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UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549
 FORM 10-Q Quarterly Report Pursuant to Section 13 or 15 (d) of the Securities Exchange Act of 1934 For the quarterly period ended March 31, 2005 Commission file number 0-17254 NOVEN PHARMACEUTICALS, INC.  STATE OF DELAWARE
(State or other jurisdiction of
incorporation or organization)
    
    59-2767632
(I.R.S. Employer
Identification Number)
 11960 S.W. 144th Street, Miami, FL 33186
(Address of principal executive offices) (Zip Code)
 (305) 253-5099
(Registrants telephone number, including area code)
 Indicate by check mark whether the registrant (1) has filed all reports required to be filed
by Section 13 or 15 (d) of the Securities Exchange Act of 1934 during the preceding 12 months (or
for such shorter period that the registrant was required to file such reports), and (2) has been
subject to such filing requirements for the past 90 days. Yes þ No o. Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule
12b-2 of the Exchange Act). Yes þ No o. Indicate the number of shares outstanding of each of the issuers classes of common stock, as
of the last practicable date. Class
Common stock $.0001 par value
    
    Outstanding at April 29, 2005
23,558,750




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NOVEN PHARMACEUTICALS, INC. INDEX Page No.PART I - FINANCIAL INFORMATIONItem 1 - Unaudited Condensed Financial StatementsCondensed Statements of Operations for the Three Months Ended March 31, 2005 and 2004
    
    
    3Condensed Balance Sheets as of March 31, 2005 and December 31, 2004
    
    
    4Condensed Statements of Cash Flows for the Three Months Ended March 31, 2005 and 2004
    
    
    5Notes to Unaudited Condensed Financial Statements
    
    
    6Item 2 - Managements Discussion and Analysis of Financial Condition and Results of Operations
    
    
    18Item 3 - Quantitative and Qualitative Disclosures About Market Risk
    
    
    33Item 4 - Controls and Procedures
    
    
    33PART II - OTHER INFORMATIONItem 1 - Legal Proceedings
    
    
    35Item 2 - Unregistered Sales of Equity Securities and Use of Proceeds
    
    
    36Item 6 - Exhibits
    
    
    36SIGNATURES
    
    
    37EX-31.1 SECTION 302 CERTIFICATION OF CEOEX-31.2 SECTION 302 CERTIFICATION OF CFOEX-32.1 SECTION 906 CERTIFICATION OF CEOEX-32.2 SECTION 906 CERTIFICATION OF CFO
  Cautionary Factors: This report contains forward-looking statements. Our actual results,
performance and achievements may be materially different from those expressed or implied by such
statements and readers should consider the risks and uncertainties associated with our business
that are listed, by category, starting on page 31 of this report. For additional information
regarding these and other risks and uncertainties, readers should refer to our Annual Report on
Form 10-K for the year ended December 31, 2004, as well as other reports filed from time to time
with the Securities and Exchange Commission. Trademark Information: Vivelle, Vivelle-Dot, Estalis, Estradot, Famvir and Menorest are trademarks
of Novartis AG or its affiliated companies; CombiPatch is a registered trademark of Vivelle
Ventures LLC; Duragesic is a registered trademark of Johnson & Johnson; Intrinsa is a trademark of
Procter & Gamble Pharmaceuticals, Inc. 2




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PART I. FINANCIAL INFORMATION 
 Item 1. Financial Statements NOVEN PHARMACEUTICALS, INC. 
     Three Months2005
    
    
    2004Revenues:Product revenues  Novogyne:Product sales
    
    $
    4,978
    
    
    $
    5,808Royalties
    
    
    1,114
    
    
    
    890Total product revenues  Novogyne
    
    
    6,092
    
    
    
    6,698Product revenues  third parties
    
    
    4,038
    
    
    
    2,977Total product revenues
    
    
    10,130
    
    
    
    9,675Contract and license revenues:Contract
    
    
    595
    
    
    
    519License
    
    
    1,011
    
    
    
    936Contract and license revenues
    
    
    1,606
    
    
    
    1,455Net revenues
    
    
    11,736
    
    
    
    11,130Expenses:Cost of products sold
    
    
    5,757
    
    
    
    5,518Research and development
    
    
    3,010
    
    
    
    2,255Marketing, general and administrative
    
    
    4,055
    
    
    
    3,904Total expenses
    
    
    12,822
    
    
    
    11,677Loss from operations
    
    
    (1,086
    )
    
    
    (547
    )Equity in earnings of Novogyne
    
    
    912
    
    
    
    637Interest income, net
    
    
    503
    
    
    
    156Income before income taxes
    
    
    329
    
    
    
    246Provision for income taxes
    
    
    118
    
    
    
    88Net income
    
    $
    211
    
    
    $
    158Basic earnings per share
    
    $
    0.01
    
    
    $
    0.01Diluted earnings per share
    
    $
    0.01
    
    
    $
    0.01Weighted average number of common shares
outstanding:Basic
    
    
    23,509
    
    
    
    23,066Diluted
    
    
    23,966
    
    
    
    24,281
 The accompanying notes are an integral part of these statements. 3




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NOVEN PHARMACEUTICALS, INC. 
    March 31, 2005
    
    
    December 31, 2004AssetsCurrent Assets:Cash and cash equivalents
    
    $
    64,315
    
    
    $
    93,958Short-term investments
    
    
    29,950
    
    
    
    Accounts receivable  trade (less allowance for doubtful
accounts of $54 in 2005 and $64 in 2004)
    
    
    2,655
    
    
    
    5,395Accounts receivable  Novogyne, net
    
    
    6,803
    
    
    
    10,098Inventories
    
    
    18,349
    
    
    
    15,988Net deferred income tax asset, current portion
    
    
    5,900
    
    
    
    6,700Prepaid income taxes
    
    
    9,369
    
    
    
    9,344Prepaid and other current assets
    
    
    1,930
    
    
    
    1,238139,271
    
    
    
    142,721Property, plant and equipment, net
    
    
    24,364
    
    
    
    22,587Other Assets:Investment in Novogyne
    
    
    19,701
    
    
    
    26,233Net deferred income tax asset
    
    
    9,051
    
    
    
    8,239Patent development costs, net
    
    
    2,222
    
    
    
    2,174Deposits and other assets
    
    
    21
    
    
    
    2130,995
    
    
    
    36,667$
    194,630
    
    
    $
    201,975Liabilities and Stockholders EquityCurrent Liabilities:Accounts payable and accrued expenses
    
    $
    7,278
    
    
    $
    12,176Capital lease obligations  current portion
    
    
    116
    
    
    
    114Accrued liability  Shire
    
    
    14,949
    
    
    
    10,587Accrued compensation and related liabilities
    
    
    3,248
    
    
    
    5,762Other accrued liabilities
    
    
    2,865
    
    
    
    3,015Deferred rent credit
    
    
    52
    
    
    
    Deferred contract revenues
    
    
    2,031
    
    
    
    2,076Deferred license revenues  current portion
    
    
    10,160
    
    
    
    11,64240,699
    
    
    
    45,372Long-Term Liabilities:Capital lease obligations
    
    
    81
    
    
    
    121Deferred rent credit
    
    
    473
    
    
    
    Deferred license revenues
    
    
    23,234
    
    
    
    27,44364,487
    
    
    
    72,936Commitments and Contingencies (Note 12)Stockholders Equity:Preferred stock  authorized 100,000 shares of $.01 par
value; no shares issued or outstanding
    
    
    
    
    
    
    Common stock  authorized 80,000,000 shares,
par value $.0001 per share; issued and
outstanding 23,549,785 at March 31, 2005 and
23,481,264 at December 31, 2004
    
    
    2
    
    
    
    2Additional paid-in capital
    
    
    89,129
    
    
    
    88,236Retained earnings
    
    
    41,012
    
    
    
    40,801130,143
    
    
    
    129,039$
    194,630
    
    
    $
    201,975
 The accompanying notes are an integral part of these statements. 4




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NOVEN PHARMACEUTICALS, INC. 
     2005
    
    
    2004Cash flows from operating activities:Net income
    
    $
    211
    
    
    $
    158Adjustments to reconcile net income to net cash flows
provided by operating activities:Depreciation
and amortization
    
    
    581
    
    
    
    588Amortization
of patent costs
    
    
    108
    
    
    
    91Amortization
of non-competition agreement
    
    
    
    
    
    
    100Amortization
of deferred rent credit
    
    
    (8
    )
    
    
    Income tax
benefits on exercise of stock options
    
    
    77
    
    
    
    2,761Deferred
income tax benefit
    
    
    (12
    )
    
    
    (2,110
    )Recognition
of deferred license revenues
    
    
    (1,011
    )
    
    
    (936
    )Equity in
earnings of Novogyne
    
    
    (912
    )
    
    
    (637
    )Distributions
from Novogyne
    
    
    7,444
    
    
    
    6,044Changes in
operating assets and liabilities:Decrease in
accounts receivable  trade, net
    
    
    2,740
    
    
    
    1,417Decrease in
accounts receivable  Novogyne, net
    
    
    3,295
    
    
    
    1,265Increase in inventories
    
    
    (2,361
    )
    
    
    (89
    )Increase in
prepaid income taxes
    
    
    (25
    )
    
    
    (197
    )Increase in
prepaid and other current assets
    
    
    (692
    )
    
    
    (504
    )Increase in
deposits and other assets
    
    
    
    
    
    
    (4
    )(Decrease)
increase in accounts payable
    
    
    (4,898
    )
    
