the patents forGLUMETZA, as well as in significant legal expenses and diversion of managementtime.**

 

In November 2009, wefiled a lawsuit in the United States District Court for the Northern Districtof California against Lupin for infringement of U.S. Patent Nos. 6,340,475;6,488,962; 6,635,280; and 6,723,340 listed in the Orange Book for GLUMETZA. Thelawsuit is in response to an Abbreviated New Drug Application (ANDA) filed byLupin with the FDA regarding Lupin’s intent to market generic versions of the500mg and 1000mg strengths of GLUMETZA prior to the expiration date of the assertedpatents.

 

We commenced the lawsuitagainst Lupin within the applicable 45 day period required toautomatically stay, or bar, the FDA from approving Lupin’s ANDA for30 months or until a district court decision that is adverse to theasserted patents, whichever may occur earlier. The 30-month stay expires in May 2012.If the litigation is still ongoing after expiration of the applicable 30-monthstay, the termination of the stay could result in the introduction of one ormore products generic to GLUMETZA prior to resolution of the litigation.

 

Although we intend tovigorously defend and enforce our patent rights, we are not able to predict thetiming or outcome of the litigation. The court may render its decision at anytime after the filing of the post-trial briefs, which may be before or afterthe expiration of the 30-month stay. An adverse outcome in this litigationcould result in one or more generic versions of GLUMETZA being launched beforethe expiration of the listed patents, which could adversely affect our abilityto successfully execute our business strategy to maximize the value of GLUMETZAand could negatively impact our financial condition and results of operations,including causing a significant decrease in our revenues and cash flows. Regardlessof how the litigation is ultimately resolved, the litigation may be costly,time-consuming and distracting to management, which could have a materialadverse effect on our business.

 

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**Thedevelopment of drug candidates is inherently uncertain and we cannot be certainthat any of our product candidates will be approved for marketing or, ifapproved, will****achieve market acceptance.**

 

We have the followingprograms in clinical development: Serada for menopausal hot flashes and DM-1992for Parkinson’s.  We also have otherproduct candidates in earlier stages of development.

 

Ourown product candidates and those of our collaborative partners are subject tothe risk that any or all of them may be found to be ineffective or unsafe, orotherwise may 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 the Phase 3trial for DM-1796 for the treatment of postherpetic neuralgia that we completedin 2007, and with the Phase 3 trials evaluating Serada for menopausal hot flasheswe completed in October 2009.

 

Weare unable to predict whether any of these product candidates will receiveregulatory clearances or be successfully manufactured or marketed.  Further, due to the extended testing andregulatory review process required before marketing clearance can be obtained,the time frames for commercialization of any products are long anduncertain.  Even if these other productcandidates receive regulatory clearance, our products may not achieve ormaintain market acceptance. Also, substantially all of our product candidatesuse the Acuform technology.  If itis discovered that the Acuform technology could have adverse effects orother characteristics that indicate it is unlikely to be effective as adelivery system for drugs or therapeutics, our product development efforts andour business could be significantly harmed.

 

**We areexpecting operating losses in the future.**

 

Todate, we have recorded revenues from license fees, product sales, royalties,collaborative research and development arrangements and feasibilitystudies.  For the six months ended June 30,2010, we recorded total revenues of $39.8 million and for the years endedDecember 31, 2009, 2008 and 2007, we recorded total revenues of $57.7million, $34.8 million, and $65.6 million, respectively. For the years endedDecember 31, 2009 and 2008, we incurred net losses of $22.0 million and$15.3 million, respectively. However, as we continue our research anddevelopment efforts, preclinical testing and clinical trial activities, weanticipate that we will incur operating losses for the remainder of 2010.  Therefore, we expect our cumulative losses toincrease. These losses, among other things, have had, and we expect that theywill continue to have, an adverse impact on our total assets, shareholders’equity and working capital.