    
    1,170Increase in
accrued liability - Shire
    
    
    4,362
    
    
    
    Decrease in
accrued compensation and related liabilities
    
    
    (2,514
    )
    
    
    (1,233
    )Decrease in
other accrued liabilities
    
    
    (150
    )
    
    
    (1,590
    )(Decrease)
increase in deferred contract revenue
    
    
    (45
    )
    
    
    1,381Increase in
deferred license revenue
    
    
    
    
    
    
    6,500Direct
expenses incurred in pursuit of
methylphenidate patch regulatory approval
    
    
    (4,680
    )
    
    
    (147
    )Cash flows
provided by operating activities
    
    
    1,510
    
    
    
    14,028Cash flows from investing activities:Purchases of property, plant and equipment, net
    
    
    (1,825
    )
    
    
    (579
    )Payments for patent development costs, net
    
    
    (156
    )
    
    
    (133
    )Purchases of short-term investments
    
    
    (95,100
    )
    
    
    Proceeds from sale of short-term investments
    
    
    65,150
    
    
    
    Cash flows
used in investing activities
    
    
    (31,931
    )
    
    
    (712
    )Cash flows from financing activities:Issuance of common stock from exercise of stock options
    
    
    816
    
    
    
    5,245Repayments of capital leases and notes payable
    
    
    (38
    )
    
    
    Cash flows
provided by financing activities
    
    
    778
    
    
    
    5,245Net (decrease) increase in cash and cash equivalents
    
    
    (29,643
    )
    
    
    18,561Cash and cash equivalents, beginning of period
    
    
    93,958
    
    
    
    83,381Cash and cash equivalents, end of period
    
    $
    64,315
    
    
    $
    101,942
 The accompanying notes are an integral part of these statements. 5




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NOVEN PHARMACEUTICALS, INC. 
 Notes to Unaudited Condensed Financial Statements
  1.
    DESCRIPTION OF BUSINESS:Noven Pharmaceuticals, Inc. (Noven) was incorporated in Delaware in 1987 and is engaged
in the research, development, manufacture and marketing of advanced transdermal drug delivery
technologies and prescription transdermal products.Noven and Novartis Pharmaceuticals Corporation (Novartis) entered into a joint venture,
Vivelle Ventures LLC (d/b/a Novogyne Pharmaceuticals) (Novogyne), effective May 1, 1998, to
market and sell womens prescription healthcare products in the United States and Canada.
These products include Novens transdermal estrogen delivery systems marketed under the brand
names Vivelle®, Vivelle-DotTM and CombiPatch®. Noven accounts
for its 49% investment in Novogyne under the equity method and reports its share of Novogynes
earnings as Equity in earnings of Novogyne on its Statements of Operations. Noven defers the
recognition of 49% of its profit on products sold to Novogyne until the products are sold by
Novogyne to third party customers.  2.
    BASIS OF PRESENTATION:In managements opinion, the accompanying unaudited condensed financial statements of
Noven contain all adjustments (consisting of only normal recurring adjustments) necessary to
present fairly, in all material respects, the financial position of Noven as of March 31, 2005,
and the results of its operations and its cash flows for the three months ended March 31, 2005
and 2004. Novens business is subject to numerous risks and uncertainties including, but not
limited to, those set forth in Novens Annual Report on Form 10-K for the year ended December
31, 2004 (Form 10-K), and in Part I  Item 2  Managements Discussion and Analysis of
Financial Condition and Results of Operations of this quarterly report on Form 10-Q.
Accordingly, the results of operations and cash flows for the three months ended March 31, 2005
and 2004 are not, and should not be construed as, necessarily indicative of the results of
operations or cash flows which may be reported for the remainder of 2005 or for periods
thereafter.The accompanying unaudited condensed financial statements have been prepared pursuant to
the rules and regulations of the Securities and Exchange Commission for reporting on Form 10-Q.
Pursuant to such rules and regulations, certain information and footnote disclosures normally
included in financial statements prepared in accordance with accounting principles generally
accepted in the United States of America have been condensed or omitted. The unaudited
condensed financial statements should be read in conjunction with the financial statements and
the notes to the financial statements included in Novens Form 10-K. The accounting policies
followed for interim financial reporting are the same as those disclosed in Note 2 of the notes
to the financial statements included in Novens Form 10-K.  3.
    CASH AND CASH EQUIVALENTS AND SHORT-TERM INVESTMENTS:Cash and cash equivalents includes all highly liquid investments with an original maturity
of three months or less at the date of purchase. Cash and cash equivalents as of March 31,
2005, and December 31, 2004, consisted primarily of overnight money market accounts, time
deposits,
commercial paper and money market funds with original maturities of three months or less
at the date of purchase. Beginning in the first quarter of 2005, Noven invested a portion of
its cash 6




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in short-term investments, which primarily consist of investment grade, asset backed,
variable rate debt obligations and municipal auction rate securities, which are categorized as
available-for-sale under the provisions of Statement of Financial Accounting Standards (SFAS)
No. 115 Accounting for Certain Investments in Debt and Equity Securities. Despite the
long-term nature of their stated contractual maturities, these securities have provisions that
allow for liquidation in the short-term. Accordingly, the short-term investments are reported
at fair value, with any related unrealized gains and losses included in comprehensive income as
a separate component of stockholders equity, net of applicable taxes. As of March 31, 2005,
the cost of all short-term investments approximated fair value. Therefore, no unrealized gains
and losses have been recognized for the quarter ended March 31, 2005. Realized gains and
losses and interest and dividends are included in interest income or interest expense, as
appropriate.  4.
    RECENT ACCOUNTING PRONOUNCEMENTS:In November 2004, the
Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standard No. 151
Inventory Costs  an amendment of ARB No. 43, Chapter 4 (SFAS 151), to clarify the
accounting for abnormal amounts of idle facility expense, freight or wasted material
(spoilage). SFAS 151 requires that those items be recognized as current-period charges
regardless of whether they meet the so abnormal criterion outlined in Accounting Research
Bulletin 43, Chapter 4, Inventory Pricing. SFAS 151 also introduces the concept of normal
capacity and requires the allocation of fixed production overheads to inventory based on the
normal capacity of the production facilities. Unallocated overheads must be recognized as an
expense in the period in which they are incurred. This statement is effective for inventory
costs incurred during fiscal years beginning after June 15, 2005. Noven is currently assessing
SFAS 151 and Noven is unable to estimate the impact it will have on
its results of operations and
financial condition.In December 2004, the FASB
issued SFAS No. 123(R) Share-Based Payment (Revised 2004)
that will require compensation costs related to share-based payment transactions to be
recognized in the financial statements. With limited exceptions, the amount of compensation
cost will be measured based on the grant-date fair value of the equity or liability instruments
issued. Compensation cost will be recognized over the period that an employee provides service
in exchange for the award, which is generally over the vesting
period. SFAS 123(R) replaces
SFAS 123, Accounting for Stock-Based Compensation, and supersedes APB 25, Accounting for
Stock Issued to Employees. For public companies such as Noven, the statement is effective as
of the beginning of the first annual reporting period that begins after June 15, 2005 and
accordingly, Noven anticipates adopting this statement in the first quarter of 2006.  5.
    RECLASSIFICATIONS:Certain reclassifications have been made to prior period financial statements to conform
to the current years presentation. 7




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6.
    INVENTORIES:The following are the major classes of inventories (in thousands): March 31,
    
    
    December 31,2005
    
    
    2004Finished goods
    
    $
    859
    
    
    $
    610Work in process
    
    
    8,082
    
    
    
    6,522Raw materials
    
    
    9,408
    
    
    
    8,856Total
    
    $
    18,349
    
    
    $
    15,988
  Included in the amounts identified above as of March 31, 2005 and December 31, 2004, were
$12.5 million and $10.8 million, respectively, in inventories to manufacture launch supplies of
Novens generic fentanyl patch for which an Abbreviated New Drug Application has been filed and
is pending before the U.S. Food and Drug Administration
(FDA). See Note 9  Contract and License Agreements
 Endo Collaboration and Note 12  Fentanyl Inventories. The remaining inventories as of March 31, 2005 and
December 31, 2004 relate to Novens marketed products.Provisions have been made to reduce inventories to net realizable value. To date, Noven
has not experienced any difficulty acquiring materials necessary to manufacture its products.
Given that certain materials and compounds, including essential polymers used by Noven, are
available from limited sources and, in some cases, a single supplier, no assurance can be given
that Noven will not experience difficulty in the future. Other than products produced for
commercial sale, Novens policy is to immediately recognize as expense all inventory purchased
for research and development purposes.  7.
    EMPLOYEE STOCK PLANS:In accordance with the provisions of Statement of Financial Accounting Standards No. 123,
Accounting for Stock-Based Compensation (SFAS 123), as amended by Statement of Financial
Accounting Standards No. 148, Accounting for Stock-Based Compensation -Transition and
Disclosure (SFAS 148), Noven may elect to continue to apply the provisions of the Accounting
Principles Boards Opinion No. 25, Accounting for Stock Issued to Employees (APB 25), and
related interpretations in accounting for its employee stock option plans, or adopt the fair
value method of accounting prescribed by SFAS 123. Noven has elected to continue to account
for its stock plans using APB 25, and therefore no stock-based employee compensation cost is
reflected in net income, as all options granted under those plans had an exercise price equal
to the market value of the underlying common stock on the date of grant. 8




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The following table illustrates the effect on net income and earnings per share for the
three months ended March 31, 2005 and 2004 if Noven had applied the fair value recognition
provisions of SFAS 123, as amended by SFAS 148 (in thousands, except per share amounts): Three Months2005
    
    
    2004Net income:As reported
    
    $
    211
    
    
    $
    158Total stock-based employee
compensation expense determined
under fair value based method for all
awards, net of related tax effects
    
    
    (1,747
    )
    
    
    (740
    )Pro forma
    
    $
    (1,536
    )
    
    $
    (582
    )Basic earnings per share:As reported
    
    $
    0.01
    
    
    $
    0.01Pro forma
    
    $
    (0.07
    )
    
    $
    (0.03
    )Diluted earnings per share:As reported
    
    $
    0.01
    
    
    $
    0.01Pro forma
    
    $
    (0.06
    )
    
    $
    (0.02
    )
  SFAS 123 requires the use of option valuation models that require the input of highly
subjective assumptions, including expected stock price volatility. Because Novens stock
options have characteristics significantly different from traded options and because changes in
the subjective input assumptions can materially affect the fair value estimate, in managements
opinion, the existing models do not necessarily provide a reliable measure of the fair value of
Novens employee stock options.The effect of applying the fair value method of accounting for stock options on reported
net income and earnings per share for the three months ended March 31, 2005 and 2004,
respectively, may not be representative of the effects for future periods.As noted in Note 4  Recent Accounting Pronouncements, above, in
December 2004, the FASB issued SFAS 123(R) that will require compensation costs
related to share-based payment transactions to be recognized in the financial statements.
Noven will be required to adopt the standards of stock option
expensing under SFAS 123(R) beginning with its first fiscal quarter of 2006. On April 5, 2005, the Compensation and Stock
Option Committee of the Board of Directors of Noven approved the acceleration of vesting of
unvested out-of-the-money stock options under the Noven 1999 Long-Term Incentive Plan. The
affected options are those with exercise prices greater than $17.28 per share, which was the
closing price of Novens common stock on April 7, 2005 (the effective date of the modification
to accelerate vesting of the out-of-the-money stock options). As a result of this action,
options to purchase approximately 932,000 shares of Novens common stock became immediately
exercisable, including options held by Novens executive officers to purchase approximately
401,000 shares. The purpose of the accelerated vesting is to eliminate the future compensation
expense that Noven would otherwise recognize in its Statement of Operations with respect to
these accelerated options upon the adoption of SFAS  123(R). As a result of acceleration of
vesting of unvested out-of-the-money stock options in April 2005, Noven expects a substantial
decrease in pro forma net income and pro forma earnings per share as presented in this footnote
for the three months ended June 30, 2005. 9




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8.
    CASH FLOW INFORMATION:Cash payments for income taxes were not material for the three months ended March 31, 2005
and were $2.9 million for the three months ended March 31, 2004. Cash payments for interest
were not material for the three months ended March 31, 2005 and 2004.Non-cash Investing ActivitiesDuring the three months ended March 31, 2005, Noven recorded approximately $0.5 million in
leasehold improvements as a deferred rent credit as the landlord paid for the leasehold
improvements. See Note 12  Commitments and Contingencies  Facility Lease.During the three months ended March 31, 2004, Noven entered into a capital lease obligation
of $0.3 million for new equipment.  9.
    CONTRACT AND LICENSE AGREEMENTS:Endo CollaborationIn July 2003, Noven submitted an Abbreviated New Drug Application (ANDA) to the FDA
seeking approval to market a generic version of Duragesic® (fentanyl transdermal
system). Duragesic® is a transdermal patch containing fentanyl, an opioid analgesic
and a Schedule II controlled substance, indicated for the management of chronic pain. Novens
ANDA for this product was accepted for filing as of October 1, 2003 and is under review at the
FDA. Johnson & Johnsons patent and exclusivity status for Duragesic® expired in
January 2005, after which the FDA approved the fentanyl transdermal system ANDA filed by Mylan
Laboratories. Also in January 2005, the FDA denied several citizen petitions intended to
prevent or delay the approval of certain generic versions of Duragesic®.In the first quarter of 2004, Noven entered into an exclusive license agreement with Endo
Pharmaceuticals Inc. (Endo) pursuant to which Noven granted Endo the right to market Novens
fentanyl patch in the United States and Canada. Noven retained all rights to the fentanyl
patch outside of the United States and Canada, and Noven is exploring strategies to
commercialize the product in other territories. In April 2005, Endo returned the Canadian
marketing rights to Noven. Noven received an up-front payment of $8.0 million from Endo upon
signing the agreement. The agreement provides that, upon Endos first commercial sale of the
fentanyl patch, Noven is entitled to receive an additional milestone payment ranging from $5.0
million to $10.0 million, depending on the timing of launch and the number of generic
competitors in the market. Under a long-term supply agreement entered into between the
parties, Noven will manufacture and supply the product at its cost and will share in Endos
profit generated from U.S. product sales.Under the terms of the transaction, Noven remains responsible for securing final
regulatory approval for its fentanyl patch. The agreement provides that Endo may terminate the
agreement, and its obligation to launch the product, if launch is delayed either (i) because of
a delayed FDA approval or (ii) Noven fails to supply Endo with its launch requirements after
approval, and in either case if as a result of the delay there is additional generic
competition beyond that expected by the parties at the time of execution of the agreement. The
earliest that this right could be triggered under the agreement is 120 days after the launch of
the next generic fentanyl transdermal product. In the event of such a termination, rights to
the fentanyl patch would return to Noven.In addition to the fentanyl license, Noven has established collaboration with Endo to seek
to identify and develop new transdermal therapies. Of the $8.0 million received at signing,
$1.5 million has been allocated to fund feasibility studies that seek to determine whether
certain 10




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compounds identified by the parties can be delivered through Novens transdermal patch
technology. Endo is expected to fund and manage clinical development of those compounds
proceeding into clinical trials.Of the $8.0 million received at signing, $6.5 million will be recognized as license
revenues as earned over a 10-year period, which is the estimated product life cycle of the
fentanyl patch. The remaining $1.5 million is being recognized as contract revenues over the
course of feasibility development of any additional patches developed under the Noven/Endo
collaboration.ShireIn the first quarter of 2003, Noven signed an agreement to license the exclusive global
rights to market its methylphenidate patch for Attention Deficit Hyperactivity Disorder
(ADHD) to Shire Pharmaceuticals Group plc (Shire) for payments of up to $150 million and
ongoing manufacturing revenues. Consideration for the transaction is as follows: (i) $25
million was paid upon closing of the transaction in April 2003; (ii) $50 million is payable
upon receipt of final marketing approval for the methylphenidate patch by the FDA; and (iii)
three installments of $25 million each are payable upon Shires achievement of $25 million, $50
million and $75 million in annual net sales of the methylphenidate patch, respectively.
Shires annual net sales will be measured quarterly on a trailing 12-month basis, with each
milestone payment due 45 days after the end of the first quarter during which trailing 12-month
sales exceed the applicable threshold. Shire has agreed that it will not sell any other
product containing methylphenidate as an active ingredient until the earlier of (i) five years
from the closing date or (ii) payment of all of the sales milestones. On the closing date,
Noven entered into a long-term supply agreement under which it expects to manufacture and
supply its methylphenidate patch to Shire. The agreement gives Shire the right to qualify a
second manufacturing source and purchase a portion of its requirements from the second source.
If Shire were to exercise this right, Novens manufacturing revenues from sales of its
methylphenidate patch would be adversely affected. Pursuant to the agreement, under certain
circumstances Shire has the right to require Noven to repurchase the product rights for $5
million.In April 2003, Noven received a not approvable letter from the FDA relating to its
methylphenidate patch New Drug Application (NDA). In April 2005, Noven and Shire announced
preliminary results from additional clinical trials conducted in 2004 and 2005 that were
intended to address clinical issues raised in the not approvable letter. Noven and Shire
plan to include these trial results in an amendment to the NDA that the parties expect to file
during 2005. The amendment is expected to receive a six-month review by the FDA. No assurance
can be given that the data obtained from the additional studies will in fact address the FDAs
issues or that the FDA may not raise additional issues following any submission of an amendment
to the NDA for Novens methylphenidate patch.Novens direct costs incurred in pursuit of approval are being deferred and offset against
a portion of the $25.0 million deferred revenue previously received from Shire. Such expenses
did not impact Novens research and development expenses in 2004 or the quarter ended March 31,
2005, although the direct expenses incurred in pursuit of FDA approval reduce Novens cash
position and will have the effect of reducing the amount of deferred revenues that Noven may
recognize in future periods. As of March 31, 2005, the amount of available deferred revenues
was $1.0 million (which excludes the $5.0 million of deferred revenues related to Shires
repurchase right) and Noven does not expect its prospective cost in pursuit of approval to
exceed this amount.Under Novens agreements with Shire, Shire has certain rights to terminate the license of
Novens methylphenidate patch, including if Shire determines that submission of the results of
the additional clinical studies to the FDA would not result in approval of a
commercially-viable 11