 

**Our operating results may fluctuate and affect our stockprice.**

 

Thefollowing factors will affect our operating results and may result in amaterial adverse effect on our stock price:

 

·                  announcements and resultsregarding clinical trial results and plans for our drug candidates, includingDM-1796 and Serada;

·                  filings and other regulatoryactions related to DM-1796, Serada and our other product candidates;

·                  developments concerning proprietaryrights, including patents, infringement allegations and litigation matters;

·                  the degree of commercialsuccess of GLUMETZA;

·                  adverse events related toour products, including recalls;

·                  interruptions ofmanufacturing or supply, including our ability to resupply the market with the500mg formulation of GLUMETZA;

·                  the outcome of our patentinfringement litigation against Lupin for GLUMETZA;

·                  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;

·                  third-party reimbursementpolicies; and

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

 

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As a result of these factors, our stock price may continue to bevolatile and investors may be unable to sell their shares at a price equal to,or above, the price paid. Additionally, any significant drops in our stockprice, such as the one we experienced following the announcement of our SeradaPhase 3 trial results in October 2009, 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 our favor.

 

**Our collaborative arrangements may give rise to disputesover commercial terms, contract interpretation and ownership of ourintellectual property and may adversely affect the commercial success ofour products.**

 

We currently have collaboration arrangements with Abbott Products,Santarus and Covidien.  In addition, wehave in the 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 enter into less favorable agreement terms that delay or defer recovery ofour development costs and reduce the funding available to support key programs.

 

We may be unable to enter into futurecollaborative arrangements on acceptable terms, which could 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 by a collaborativepartner of competitive technologies or products;

·                  arrangements with collaborative partners thatlimit or preclude us from developing products or technologies;

·                  premature termination of a collaborationagreement; or

·                  failure by a collaborative partner to devotesufficient resources to the development and commercial sales of products usingthe Acuform technology.

 

Our collaborativearrangements do not necessarily restrict our collaborative partners fromcompeting with us or restrict their ability to market or sell competitiveproducts. Our current and any future collaborative partners may pursueexisting or other development-stage products or alternative technologies inpreference to those being developed in collaboration with us. Our collaborativepartners may also terminate their collaborative relationships with us orotherwise decide not to proceed with development and commercialization of ourproducts.

 

**We havelimited in-house sales and marketing resources, which we will require in orderto successfully promote products through our own sales force.**

 

IfSerada or another product we develop or acquire is approved for marketing inthe United States, we may choose to promote the product with our own sale forceor through a contract sales organization. We also have rights to promoteGLUMETZA through our own sales force, or through third parties, and we haveretained co-promotion rights for certain product candidates our collaborativepartners may develop. We currently have no sales force and limited marketingand sales staff.  The success of our ownpromotion efforts for Serada, GLUMETZA and any other product candidates thatreceive regulatory approval that we choose to market or co-market, will requirethat we substantially enhance our in-house marketing and sales force withtechnical expertise, 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 besuccessful. If we fail to fully develop marketing and sales capabilities, orenter into arrangements with third parties, our revenues may suffer.

 

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**We depend on our marketing partners for the successfulcommercialization of GLUMETZA in Canada and Korea, and of Proquin XR in Europe.**

 

Wehave licensed exclusive marketing rights to the 500mg GLUMETZA in Canada toBiovail, and in Korea to LG Life Sciences. Biovail launched the 500mg GLUMETZA in Canada in November 2005, andLG launched a 500mg product in Korea in 2006 under the trade name NovametGR.  We have also entered into a licenseagreement with Madaus, a company acquired by Rottapharm in June 2007,related to the commercialization of Proquin XR in Europe. If our internationalcommercial partners fail to successfully commercialize products we havelicensed to them, our future revenues may be adversely affected.

 

**Our credit facility contains operating covenants that mayrestrict our business and financing activities.**

 

Weentered into a $15.0 million credit facility with Oxford FinanceCorporation and General Electric Capital Corporation in June 2008.  We have drawn $9.4 million under the facilityand will not make any further draws under the facility. As of June 30,2010, we have $4.2 million of principal outstanding under the facility. Thecredit facility is secured by a pledge of all of our assets other thanintellectual property, and contains a variety of operational covenants,including limitations on our ability to incur liens or additional debt, makedispositions, pay dividends, redeem our stock, make certain investments andengage in certain merger, consolidation or asset sale transactions andtransactions with affiliates, among other restrictions.  Any future debt financing we enter into mayinvolve similar or more restrictive covenants affecting our operations.  Our borrowings under the credit facility orany future debt financing will need to be repaid, which creates additionalfinancial risk for our company, particularly if our business, or prevailingfinancial market conditions, are not conducive to paying off or refinancing ouroutstanding debt obligations. Furthermore, our failure to comply with thecovenants in the credit facility could result in an event of default that, ifnot cured or waived, could result in the acceleration of all or a substantialportion of our debt, which could have a material adverse effect on our cash positionand significantly harm our business.

 

**Ourexisting resources may not be sufficient to fund our operations until such timeas we may be able to consistently generate sufficient revenues to support ouroperations.**

 

Ourexisting capital resources may not be sufficient to fund our operations untilsuch time as we may be able to generate sufficient revenues to consistentlysupport our operations.  We have limitedcredit facilities and, except for our common stock purchase agreement withAzimuth, we have no other committed sources of capital.  Any additional development of Serada formenopausal hot flashes or other clinical development programs may requireconsiderable financial resources, should we choose to invest in those programs.To the extent that our capital resources are insufficient to meet our futurecapital requirements, in order to continue our development programs, we willhave to raise additional funds through the sale of our equity securities,through debt financing, or from development and licensing arrangements. We maybe unable to raise such additional capital on favorable terms, or at all. If weraise additional capital by selling our equity or convertible debt securities,the issuance of such securities could result in dilution of our shareholders’equity positions. If adequate funds are not available we may have to:

 

·                  delay, postponeor terminate clinical trials;

·                  significantlycurtail commercialization of our marketed products or other operations; and/or

·                  obtain fundsthrough entering into collaboration agreements on unattractive terms.

 

**The globaleconomic downturn may adversely affect our business.**

 

Theeconomic downturn that has affected the global economy over the past severalfiscal quarters may have a material adverse effect on our liquidity andfinancial condition and our ability to raise additional funds, whether pursuantto our existing or future financing arrangements.  In addition, if thesedevelopments negatively impact the ability of our collaborative partners todevelop, manufacture, promote or commercialize our products and productcandidates, our revenues may suffer and our business, financial condition andresults of operations could be materially and adversely affected. Similarly, any negative impact of an economic downturn or recession on ourpotential collaborative partners could adversely affect the terms on whichcollaborative partnerships may be available to us, if at all.

 

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**We may be unable to protect our intellectualproperty and may be liable for infringing the intellectual property ofothers.**

 

Our success will depend in part on ourability to obtain and maintain patent protection for our products andtechnologies, and to preserve our trade secrets.  Our policy is to seek to protect ourproprietary rights, by, among other methods, filing patent applications in theUnited States and foreign jurisdictions to cover certain aspects of ourtechnology. We hold issued United States patents, and have patent applicationspending in the United States.  In addition, we are preparing patentapplications relating to our expanding technology for filing in the UnitedStates and abroad.  We have also applied for patents in numerous foreigncountries. Some of those countries have granted our applications and otherapplications are still pending. Our pending patent applications may lackpriority over others’ applications or may not result in the issuance ofpatents. Even if issued, our patents may not be sufficiently broad to provideprotection against competitors with similar technologies and may be challenged,invalidated or circumvented, which could limit our ability to stop competitorsfrom marketing related products or may not provide us with competitiveadvantages against competing products. We also rely on trade secrets andproprietary know-how, which are difficult to protect. We seek to protect suchinformation, in part, through entering into confidentiality agreements withemployees, consultants, collaborative partners and others before such personsor entities have access to our proprietary trade secrets and know-how. Theseconfidentiality agreements may not be effective in certain cases, due to, amongother things, the lack of an adequate remedy for breach of an agreement or afinding that an agreement is unenforceable. In addition, our trade secrets mayotherwise become known or be independently developed by competitors.

 

Our ability to develop our technologies andto make commercial 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 pharmaceuticalindustry has experienced extensive litigation regarding patents and otherintellectual property rights. For example, Pfizer has initiated several suitsagainst companies marketing generic gabapentin products, claiming that theseproducts infringe Pfizer’s patents. The results of this litigation couldadversely impact the commercialization of pharmaceutical products that containgabapentin as an active pharmaceutical ingredient.  Also, patents issuedto third parties relating to sustained release drug formulations or particularpharmaceutical compounds could in the future be asserted against us, althoughwe believe that we do not infringe any valid claim of any patents.  Ifclaims concerning any of our products were to arise and it was determined thatthese products infringe a third party’s proprietary rights, we could be subjectto substantial 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 a license may not be available onacceptable terms, or at all.  Even if we, our collaborators or our licensorswere able to obtain a license, the rights may be nonexclusive, which could giveour competitors access to the same intellectual property.  In addition,any public announcements related to litigation or interference proceedingsinitiated or threatened against us, even if such claims are without merit,could cause our stock price to decline.