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product. If Shire were to terminate on this basis, all product rights
would revert to Noven, and Noven would retain the $25.0 million previously paid by Shire.
Shire also has the right to require Noven to repurchase the product rights to the
methylphenidate patch for $5.0 million under certain circumstances.In June 2004, Noven entered into an agreement with Shire for the development of a
transdermal amphetamine patch for ADHD. The agreement provides for the payment to Noven of up
to $5.0 million if certain development milestones are achieved. The product is in pre-clinical
development and Noven is recognizing payments received as contract revenue as the work is
performed.P&G Pharmaceuticals CollaborationIn April 2003, Noven
established a collaboration with Procter & Gamble Pharmaceuticals, Inc.
(P&G Pharmaceuticals) for the development of new prescription patches. The products under
development explore follow-on product opportunities for Intrinsa®, P&G
Pharmaceuticals in-licensed investigational transdermal testosterone patch designed to help
restore desire in menopausal women who have Hypoactive Sexual Desire Disorder. P&G
Pharmaceuticals withdrew its NDA for Intrinsa® in December 2004 based on feedback
from an FDA Advisory Committee and has stated its intention to file a new NDA with additional
clinical data. During 2004, Noven earned $4.4 million under the P&G Pharmaceuticals
collaboration. No development milestones under this collaboration were earned for the three
months ended March 31, 2005.  10.
    INVESTMENT IN VIVELLE VENTURES LLC (d/b/a NOVOGYNE):Noven shares in the earnings of Novogyne, after satisfaction of an annual preferred return
of $6.1 million to Novartis, according to an established formula. Novens share of Novogynes
earnings increases as Novogynes product sales increase, subject to a cap of 49%. Novogyne
produced sufficient income in the first quarter of 2005 and 2004 to meet Novartis annual
preferred return for those years and for Noven to recognize earnings from Novogyne under the
formula.During the three months ended March 31, 2005 and 2004, Noven had the following transactions
with Novogyne (in thousands): Three Months2005
    
    
    2004Revenues:Product sales
    
    $
    4,978
    
    
    $
    5,808Royalties
    
    
    1,114
    
    
    
    890$
    6,092
    
    
    $
    6,698Reimbursed expenses
    
    $
    7,242
    
    
    $
    6,289
  As of March 31, 2005 and December 31, 2004, Noven had amounts due from Novogyne of $6.8
million and $10.1 million, respectively, for products sold to, and marketing expenses
reimbursable by, Novogyne. 12




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The unaudited condensed Statements of Operations of Novogyne for the three months ended
March 31, 2005 and 2004 are as follows (in thousands): Three Months2005
    
    
    2004Gross revenues
    
    $
    27,334
    
    
    $
    25,134Sales allowances
    
    
    3,395
    
    
    
    2,772Sales return allowances
    
    
    1,266
    
    
    
    1,009Sales allowances and returns
    
    
    4,661
    
    
    
    3,781Net revenues
    
    
    22,673
    
    
    
    21,353Cost of sales
    
    
    4,555
    
    
    
    4,835Selling, general and
administrative expenses
    
    
    8,670
    
    
    
    7,625Amortization of intangible assets
    
    
    1,545
    
    
    
    1,545Income from operations
    
    
    7,903
    
    
    
    7,348Interest income
    
    
    93
    
    
    
    40Net income
    
    $
    7,996
    
    
    $
    7,388Novens equity in earnings of Novogyne
    
    $
    912
    
    
    $
    637
  The activity in the Investment in Novogyne account for the three months ended March
31, 2005 is as follows (in thousands): Investment in Novogyne, beginning of period
    
    $
    26,233Equity in earnings of Novogyne
    
    
    912Cash distributions from Novogyne
    
    
    (7,444
    )Investment in Novogyne, end of period
    
    $
    19,701
  Subject to the approval of Novogynes management committee, Novogyne may, from time to
time, distribute cash to Novartis and Noven based upon a contractual formula. For the three
months ended March 31, 2005 and 2004, Noven received cash distributions of $7.4 million and $6.0
million from Novogyne, respectively. These amounts were recorded as reductions in the
investment in Novogyne when deemed received.  11.
    SHARE REPURCHASE PROGRAM:In the first quarter of 2003, Novens Board of Directors authorized a share repurchase
program under which Noven may acquire up to $25.0 million of its common stock. To date, Noven
has repurchased 105,000 shares of its common stock at an aggregate price of approximately $1.3
million. No shares were repurchased during the three months ended March 31, 2005 and 2004.  12.
    COMMITMENTS AND CONTINGENCIES:HT StudiesIn July 2002, the National Institutes of Health (NIH) released data from its Womens
Health Initiative (WHI) study on the risks and benefits associated with the use of oral
combination hormone therapy (HT). The study revealed an increase in the risk of developing
breast cancer and increased risks of stroke, heart attack and blood clots. The WHI study was 13




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followed by the publication during 2002  2004 of the results of a number of other studies that
found that the overall health risks from the use of certain HT products exceed the benefits
from the use of those products. In the first quarter of 2004, the NIH discontinued the
estrogen-only arm of the WHI study because results were showing an increased risk of stroke and
because, after nearly seven years of follow-up, the NIH determined that it had sufficient data
to assess the risks and benefits of estrogen use in the trial. Researchers continue to analyze
data from both arms of the WHI study and other studies, and other publications may be
forthcoming.These studies and others have caused the HT market, and the market for Novens products,
to significantly decline. Prescriptions for CombiPatch®, Novens combination
estrogen/progestin patch, continue to decline in the post-WHI environment. Novogyne recorded
the acquisition of the marketing rights for Novens CombiPatch® product at cost and
tests this asset for impairment on a periodic basis. Further adverse change in the market for
HT products could have a material adverse impact on the ability of Novogyne to recover its
investment in these rights, which could require Novogyne to record an impairment loss on the
CombiPatch® intangible asset. Impairment of the CombiPatch® intangible
asset would adversely affect Novogynes and Novens financial results. Management cannot
predict whether these or other studies will have additional adverse effects on Novens
liquidity and results of operations, or Novogynes ability to recover the net carrying value of
the CombiPatch® intangible asset.Production IssuesNoven maintains in-house product stability testing for its commercialized products. This
process includes, among other things, testing samples from commercial lots under a variety of
conditions to confirm that the samples remain within required specifications for the shelf-life
of the product.As a result of the 2003 recall of Vivelle-Dot patches, Noven initiated a
series of special stability protocols to monitor commercial lots in distribution as well as
future production of Vivelle-Dot. As previously disclosed, in the first quarter of
2005, a total of ten lots of Vivelle-Dotmanufactured in 2003 were identified for
recall when one of Novens stability protocols revealed that these lots did not meet required
specifications or were associated with lots that did not meet specifications. Because these
lots were manufactured in 2003, Noven estimates that an immaterial number of patches from these
lots currently remain in distribution. The effect of these recalled lots on Novens and
Novogynes results of operations was immaterial.Based on testing and analysis to date, Noven believes that the probable cause of the
Vivelle-Dot stability failures remains related to certain patch backing material
that Noven obtained from a raw material supplier. Noven and Novartis have established a joint
task force to identify the definitive root cause of the Vivelle-Dot stability
failures. If the root cause determination or additional testing (including Novens routine
stability testing) indicates that the production issue affects more product than Novens
current testing and analysis suggests, additional recalls may be required. The final field
alert for the recall of the additional lots of Vivelle-Dotwas submitted to the FDA
in March 2005. Noven cannot predict what action, if any, the FDA may take with respect to the
recalls of Vivelle-Dot. Although Noven and Novartis are working together in
assessing the Vivelle-Dot production issues, the decision to recall product resides
with Novartis as the holder of the Vivelle-Dot NDA and is not within Novens
control. Among others risks, the recent, or any additional, recalls of Vivelle-Dot
could result in a decision to: recall all or a significant portion of the product in
distribution until a definitive root cause has been identified and any required corrective
action has been completed; cease production or shipment of new product until a definitive root
cause has been identified and any required corrective action has been completed; or reduce the
shelf-life of Vivelle-Dot. Vivelle-Dot represented over 80% of
Novogynes total prescriptions in the first quarter of 2005 14




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and Novens and Novogynes results
of operations and prospects would be materially and adversely affected in the event these or
similar actions were to occur.As previously disclosed by Noven, in late October 2004, Novens product stability testing
program indicated that one commercial lot of CombiPatch® product did not maintain
required specifications throughout the products shelf-life due to the formation of crystals.
Novartis has recalled the affected lot. The 2004 recall of this lot did not have a material
impact on Novens and Novogynes financial statements. Noven continues to manufacture and ship
CombiPatch® to Novogyne. Noven continues to maintain stability testing for
CombiPatch®, and is undertaking additional testing related to the October 2004
stability failure. If Novens testing indicates that additional CombiPatch® lots do
not meet specifications or are affected by the issue impacting the lot recalled, Novartis could
initiate additional recalls. Although Noven and Novartis are working together to assess
production issues, the decision to recall product resides with Novartis as the holder of the
CombiPatch® NDA and is not within Novens control. If Novens estimates concerning
product returns associated with the recall are incorrect, or if Novens continued testing
indicates that more than one lot is affected, or if Novartis should initiate additional recalls
for any reason, then Novens and Novogynes business and results of operations could be
materially and adversely impacted.The recent recalls may result in an FDA inspection of Novens facilities and procedures
and Noven cannot assure that the FDA will be satisfied with Novens operations and procedures,
which could result in more frequent and stringent inspections and monitoring. If the FDA were
to conclude that Novens manufacturing controls and procedures are not sufficient, Noven could
be required to suspend production until Noven demonstrates to the FDA that Novens controls and
procedures are sufficient.Supply AgreementNovens supply agreement with Novogyne for Vivelle® and
Vivelle-DotTM patches expired in January 2003. Since expiration, the parties have
continued to operate in accordance with the supply agreements commercial terms. There is no
assurance that the agreements non-commercial terms would be enforceable with respect to
post-expiration occurrences. A decision to discontinue operating in
accordance with
the agreements commercial terms could have a material adverse effect on Novens financial
position and results of operations. Novogynes designation of a new supplier and approval of a new supply
agreement would require the affirmative vote of four of the five members of Novogynes
Management Committee. Accordingly, both Novartis and Noven must agree on Novogynes supplier.Litigation, Claims and AssessmentsOn March 15, 2005, the United States District Court for the Southern District of Florida
issued an order dismissing without prejudice the lawsuit filed against Noven and certain
individual defendants styled In re: Noven Pharmaceuticals, Inc. Securities Litigation.
The notice of voluntary dismissal (attached to the order of dismissal) indicated that the lead
plaintiffs and their counsel, after further investigation, concluded that the complaint should
be voluntarily dismissed. Noven agreed to the dismissal, with each party bearing its own
costs.In July 2004, an individual plaintiff and her husband filed a complaint in Superior Court
of New Jersey Law Division, Atlantic County, against Noven, Novartis, Wyeth Pharmaceuticals,
Inc. and others alleging liability in connection with personal injury claims allegedly
arising from the use of HT products, including CombiPatch®, which is manufactured by
Noven and distributed by Novogyne. The plaintiffs claim compensatory, punitive and other
damages in an unspecified amount. In April 2005, the plaintiff agreed to substitute Aventis
Pharmaceuticals, Inc. for Noven and Novartis in this case and to dismiss Noven and Novartis
without prejudice for 15