 

From time to time, we may become aware ofactivities by third parties that may infringe our patents.  Infringementby others of our patents may reduce our market shares (if a related product isapproved) and, consequently, our potential future revenues and adversely affectour patent rights if we do not take appropriate enforcement action.  Wemay need to engage in litigation in the future to enforce any patents issued orlicensed to us or to determine the scope and validity of third-partyproprietary rights.  Our issued or licensed patents may not be held validby a court of competent jurisdiction. Whether or not the outcome of litigationis favorable to us, defending a lawsuit takes significant time, may beexpensive and may divert management attention from other business concerns. Wemay also be required to participate in interference proceedings declared by theUnited States Patent and Trademark Office for the purpose of determining thepriority 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 alicense, we may be prevented from marketing the affected product.

 

**Our licensed patent covering the use of gabapentin to treathot flashes associated with menopause is a method-of-use patent, whichincreases the risk that prescriptions for gabapentin to treat hot flashes inmenopausal women could be written for, or filled with, generic gabapentin.**

 

Wehave an exclusive sublicense from PharmaNova, Inc. to a patent held by theUniversity of Rochester to develop and commercialize in the United States agabapentin product for the treatment of hot flashes associated withmenopause.  Because a method-of-usepatent, such as the patent we have sublicensed from PharmaNova, covers only aspecified use of a particular compound, not a particular composition of matter,we cannot prevent others from commercializing gabapentin.  Accordingly, physicians could prescribeanother manufacturer’s gabapentin to treat hot flashes in menopausal womenrather than Serada, or pharmacists could seek to fill prescriptions for Seradawith another manufacturer’s gabapentin. Although any such “off-label” use could violate our licensed patent,effectively monitoring compliance with our licensed patent may be difficult andcostly.

 

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**It is difficult to develop a successful product. If we do notcontinue to develop successful products, our financial position and liquiditywill be adversely affected.**

 

Thedrug development process is costly, time-consuming and subject to unpredictabledelays and failures. Before we or others make commercial sales of productsusing the Acuform technology, other than GLUMETZA and Proquin XR, we, ourcurrent and 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.

 

Wewill have to curtail, redirect or eliminate our product development programs ifwe or our collaborative 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.

 

Evenwhen or if our products obtain regulatory approval, successfulcommercialization requires:

 

·                  market acceptance;

·                  cost-effective commercialscale production; and

·                  reimbursement under privateor governmental health plans.

 

Anymaterial delay or failure in the governmental approval process and/or thesuccessful commercialization of our potential products could adversely impactour financial position and liquidity.

 

**If we do not achieve our projected development andcommercialization goals in the timeframes we announce and expect, thecommercialization of our product candidates may be delayed and our businesswill be harmed and our stock price may decline.**

 

For planning purposes, we sometimes estimate thetiming of the accomplishment of various scientific, clinical, regulatory andother product development and commercialization goals.  These milestones may include our expectationsregarding the commercial launch of our products by us or our licensees, and thecommencement or completion of scientific studies and clinical trials and thesubmission or approval of regulatory filings. From time to time, we may publicly announce the expected timing of someof these milestones, such as the completion of an ongoing clinical trial, theinitiation of other clinical programs, or the commercial launch ofproducts.  All of these milestones arebased on a variety of assumptions.  Theactual timing of these milestones can vary considerably from our estimatesdepending on numerous factors, some of which are beyond our control, including:

 

·                  the efforts of our marketing partners withrespect to the commercialization of our products;

·                  the rate of progress, costs and results ofour clinical trial and research and development activities, including theextent of scheduling conflicts with participating clinicians and clinicalinstitutions and our ability to identify and enroll patients who meet clinicaltrial eligibility criteria;

·                  our receipt of approvals by the FDA and otherregulatory agencies and the timing thereof;

·                  other actions by regulators;

·                  our ability to access sufficient, reliableand affordable supplies of components used in the manufacture of our productcandidates, including materials for our Acuform technology;

·                  our available capital resources; and

·                  the costs of ramping up and maintainingmanufacturing 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.

 

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**We depend on clinical investigators and clinical sites toenroll patients in our clinical trials and other third parties to manage thetrials and to perform related data collection and analysis, and, as a result,we may face costs and delays outside of our control.**

 

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 beunable to complete these trials or to complete them as planned, which coulddelay or prevent us from obtaining regulatory approvals for our productcandidates.

 

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.

 

**If we are unable to obtain or maintain regulatory approval, we will belimited in our ability to commercialize our products, and our business will beharmed.**

 

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 could impair our ability tocommercialize our products and could allow our competitors to bring products tomarket before we do. In addition, changesin regulatory policy for product approval during the period of productdevelopment and regulatory agency review of each submitted new application maycause delays or rejections. Even if we receive regulatory approval, thisapproval may entail limitations on the indicated uses for which we can market aproduct.

 

For example, the active ingredients in the productsutilizing our Acuform delivery technology that are being developed pursuant toour collaboration with Covidien include acetaminophen in combination withopiates.  In connection with concernsthat consumers may inadvertently take more than the recommended daily dose ofacetaminophen, potentiallycausing liver damage, an FDA advisory committee has recommended thatprescription products containing acetaminophen in combination with prescriptionanalgesics (including opiates) should include black box warnings and/or beremoved from the market.  The FDA isevaluating the recommendations and has indicated that such an evaluation willtake some time.  The FDA is not requiredto accept advisory committee recommendations. Covidien’s ability or willingness to develop and market the productssubject to our collaboration may be adversely affected by actions of the FDA inresponse to the advisory committee recommendations.

 

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 and inspection,including compliance with FDA regulations governing current Good ManufacturingPractices (cGMP). The Food, Drug andCosmetic Act, or FDCA, the Controlled Substances Act and other federal andforeign statutes and regulations govern and influence the testing,manufacturing, packing, labeling, storing, record keeping, safety, approval,advertising, promotion, sale and distribution of our products.  The failure to comply with theseregulations can result in, among other things, warning letters, fines,injunctions, civil penalties, recall or seizure of products, total or partialsuspension of production, non-renewal of marketing applications or criminalprosecution.

 

We are also required toreport adverse events associated with our products to the FDA and otherregulatory authorities. Unexpected or serious health or safety concerns couldresult in labeling changes, recalls, market withdrawals or other regulatoryactions.  Recalls may be issued at ourdiscretion or at the discretion of the FDA or other empowered regulatoryagencies.  For example, in June 2010,we instituted a voluntary class 2 recall of 52 lots of our 500mgGLUMETZA product after chemical traces of 2,4,6-tribromoanisole or TBAwere found in the product bottle.  Wecannot be certain that the FDA will determine that we adequately addressed thematters that led to this recall or that the FDA will not seek to impose finesor

 

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sanctionsagainst us as a result of this recall. Any such fines or sanctions could adversely affect our financialcondition and results of operations.

 

**We are subject to risks associated with NDAs submitted under Section 505(b)(2) ofthe Food, Drug and Cosmetic Act.**

 

Theproducts we develop generally are or will be submitted for approval under Section 505(b)(2) ofthe Food, Drug and Cosmetic Act, or FDCA, which was enacted as part of the DrugPrice Competition and Patent Term Restoration Act of 1984, otherwise known asthe Hatch-Waxman Act.  Section 505(b)(2) permits the submissionof an NDA where at least some of the information required for approval comesfrom studies not conducted by or for the applicant and for which the applicanthas not obtained a right of reference.  For instance, our licensee’s NDAfor DM-1796 relies on the FDA’s prior approval of Neurontin® (gabapentin),the immediate release formulation of gabapentin initially approved by theFDA.  An NDA for Serada would also rely in part on the FDA’s priorapproval of Neurontin®.

 