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a period of six months and with prejudice thereafter. In addition,
Novartis has advised Noven that Novartis has been named as a
defendant in at least 13
additional lawsuits that include
approximately 23 plaintiffs that allege liability in connection with personal
injury claims allegedly arising from the use of HT patches distributed and sold by Novartis and
Novogyne, including Novens Vivelle®, Vivelle-Dot and
CombiPatch® products. To date, Noven has been named in one lawsuit and, to Novens
knowledge, Novogyne has not been named in any. Novartis has indicated that it will seek
indemnification from Noven and Novogyne to the extent permitted by the agreements between and
among Novartis, Novogyne and Noven. Novogynes accrual for expected legal fees and
settlements of these lawsuits was $2.4 million as of March 31, 2005, for which there was a
related insurance receivable of $1.4 million. Novogyne recognized a $0.1 million expense for
the three months ended March 31, 2005, based on the net increase during such three month period
in this accrual less the insurance receivable. This accrual represents Novartis managements
best estimate as of March 31, 2005. The ultimate outcome of these product liability lawsuits cannot be predicted. Noven is involved in certain litigation and claims incidental to its business. Noven does
not believe, based on currently available information, that these matters will have a material
adverse effect on the accompanying financial statements. Contract and License Agreements Noven is obligated to perform under its contract and license agreements. In certain
circumstances, Noven is required to indemnify its licensees from damages caused by the products
Noven manufactures as well as claims or losses related to patent infringement. Internal Revenue Service Audit Noven, from time to time, is subject to audits by taxing authorities, covering a wide
range of matters and the Internal Revenue Service is currently auditing Novens federal income
tax returns for certain open years. Such matters are subject to various uncertainties, and it
is possible that some of these matters may be resolved unfavorably to Noven. Since 2001,
Noven has established $1.1 million in accruals for pending matters that it believes are
probable and reasonably estimable. There was no change in the amount for the periods ended
March 31, 2005 and 2004. The outcome of the pending matters cannot ultimately be predicted. Fentanyl Inventories As of March 31, 2005, Noven had incurred $12.5 million for the cost of producing
pre-launch inventories for its fentanyl patch. If approval of the fentanyl patch is not
ultimately received or is delayed, Novens agreement with Endo provides that the parties will
share the cost of manufacturing product that cannot be sold by Endo in accordance with an
agreed-upon formula. In such a case, Noven may be unable to recover its share of such costs,
which could be up to approximately $7.2 million. Facility Lease In February 2005, Noven entered into an Industrial Long-Term Lease (the Lease) for
approximately 73,000 square feet of newly constructed space located in close proximity to its
manufacturing facility in Miami, Florida. Noven intends to use the leased space for the storage
and, as needed, the manufacture of new product. The lease term is 10 years, which may be
extended for up to an additional 21 years pursuant to four renewal options of five years each
and a one-time option to renew for one year. The annual base rent is $6.40 per square foot.
Noven will also pay a monthly management fee equal to 1.5% of the base rent. The rent for the
first year is discounted to $3.20 per square foot. The base rent is subject to annual increases
of 3% 16




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during the initial 10-year term. After the initial term, the rent will be 95 percent of
the fair market rate of the leased space as determined under the Lease. Noven is in the process
of improving the leased space in order to prepare it for its intended use. The landlord will
be responsible for leasehold improvements paid to the general contractor improving the leased
space, up to approximately $0.9 million. Any amounts paid to the general contractor in excess
of this amount and any other leasehold improvements will be the responsibility of Noven. For
accounting purposes, Noven is amortizing the expected rental payments on a straight-line basis
over the initial 10-year term of the Lease. The renewal terms have not been included for
amortization purposes because Noven cannot reasonably estimate the rental payments after the
initial term and Noven cannot assure that it will renew the Lease after the initial term. Any
leasehold improvements will be recorded at cost and will be amortized on a straight-line basis
over the shorter of the estimated useful life of the improvements or the remaining initial
10-year lease term. Leasehold improvements to the leased space paid by the landlord will be
recorded by Noven as a deferred rent credit and will be amortized on a straight-line basis when
incurred over the remaining initial 10-year lease term as a reduction of rent expense. Rent
expense related to this lease was $0.1 million for the three months ended March 31, 2005.
Leasehold improvements paid by the landlord and recorded as a deferred rent credit were
approximately $0.5 million for the three months ended March 31, 2005. 17




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Item 2. Managements Discussion and Analysis of Financial Condition and Results of
Operations The following section addresses material aspects of Novens financial condition at March 31,
2005, and the results of operations for the three months ended March 31, 2005 and 2004. The
contents of this section include:  
    An overview of Noven and our Novogyne joint venture;
    A review of certain items that affect the historical or future comparability of our
results of operations;
    An analysis of our results of operations and our liquidity and capital resources;
    A discussion of recently issued accounting standards and the application of our
critical accounting policies;
    An outlook that includes our current financial guidance for 2005; and
    A review of cautionary factors that could have a material adverse effect on our
business, financial condition and results of operations. This discussion should be read in conjunction with Novens financial statements for the three
months ended March 31, 2005 and 2004 and the related notes included elsewhere in this Form 10-Q, as
well as the section Managements Discussion and Analysis of Financial Condition and Results of
Operations from our Annual Report on Form 10-K for the year ended December 31, 2004. Overview We develop and manufacture advanced transdermal patches and presently derive substantially all
of our revenues from sales of transdermal patches for use in menopausal hormone therapy. In the
United States, our HT products are marketed and sold by Novogyne Pharmaceuticals, the joint venture
that we formed with Novartis in 1998. Our business, financial position and results of operations
currently depend on Novogyne and its marketing of our three principal HT products 
Vivelle®, Vivelle-Dot and CombiPatch® in the United States. A
discussion of Novogynes results and their impact on our results can be found under the caption
Results of OperationsEquity in Earnings of Novogyne. In all countries other than the United States, Canada and Japan, we have licensed the
marketing rights to these products to Novartis Pharma AG (Novartis Pharma), which is an affiliate
of Novartis. In most of these markets, Vivelle® is marketed under the brand name
Menorest, Vivelle-Dot is marketed under the brand name Estradot and
CombiPatch® is marketed under the brand name Estalis®. We hold a 49% equity interest in Novogyne, and Novartis holds the remaining 51% equity
interest. Under the terms of the joint venture agreements, we manufacture and supply
Vivelle®, Vivelle-Dot and CombiPatch® to Novogyne, perform
marketing, sales and promotional activities, and receive royalties from Novogyne based on
Novogynes sales of the estrogen therapy (ET) products. Novartis distributes
Vivelle®, Vivelle-Dot and CombiPatch® and provides certain other
services to Novogyne, including financial and accounting functions. Novartis is entitled to an annual $6.1 million preferred return from Novogyne, which has the
effect of reducing our share of Novogynes income in the first quarter of each year. After the
annual preferred return to Novartis, our share of Novogynes income increases as product sales
increase, subject to a maximum of 49%. Our share of Novogynes income was $0.9 million and $0.6
million for the three months ended March 31, 2005 and 2004, respectively. The income we recognize
from Novogyne is a non-cash item. Any cash we receive from Novogyne is in the form of cash 18