ForNDAs submitted under Section 505(b)(2) of the FDCA, the patentcertification and related provisions of the Hatch-Waxman Act apply.  Inaccordance with the Hatch-Waxman Act, such NDAs may be required to includescertifications, known as “Paragraph IV certifications,” that certify anypatents listed in the FDA’s Orange Book publication in respect to any productreferenced in the 505(b)(2) application, are invalid, unenforceable,and/or will not be infringed by the manufacture, use, or sale of the productthat is the subject of the 505(b)(2) application.  Under theHatch-Waxman Act, the holder of the NDA which the 505(b)(2) applicationreferences may file a patent infringement lawsuit after receiving notice of theParagraph IV certification.  Filing of a patent infringement lawsuittriggers a one-time automatic 30-month stay of the FDA’s ability to approve the505(b)(2) application.  Accordingly, we may invest a significantamount of time and expense in the development of one or more products only tobe subject to significant delay and patent litigation before such products maybe commercialized, if at all.  A Section 505(b)(2) applicationmay also not be approved until any non-patent exclusivity, such as exclusivityfor obtaining approval of a new chemical entity, listed in the Orange Book forthe referenced product has expired.  The FDA may also require us toperform one or more additional clinical studies or measurements to support thechange from the approved product. The FDA may then approve the new formulationfor all or only some of the indications sought by us.  The FDA may alsoreject our future Section 505(b)(2) submissions and require us tofile such submissions under Section 501(b)(1) of the FDCA, whichcould be considerably more expensive and time consuming.  These factors,among others, may limit our ability to successfully commercialize our productcandidates.

 

**Pharmaceutical marketing is subject tosubstantial regulation in the United States.**

 

All marketing activities associated with GLUMETZAand Proquin XR, as well as marketing activities related to any other productsfor which we obtain regulatory approval, will be subject to numerous federaland state laws governing the marketing and promotion of pharmaceuticalproducts. The FDA regulates post-approval promotional labeling and advertisingto ensure that they conform to statutory and regulatory requirements. Inaddition to FDA restrictions, the marketing of prescription drugs is subject tolaws and regulations prohibiting fraud and abuse under government healthcareprograms. For example, the federal healthcare program antikickback statuteprohibits giving things of value to induce the prescribing or purchase ofproducts that are reimbursed by federal healthcare programs, such as Medicare andMedicaid. In addition, federal false claims laws prohibit any person fromknowingly presenting, or causing to be presented, a false claim for payment tothe federal government. Under this law, the federal government in recent yearshas brought 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 regulationsrelating to the marketing of our products, we could be subject to criminalprosecution, civil penalties, seizure of products, injunction, and exclusion ofour products from reimbursement under government programs, as well as otherregulatory actions against our product candidates, our collaborative partnersor us.

 

**The approval process outside the United States is uncertainand may limit our ability to develop, manufacture and sell our productsinternationally.**

 

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 are unable to obtainacceptable prices or adequate reimbursement for our products from third-partypayers, 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 health administration authorities;

·                  private health insurers;

·                  health maintenance organizations;

·                  pharmacy benefit management companies; and

·                  other healthcare-related organizations.

 

If reimbursement is not available for our productsor product candidates, demand for these products may be limited. Further, anydelay in receiving approval for reimbursement from third-party payers couldhave 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 Statesand foreign governments continue to propose and pass new legislation designedto contain 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.**

 

Othercompanies that have oral drug delivery technologies competitive with theAcuform technology include Elan Corporation, Bristol-Myers Squibb, IVAXCorporation (a subsidiary of TEVA Pharmaceutical Industries, Ltd.),Johnson & Johnson, SkyePharma plc, Biovail Corporation, FlamelTechnologies S.A., Ranbaxy Laboratories, Ltd., and Intec Pharma, all ofwhich develop oral tablet products designed to release the incorporated drugsover time. Each of these companies has patented technologies with attributesdifferent from ours, and in some cases with different sites of delivery to thegastrointestinal tract.

 

Bristol-MyersSquibb is currently marketing a sustained release formulation of metformin,Glucophage XR, with which GLUMETZA competes. The limited license thatBristol-Myers Squibb obtained from us under our November 2002 settlementagreement extends to certain current and internally-developed future compounds,which may increase the likelihood that we will face competition fromBristol-Myers Squibb in the future on products in addition to GLUMETZA. Severalother companies, including Shinogi & Co., Ltd., BarrPharmaceuticals, Inc., Mylan Laboratories, Inc. and TevaPharmaceutical Industries, Ltd. have received FDA approval for and areselling a controlled-release metformin product.

 

There may be other companiesdeveloping products competitive with GLUMETZA of which we are unaware.

 

Gabapentinis currently marketed by Pfizer as Neurontin® for adjunctive therapy forepileptic seizures and for postherpetic pain. Pfizer’s basic U.S. patentsrelating to Neurontin have expired, and numerous companies have receivedapproval to market generic versions of the immediate release product. Inaddition, Pfizer has developed Lyrica® (pregabalin), which has been approvedfor marketing in the United States and the European Union.

 

Competitionin pharmaceutical products and drug delivery systems is intense. We expectcompetition to increase. Competing technologies or products developed in thefuture may prove superior to the Acuform technology or products usingthe Acuform technology, either generally or in particular market segments.These developments could make the Acuform technology or products using theAcuform technology noncompetitive or obsolete.

 

Mostof our principal competitors have substantially greater financial, sales,marketing, personnel and research and development resources than we do. In addition,many of our potential collaborative partners have devoted, and continue todevote, significant resources to the development of their own drug deliverysystems and technologies.

 

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**We depend on third parties who are single source suppliers tomanufacture GLUMETZA and our other product candidates.  If these suppliers are unable to manufactureGLUMETZA or our product candidates, our business will be harmed.**

 

We are responsible for the supply and distributionof GLUMETZA, and Patheon, Puerto Rico Inc. is our sole supplier for tablets ofthe 500mg strength of GLUMETZA pursuant to a supply agreement we entered intowith Patheon in December 2006. Biovail is our sole supplier for the 1000mg formulation GLUMETZA.  We will be unable to manufacture GLUMETZA ina timely manner if we are unable to obtain 500mg GLUMETZA tablets from ourcontract manufacturer, active pharmaceutical ingredient from suppliers, orexcipient suppliers, or 1000mg GLUMETZA tablets from Biovail.

 

Although we have obtained clinical batches ofDM-1796 and Serada from a contract manufacturer, we currently have no long-termsupply arrangement with respect to DM-1796 and Serada.  Any failure to obtain clinical supplies ofDM-1796 and Serada could adversely affect these clinical development programs.

 

We do not have, and we do not intend to establish inthe foreseeable future, internal commercial scale manufacturing capabilities.Rather, we intend to use the facilities of third parties to manufactureproducts for clinical trials and commercialization. Our dependence on thirdparties for the manufacture of products using the Acuform technology may adverselyaffect our ability to deliver such products on a timely or competitivebasis.  The manufacturing processes ofour third party manufacturers may be found to violate the proprietary rights ofothers. If we are unable to contract for a sufficient supply of requiredproducts on acceptable terms, or if we encounter delays and difficulties in ourrelationships with manufacturers, the market introduction and commercial salesof our products will be delayed, and our future revenue will suffer.

 

**A successful product liability claim against us could materially harmour business.**

 

Ourbusiness involves exposure to potential product liability risks that areinherent in the development and production of pharmaceutical products. We haveobtained product liability insurance for clinical trials currently underway andforecasted 2010 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 theAcuform technology proceeds; or

·                  our insurance may notprovide adequate protection against potential liabilities.

 

Ourinability to obtain adequate insurance coverage at an acceptable cost couldprevent or inhibit the commercialization of our products. Defending a lawsuitcould be costly and significantly divert management’s attention from conductingour business. If third parties were to bring a successful product liabilityclaim or series of claims against us for uninsured liabilities or inexcess of insured liability limits, our business, financial condition andresults of operations could be materially harmed.

 

From time to time, we may recall products for various reasons.  Any recall, such as the recall of 500mgGLUMETZA product we initiated in June 2010, may adversely affect ourreputation and that of any affected product.

 

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**Our success is dependent in large part upon the continued services ofour CEO and senior management with whom we do not have employment agreements.**

 

Oursuccess is dependent in large part upon the continued services of our Presidentand Chief Executive Officer, Carl A. Pelzel, and other members of our executivemanagement team, and on our ability to attract and retain key management andoperating personnel. We do not have agreements with Mr. Pelzel or any ofour other executive officers that provide for their continued employment withus.  We may have difficulty filling opensenior scientific, financial and commercial positions. Management, scientificand operating personnel are in high demand in our industry and are oftensubject to competing offers. The loss of the services of one or more members ofmanagement or key employees or the inability to hire additional personnel asneeded could result in delays in the research, development andcommercialization of our products and potential product candidates.

 

**If we choose to acquire new and complementary businesses, products ortechnologies, we may be unable to complete these acquisitions or to successfullyintegrate them in a cost effective and non-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.