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distributions declared by Novogynes Management Committee. Accordingly, the amount of cash
that we receive from Novogyne in any period may not be the same as the amount of income we
recognize from Novogyne for that period. For the three months ended March 31, 2005 and 2004, we
received $7.4 million and $6.0 million, respectively, in distributions from Novogyne, which accounted for a
substantial portion of our net cash flows provided by operating activities for these periods. We
expect that a significant portion of our earnings and cash flow for the next several years will be
generated through our interest in Novogyne, but we cannot assure that Novogyne will continue to be
profitable or make cash distributions. Any failure by Novogyne to remain profitable or to continue
to make distributions could have a material adverse effect on our results of operations and
financial condition. The market for HT products, including our transdermal HT products, has contracted since the
July 2002 publication of the WHI study that found adverse health risks associated with HT products.
Comparing the second quarter of 2002 (the quarter immediately preceding the publication of initial
data from the WHI study) to the first quarter of 2005, total prescriptions dispensed in the HT
market in the United States decreased by 51%. For the same period, aggregate prescriptions for
Novens United States HT products decreased 14%. The estrogen segment of the HT market in the
United States declined 47%, while our Vivelle® line of products decreased 4%.
Vivelle-Dot, which represented 83% of our total United States prescriptions in the
first quarter of 2005, increased 19% from the second quarter of 2002 to the first quarter of 2005.
We believe Vivelle-Dot patch prescriptions have benefited from both increased demand
and patient conversions from the original Vivelle® product. United States prescriptions for our CombiPatch® product (which represented
approximately 12% of our total United States prescriptions in the first quarter of 2005) declined
51% from the second quarter of 2002 to the first quarter of 2005, while prescriptions for the total
United States market for fixed combination hormone therapy products decreased 70%. The combination
therapy arm of WHI involved an oral combination estrogen/progestin product and, accordingly, the
combination therapy segment of the HT market has experienced the most significant decrease.
Further decreases for our CombiPatch® product (whether as a result of the WHI studies,
the production issues discussed below or otherwise) could require Novogyne (which holds the
CombiPatch® marketing rights) to record an impairment loss related to these marketing
rights, which would adversely affect the results of operations of both Noven and Novogyne. Certain Items that Affect Historical or Future Comparability Stock Options In April 2005, the Compensation and Stock Option Committee of the Board of Directors of Noven
approved the acceleration of vesting of unvested out-of-the-money stock options under the Noven
1999 Long-Term Incentive Plan. The affected options are those with exercise prices greater than
$17.28 per share, which was the closing price of Novens common stock on April 7, 2005 (the
effective date of the modification to accelerate vesting of the out-of-the-money stock options).
As a result of this action, options to purchase approximately 932,000 shares of Novens common
stock became immediately exercisable, including options held by Novens executive officers to
purchase approximately 401,000 shares. The accelerated options represent approximately 26% of
Novens total outstanding options on the date of the transaction. The exercise prices of the
accelerated options range from $17.88 to $41.81 per share. The purpose of the accelerated vesting is to eliminate the future compensation expense that
Noven would otherwise recognize in its Statement of Operations with respect to these accelerated
options upon the adoption of Financial Accounting Standards Board Statement of Financial Accounting
Standards No. 123 (Revised 2004), Share-Based Payment (SFAS 123R). SFAS 123R is effective from
the first annual reporting period that begins after June 15, 2005, and will require that 19




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the compensation expense associated with stock options be recognized in Novens Statement of
Operations, rather than as historically presented as a footnote disclosure in Novens financial
statements. We anticipate adopting this statement in the first quarter of 2006. Production Issues We maintain in-house product stability testing for our commercialized products. This process
includes, among other things, testing samples from commercial lots under a variety of conditions to
confirm that the samples remain within required specifications for the shelf-life of the product. As a result of the 2003 recall of Vivelle-Dot patches, Noven initiated a series of
special stability protocols to monitor commercial lots in distribution as well as future production
of Vivelle-Dot. As previously disclosed, in the first quarter of 2005, a total of ten
lots of Vivelle-Dotmanufactured in 2003 were identified for recall when one of our
stability protocols revealed that these lots did not meet required specifications or were
associated with lots that did not meet specifications. Because these lots were manufactured in
2003, we estimate that an immaterial number of patches from these lots currently remain in
distribution. The effect of these recalled lots on Novens and Novogynes results of operations
was immaterial. Based on testing and analysis to date, Noven believes that the probable cause of the
Vivelle-Dot stability failures remains related to certain patch backing material that
Noven obtained from a raw material supplier. Noven and Novartis have established a joint task
force to identify the definitive root cause of the Vivelle-Dot stability failures. If
the root cause determination or additional testing (including Novens routine stability testing)
indicates that the production issue affects more product than Novens current testing and analysis
suggests, additional recalls may be required. The final field alert for the recall of the
additional lots of Vivelle-Dotwas submitted to the FDA in March 2005. We cannot
predict what action, if any, the FDA may take with respect to the recalls of
Vivelle-Dot. Although Noven and Novartis are working together in assessing the
Vivelle-Dot production issues, the decision to recall product resides with Novartis as
the holder of the Vivelle-Dot NDA and is not within our control. Among others risks,
the recent, or any additional, recalls of Vivelle-Dot could result in a decision to:
recall all or a significant portion of the product in distribution until a definitive root cause
has been identified and any required corrective action has been completed; cease production or
shipment of new product until a definitive root cause has been identified and any required
corrective action has been completed; or reduce the shelf-life of Vivelle-Dot.
Vivelle-Dot
represented over 80% of Novogynes total prescriptions in the first
quarter of 2005 and Novens and Novogynes results of operations and prospects would be materially
and adversely affected in the event these or similar actions were to occur. As previously disclosed by Noven, in late October 2004, our product stability testing program
indicated that one commercial lot of CombiPatch® product did not maintain required
specifications throughout the products shelf-life due to the formation of crystals. Novartis has
recalled the affected lot. The 2004 recall of this lot did not have a
material impact on Novens and
Novogynes financial statements. We continue to manufacture and ship CombiPatch® to
Novogyne. We continue to maintain our stability testing for CombiPatch®, and are
undertaking additional testing related to the October 2004 stability failure. If our testing
indicates that additional CombiPatch® lots do not meet specifications or are affected by
the issue impacting the lot recalled, Novartis could initiate additional recalls. Although Noven
and Novartis are working together to assess production issues, the decision to recall product
resides with Novartis as the holder of the CombiPatch® NDA and is not within our
control. If our estimates concerning product returns associated with the recall are incorrect, or
if our continued testing indicates that more than one lot is affected, or if Novartis should
initiate additional recalls for any reason, then Novens and Novogynes business and results of
operations could be materially and adversely impacted. 20




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The recent recalls may result in an FDA inspection of our facilities and procedures and we
cannot assure that the FDA will be satisfied with our operations and procedures, which could result
in more frequent and stringent inspections and monitoring. If the FDA were to conclude that our
manufacturing controls and procedures are not sufficient, we could be required to suspend
production until we demonstrate to the FDA that our controls and procedures are sufficient. Shire We are developing a transdermal methylphenidate patch for ADHD. Global rights to the
developmental product were licensed to Shire in the first quarter of 2003 for payments up to $150.0
million, including $25.0 million paid at closing of the license transaction. In April 2005, Noven and Shire announced preliminary results from additional clinical trials
conducted in 2004 and 2005 that were intended to address clinical issues raised in the not
approvable letter that we received from the FDA in April 2003. Noven and Shire plan to include these trial results in an
amendment to the NDA that the parties expect to file during 2005. The amendment is expected to
receive a six-month review by the FDA. No assurance can be given that the data obtained from the
additional studies will in fact address the FDAs issues or that the FDA may not raise additional
issues following any submission of an amendment to the NDA for our methylphenidate patch,
including issues raised by a 2005 study by researchers at the M.D. Anderson Cancer Center that
found adverse chromosomal effects on 12 children treated with oral methylphenidate. Novens direct costs incurred in pursuit of approval are being deferred and offset against a
portion of the $25.0 million deferred revenue previously received from Shire. Such expenses did
not impact Novens research and development expenses in 2004 or the quarter ended March 31, 2005,
although the direct expenses incurred in pursuit of FDA approval reduce our cash position and will
have the effect of reducing the amount of deferred revenues that Noven may recognize in future
periods. As of March 31, 2005, the amount of available deferred revenues was $1.0 million (which
excludes the $5.0 million of deferred revenues related to Shires repurchase right) and Noven does
not expect its prospective cost in pursuit of approval to exceed this amount. 21




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Results of Operations Three months ended March 31, 2005 compared to the three months ended March 31, 2004 Revenues Total revenues for the three months ended March 31, 2005 and 2004 are summarized as follows
(dollar amounts in thousands): Three Months2005
    
    
    2004
    
    
    % ChangeProduct revenues  Novogyne:Product sales
    
    $
    4,978
    
    
    $
    5,808
    
    
    
    (14
    %)Royalties
    
    
    1,114
    
    
    
    890
    
    
    
    25
    %6,092
    
    
    
    6,698
    
    
    
    (9
    %)Product revenues  third parties:Product sales
    
    
    3,965
    
    
    
    2,838
    
    
    
    40
    %Royalties
    
    
    73
    
    
    
    139
    
    
    
    (47
    %)4,038
    
    
    
    2,977
    
    
    
    36
    %Total product revenues
    
    
    10,130
    
    
    
    9,675
    
    
    
    5
    %Contract and license revenues:Contract
    
    
    595
    
    
    
    519
    
    
    
    15
    %License
    
    
    1,011
    
    
    
    936
    
    
    
    8
    %1,606
    
    
    
    1,455
    
    
    
    10
    %Net revenues
    
    $
    11,736
    
    
    $
    11,130
    
    
    
    5
    %
 Net Revenues As described in more detail below, the increase in net revenues for the three months ended
March 31, 2005 as compared to the same period in 2004 was primarily attributable to receipt of a
$1.2 million price adjustment payment related to international product sales, partially offset by
an aggregate decline in sales to Novogyne. In addition, royalties increased for the three months
ended March 31, 2005 as compared to the same period in 2004 as a result of Novogynes higher sales
of Vivelle® and Vivelle-Dot. Product Revenues  Novogyne Product revenues  Novogyne consists of our sales of Vivelle®,
Vivelle-DotTM/Estradot and CombiPatch® to Novogyne at a fixed price for
resale by Novogyne primarily in the United States as well as the royalties we receive as a result
of Novogynes sales of Vivelle® and Vivelle-DotTM. The $0.6 million decrease in product revenues from Novogyne for the three months ended March
31, 2005 as compared to the same period in the prior year primarily related to a $0.3 million and
$0.5 million reduction in unit sales of Vivelle-DotTM and Estradot, respectively,
partially offset by a $0.2 million increase in royalties. The decline in sales of
Vivelle-DotTM to Novogyne was primarily due to the timing of Vivelle-DotTM
sample orders. In addition, sales to Novogyne in the 22




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first quarter of 2004 benefited from
stocking orders of Estradot related to a planned transition from Vivelle® to Estradot in
Canada. Product Revenues  Third Parties Product revenues  third parties consists primarily of sales of Menorest, Estradot and
Estalis® to Novartis Pharma at a price based on a percentage of Novartis Pharmas net
selling price (subject to certain minima) for resale primarily outside the United States and Japan,
together with royalties generated from Novartis Pharmas sales of Vivelle® and Estradot
in Canada. The $1.1 million increase in product revenues from third parties for the three months ended
March 31, 2005 as compared to the same period in the prior year primarily related to $1.5 million
in increased revenue related to pricing, partially offset by $0.5 million of lower unit sales. The
$1.5 million price increase is primarily related to a $1.2 million price adjustment payment from
Novartis Pharma, which was recorded in the first quarter of 2005. Noven records such price
adjustment payments from time to time upon Novartis Pharmas determination that its actual sales
price of our product entitles us to receive amounts in excess of the minimum transfer price. No
such price adjustment was recorded for the three months ended March 31, 2004. The decline in unit
sales reflected continuing lower prescription trends following the publication of the WHI and other
study results. Contract and License Revenues The increase in license revenues for the three months ended March 31, 2005 as compared to the
same period in the prior year was due to the recognition in the current period of license revenue
in connection with our collaboration with Endo. The increase in
contract revenues for the three months ended March 31, 2005
related to work performed on certain development contracts. We entered into our
collaboration with Endo on February 25, 2004 and did not recognize meaningful revenue from it
during the first quarter of 2004. Gross Margin Gross margin for the three months ended March 31, 2005 and 2004 are summarized as follows
(dollar amounts in thousands): 2005
    
    
    
    2004
    
    
    % ChangeTotal product revenues
    
    $
    10,130
    
    
    
    $
    9,675
    
    
    5
    %Cost of products sold
    
    
    5,757
    
    
    
    
    5,518
    
    
    4
    %Gross profit (product revenues
less cost of products sold)
    
    
    4,373
    
    
    
    
    4,157
    
    
    5
    %Gross margin (gross profit as a
percentage of product revenues)
    
    
    43
    %
    
    
    
    43
    %Changes in deferred profit on
sales of product to Novogyne
    
    
    142
    
    
    
    
    218
    
    
    (35
    %)Gross margin excluding impact of
deferred profit
    
    
    45
    %
    
    
    
    45
    %
 Novens cost of products sold may be affected in a given period by changes in deferred
profit on Novens sale of product to Novogyne. As a result of our 49% equity investment in
Novogyne, we are required to defer 49% of our profit on product that we sell to Novogyne until that
product is sold by Novogyne to trade customers. Since our cost of products sold is adjusted to
reflect changes in deferred profit, our gross margin can vary from period to period based on the
timing of our shipments to Novogyne and Novogynes sale of our products to trade customers. If
Novogyne sells more 23




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product than we provide it in a given period (i.e., if Novogynes inventories
decline), we will defer less profit from sales to Novogyne. In light of the significant historic
fluctuations in our deferred profit on sales of product to Novogyne, we have included our gross
margin net of the changes in deferred profit on sales of product to Novogyne, which, Novens
management believes, is useful to understanding Novens revenues as they relate to its cost of
production. Gross margin (both including and excluding the impact of deferred profit) was consistent for
the three months ended March 31, 2005 as compared to the same period in 2004. Operating Expenses Operating expenses for the three months ended March 31, 2005 and 2004 are summarized as
follows (dollar amounts in thousands): Three Months2005
    
    
    2004
    
    
    % ChangeResearch and development
    
    $
    3,010
    
    
    $
    2,255
    
    
    
    33
    %Marketing, general and
administrative
    
    
    4,055
    
    
    
    3,904
    
    
    
    4
    %
 Research and Development The $0.8 million increase in research and development expenses for the three months ended
March 31, 2005 as compared to the same period in 2004 was primarily attributable to an increase in
non-clinical development expenses related to our fentanyl transdermal system. Marketing, General and Administrative There were no material fluctuations in the components of marketing, general and administrative
expenses for the three months ended March 31, 2005 compared to the same period in 2004. Other Income and Expenses Income Taxes Our effective tax rate was approximately 36% for each of the three months ended March 31, 2005
and 2004. The provision for income taxes is based on the Federal statutory and state income tax
rates. From time to time, we are subject to audits by taxing authorities covering a wide range of
matters, and the Internal Revenue Service is currently auditing our federal income tax returns for
certain open years. Such matters are subject to various uncertainties, and it is possible that
some of these matters may be resolved unfavorably to us. Since 2001, we have established accruals
for pending matters that we believe are probable and reasonably estimable. As of March 31, 2005, we
had $1.1 million in accruals related to these matters. Management believes that any liability that
may ultimately result from the resolution of pending matters in excess of the amount accrued should
not have a material adverse effect on our financial position, results of operations or cash flows. Net deferred income tax assets are measured using the average graduated tax rate for the
estimated amount of annual taxable income in the years that the liability is expected to be settled
or the asset recovered. The effect of adjusting the expected tax rate related to the net deferred
income tax assets is included in the provision for income taxes. As of March 31, 2005, we had a
net deferred tax asset of $15.0 million. Realization of this deferred tax asset depends upon the
generation of sufficient future taxable income. Although realization is not assured, we believe it
is more likely 24




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than not that the deferred income tax asset will be realized based upon estimated
future taxable income. Equity in Earnings of Novogyne We share in the earnings of Novogyne according to an established formula after satisfaction of
an annual preferred return of $6.1 million to Novartis. Our share of Novogynes earnings increases
as Novogynes product sales increase, subject to a cap of 49%. Novogyne produced sufficient income
in the first quarters of 2005 and 2004 to meet Novartis annual preferred return for those years
and for us to recognize earnings from Novogyne under the formula. We report our share of
Novogynes earnings as Equity in earnings of Novogyne on our unaudited Condensed Statements of
Operations. The financial results of Novogyne for the three months ended March 31, 2005 and 2004 are
summarized as follows (dollar amounts in thousands): Three Months2005
    
    
    2004
    
    
    % ChangeGross revenues(1)
    
    $
    27,334
    
    
    $
    25,134
    
    
    
    9
    %Sales allowances
    
    
    3,395
    
    
    
    2,772
    
    
    
    22
    %Sales returns allowances
    
    
    1,266
    
    
    
    1,009
    
    
    
    25
    %Sales and returns allowances
    
    
    4,661
    
    
    
    3,781
    
    
    
    23
    %Net revenues
    
    
    22,673
    
    
    
    21,353
    
    
    
    6
    %Cost of sales
    
    
    4,555
    
    
    
    4,835
    
    
    
    (6
    %)Gross profit
    
    
    18,118
    
    
    
    16,518
    
    
    
    10
    %Gross margin percentage
    
    
    80
    %
    
    
    77
    %Selling, general and
administrative expenses
    
    
    8,670
    
    
    
    7,625
    
    
    
    14
    %Amortization of intangible asset
    
    
    1,545
    
    
    
    1,545
    
    
    
    Income from operations
    
    
    7,903
    
    
    
    7,348
    
    
    
    8
    %Interest income
    
    
    93
    
    
    
    40
    
    
    
    133
    %Net income
    
    $
    7,996
    
    
    $
    7,388
    
    
    
    8
    %Novens equity in earnings of Novogyne
    
    $
    912
    
    
    $
    637
    
    
    
    43
    %
   (1)
    
    Novogynes gross revenues, which are calculated by adding sales allowances and sales
returns allowances to net revenues, are discussed in this section because Novens management
believes it is a useful measure to evaluate and compare Novogynes sales period to period in light
of the significant historic fluctuations in Novogynes sales allowances and returns. Novogyne Net Revenues Novogynes gross revenues increased $2.2 million for the three months ended March 31, 2005
compared to the same period in the prior year, primarily due to a $4.6 million increase in sales of
Vivelle-DotTM partially offset by a $1.2 million decrease in sales of Estradot to Canada
and a $0.8 million decrease in sales of CombiPatch®. In addition, Vivelle®,
our first generation estrogen patch, decreased $0.4 million in unit sales. Approximately $3.5
million of the Vivelle-DotTM increase was due to increased unit sales based on increased
trade demand, while the remaining $1.1 million increase related to price increases. We believe
Vivelle-DotTM sales in the first quarter of 2004 were adversely affected by the timing
of orders by trade customers. Sales to Canada by Novogyne in the first quarter of 2004 benefited
from stocking orders of Estradot related to a planned transition from Vivelle® to 25




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Estradot Canada. The lower sales of CombiPatch® were due to a continuing decline in the
market for combination therapies after the publication of the combination arm of the WHI study.
The decline in unit sales of Vivelle® is primarily attributable to product maturity. Sales allowances consist of chargebacks, Medicaid rebates, managed healthcare rebates, cash
discounts and other allowances, which tend to fluctuate based on changes in gross revenues. These
sales allowances were 12% and 11% of gross revenues for the three months ended March 31, 2005
and 2004, respectively. Sales returns allowances consist of: (i) allowances for returns of expiring product, and (ii)
allowances for returns for product recalls. The activity for sales returns allowances for the
three months ended March 31, 2005 and 2004 was as follows: Three Months2005
    