 

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

 

Certain provisions of our articles of incorporation and the CaliforniaGeneral Corporation Law could discourage a third party from acquiring, or makeit more difficult for a third party to acquire, control of our company withoutapproval of our board of directors. These provisions could also limit the pricethat certain investors might be willing to pay in the future for shares of ourcommon stock. Certain provisions allow the board of directors to authorize theissuance of preferred stock with rights superior to those of the common stock.We are also subject to the provisions of Section 1203 of the CaliforniaGeneral Corporation Law which requires a fairness opinion to be provided to ourshareholders in connection with their consideration of any proposed “interestedparty” reorganization transaction.

 

We have adopted a shareholder rights plan, commonly known as a “poisonpill”. The provisions described above, our poison pill and provisions of theCalifornia General Corporation Law may discourage, delay or prevent a thirdparty from acquiring us.

 

**Increased costs associated with corporate governancecompliance may significantly impact our results of operations.**

 

Changing laws, regulations and standardsrelating to corporate governance, public disclosure and compliance practices,including the Sarbanes-Oxley Act of 2002, new SEC regulations and NASDAQ GlobalMarket rules, are creating uncertainty for companies such as ours inunderstanding and complying with these laws, regulations and standards.  As a result of this uncertainty and otherfactors, devoting the necessary resources to comply with evolving corporategovernance and publicdisclosure standards has resulted in and may in the future result in increasedgeneral and administrative expenses and a diversion of management time andattention to compliance activities.  Wealso expect these developmentsto increase our legal compliance and financial reporting costs.  In addition, these developments may make itmore difficult and more expensive for us to obtain director and officerliability insurance, and we may be required to accept reduced coverage or incursubstantially higher costs to obtain coverage. Moreover, we may be unable to comply with these new rules andregulations on a timely basis.

 

These developments could make it more difficult forus to attract and retain qualified members of our board of directors, orqualified executive officers.  We arepresently evaluating and monitoring regulatory developments and cannot estimatethe timing or magnitude of additional costs we may incur as a result.  To the extent these costs are significant,our selling, general and administrative expenses are likely to increase.

 

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**If we sell shares of our common stock under our equity line of creditarrangement or in other future financings, existing common shareholders willexperience immediate dilution and, as a result, our stock 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 common stock.  As a result, our existing common shareholderswill experience immediate dilution upon the purchase of any shares of ourcommon stock sold at such discount.  Forexample, 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 regulatory requirements relatingto internal controls, our stock price could suffer.**

 

Section 404 of the Sarbanes-Oxley Act of 2002 requires companiesto 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.

 

**Business interruptions could limitour 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 Bayarea, which has a history of seismic activity. We have not established a formaldisaster recovery plan, and our back-up operations and our businessinterruption insurance may not be adequate to compensate us for losses thatoccur. A significant business interruption could result in losses or damagesincurred by us and require us to cease or curtail our operations.

 

**ITEM 2.          UNREGISTERED SALES OF EQUITYSECURITIES AND USE OF PROCEEDS**

 

Not applicable.

 

**ITEM 3.          DEFAULTS UPON SENIOR SECURITIES**

 

Not applicable.

 

**ITEM 4.          RESERVED**

 

Not applicable.

 

**ITEM 5.          OTHER INFORMATION**

 

Not applicable.

 

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**ITEM 6. EXHIBITS**

 
| (a)    | Exhibits |
|--------|----------|
|   | 31.1     | Certification  pursuant to Rule 13a-14(a) under the Securities Exchange Act of  1934 of Carl A. Pelzel |
|   | 31.2     | Certification  pursuant to Rule 13a-14(a) under the Securities Exchange Act of  1934 of Tammy L. Cameron |
|   | 32.1     | Certification  pursuant to 18 U.S.C. Section 1350 of Carl A. Pelzel |
|   | 32.2     | Certification  pursuant to 18 U.S.C. Section 1350 of Tammy L. Cameron |

 

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**SIGNATURES**

 

Pursuantto the requirements of the Securities Exchange Act of 1934, the Registrant hasduly caused this report to be signed on its behalf by the undersigned thereuntoduly authorized.

 

 
| Date:  August 6, 2010 | DEPOMED, INC.       |
|----------------------------|--------------------------|
|                       |                     |
|                       |                     |
|                       | /s/  Carl A. Pelzel      |
|                       | Carl  A. Pelzel          |
|                       | President  and           |
|                       | Chief  Executive Officer |
|                       |                     |
|                       |                     |
|                       | /s/  Tammy L. Cameron    |
|                       | Tammy  L. Cameron        |
|                       | Vice  President, Finance |

 

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