    
    2004Changes in allowances for returns of expiring product
    
    $
    1,266
    
    
    $
    1,709Changes in allowances for returns for product recalls
    
    
    
    
    
    
    (700
    )Net change in sales returns allowances
    
    $
    1,266
    
    
    $
    1,009Actual returns for expiring product
    
    
    (928
    )
    
    
    (2,273
    )Actual returns for product recalls
    
    
    
    
    
    
    (2,007
    )Actual returns for the period
    
    $
    (928
    )
    
    $
    (4,280
    )Balance of sales returns allowances at March 31,
    
    $
    9,507
    
    
    $
    10,969
 The decline in allowances for returns of expiring product for the three months ended
March 31, 2005 as compared to the same period in 2004 is primarily related to lower expected
returns as a result of a decline in actual returns of Vivelle® in the current period as
compared to the same period in the prior year. The reduction in allowances for returns for product
recalls for the three months ended March 31, 2004 was based on a review at the time of available
relevant information, including actual product returns and future expected returns for the 2003
recalls. Novogyne Gross Margin Gross margin increased for the three months ended March 31, 2005 as compared to the same
period in 2004 due to increased sales of Vivelle-DotTM, which has a higher gross margin
than the other products sold by Novogyne, coupled with decreased sales of Estradot to Canada, which
typically have a lower gross margin. Novogyne Selling, General and Administrative Expenses Selling, general and administrative expenses for the three months ended March 31, 2005
increased $1.0 million compared to the same period in 2004, due primarily to increased advertising
and promotional costs, increased sales force expenses and the elimination of the reduction in
expenses associated with the co-promotion of Novartis Famvir® product, partially offset
by a $0.5 million decrease in samples expense. Novogyne Amortization of Intangible Asset Novogyne amortized $1.5 million related to the acquisition cost for the CombiPatch®
product for each of the three month periods ended March 31, 2005 and 2004. Our
CombiPatch® product was licensed by Novogyne in March 2001. 26




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##### Table of Contents



Liquidity and Capital Resources As of March 31, 2005 and December 31, 2004, we had the following (amounts in thousands): March 31, 2005
    
    
    December 31, 2004Cash and cash equivalents
    
    $
    64,315
    
    
    $
    93,958Short-term investments
    
    
    29,950
    
    
    
    Working capital
    
    
    98,572
    
    
    
    97,349
 Cash provided by (used in) operating, investing and financing activities for the three months
ended March 31, 2005 and 2004 is summarized as follows (amounts in thousands): Three Months2005
    
    
    2004Cash flows:Operating activities
    
    $
    1,510
    
    
    $
    14,028Investing activities
    
    
    (31,931
    )
    
    
    (712
    )Financing activities
    
    
    778
    
    
    
    5,245
 Operating Activities Net cash provided by operating activities for the three months ended March 31, 2005 primarily
resulted from $7.4 million in distributions from Novogyne,
largely offset by changes in working capital due to the timing of
certain
payments, including those related to insurance, compensation and related
liabilities and purchases of inventory. Net cash provided by operating activities for the three months ended March 31, 2004 primarily
resulted from the receipt of an $8.0 million license payment upon the closing of the Endo
transaction in February 2004 and $6.0 million in distributions from Novogyne. Investing Activities Net cash used in investing activities for the three months ended March 31, 2005 was primarily
attributable to $30.0 million in net purchases of short-term
investments, as well as the purchase of $1.8 million in fixed
assets to expand production capacity for future products. Beginning in the first
quarter of 2005, Noven invested a portion of its cash in short-term investments, which primarily
consist of investment grade, asset backed, variable rate debt obligations and municipal auction
rate securities, which are categorized as available-for-sale under the provisions of Statement of
Financial Accounting Standards (SFAS) No. 115 Accounting for Certain Investments in Debt and
Equity Securities. Net cash used in investing activities for the three months ended March 31, 2004 was primarily
attributable to the purchase of fixed assets to expand production capacity for future products and
payment of patent development costs. 27




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##### Table of Contents



Financing Activities Net cash provided by financing activities for the three months ended March 31, 2005 and March
31, 2004 was primarily attributable to $0.8 million and $5.2 million, respectively, received in
connection with the issuance of common stock from the exercise of stock options. Short-Term and Long-Term Liquidity Our principal sources of short-term liquidity are existing cash, cash generated from product
sales, fees and royalties under development and license agreements and distributions from Novogyne.
For the three months ended March 31, 2005, substantially all of our income before income taxes was
comprised of equity in earnings of Novogyne, a non-cash item.
Accordingly, our net income may not be reflective of our cash from
operations. Although we expect to receive
distributions from Novogyne, there can be no assurance that Novogyne will have sufficient profits
or cash flow to pay distributions or that Novogynes Management Committee will authorize such
distributions. Our short-term cash flow is dependent on sales, royalties and license fees associated with
transdermal HT products. Any decrease in sales of those products by us or our licensees or any
increase in returns of products to Novogyne (including any such changes resulting from the HT
studies), the further decline of the HT market, or the inability or failure of Novogyne to pay
distributions would have a material adverse effect on our short-term liquidity and require us to
rely on our existing cash balances or on borrowings to support our operations and business. For the three months ended March 31, 2005, $4.7 million in deferred license revenues were used
to offset development expenses related to our methylphenidate patch. As of March 31, 2005, $14.9
million remained payable to Shire, of which $10.0 million was paid in April 2005. The remaining
$4.9 million is expected to be paid in the second quarter of 2005. We cannot assure that our
methylphenidate patch will be approved by the FDA, particularly in light of the not approvable
letter we received from the FDA in April 2003, and there is no assurance that the recently
completed additional studies will address the FDAs issues or that the FDA may not raise additional
issues following any submission of an amendment to our methylphenidate patch NDA. Additionally,
even if the FDA approves our methylphenidate patch, we cannot assure that Shire will generate sales
at levels that would trigger our milestone payments; therefore, we cannot assure that we will
receive any further payments from Shire with respect to our methylphenidate patch or that we will
be able to recover our development expenses through sales of the product. As of March 31, 2005, we had incurred $12.5 million for the cost of producing pre-launch
inventories for our fentanyl patch. If approval is not ultimately received or is delayed, our
agreement with Endo provides that the parties will share the cost of manufacturing product that
cannot be sold by Endo in accordance with an agreed-upon formula. In such a case, we may be unable
to recover our share of such costs, which could be up to approximately $7.2 million. If the
product has not been approved within 120 days after the launch of the next generic fentanyl transdermal product, Endo may have the
right to terminate the license. Capital
expenditures were $2.3 million in the first quarter of 2005, of
which $0.5 million represented leasehold improvements paid by
the landlord of a leased facility. We expect that our capital
expenditures will increase significantly in 2005 as we continue to expand our manufacturing and
storage facilities for products under development, including those
under development with Endo, Shire,
P&G Pharmaceuticals and others. We expect to fund these capital expenditures from our existing
cash balances. As a general matter, we believe that we have sufficient liquidity available to
meet our operating needs and anticipated short-term capital requirements. In February 2005, we entered into an Industrial Long-Term Lease (the Lease) for
approximately 73,000 square feet of newly constructed space located in close proximity to our 28




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manufacturing facility in Miami, Florida. We intend to use the leased space for the storage and,
as needed, the manufacture of new product. The lease term is 10 years, which may be extended for
up to an additional 21 years pursuant to four renewal options of five years each and a one-time
option to renew for one year. The annual base rent is $6.40 per square foot. We also pay a
monthly management fee equal to 1.5% of the base rent. The rent for the first year is discounted
to $3.20 per square foot. The base rent is subject to annual increases of 3% during the initial
10-year term. After the initial term, the rent will be 95 percent of the fair market rate of the
leased space as determined under the Lease. We are in the process of improving the leased space in
order to prepare it for its intended use. The landlord will be responsible for leasehold
improvements paid to the general contractor improving the leased space, up to approximately $0.9
million. Any amounts paid to the general contractor in excess of this amount and any other
leasehold improvements will be our responsibility. For accounting
purposes, we are amortizing
the expected rental payments on a straight-line basis over the initial 10-year term of the Lease.
The renewal terms have not been included for amortization purposes because we cannot reasonably
estimate the rental payments after the initial term and we cannot assure that we will renew the
Lease after the initial term. Any leasehold improvements will be recorded at cost and will be
amortized on a straight-line basis over the shorter of the estimated useful life of the
improvements or the remaining initial 10-year lease term. Leasehold improvements to the leased
space paid by the landlord will be recorded by us as a deferred rent credit and will be amortized
on a straight-line basis when incurred over the remaining initial 10-year lease term as a reduction
of rent expense. Leasehold improvements paid by the landlord and recorded as a deferred rent
credit were approximately $0.5 million for the three months ended March 31, 2005. For our long-term operating needs, we intend to utilize funds derived from the above sources,
as well as funds generated through sales of products under development or products that we may
license or acquire from others. We expect that such funds will be comprised of payments received
pursuant to future development and licensing arrangements, as well as possible direct sales of our
own products. We expect that our cash requirements will continue to increase, primarily to fund
plant and equipment purchases to expand production capacity for new products. If our products
under development with Shire, Endo, P&G Pharmaceuticals and others are successful, these
expenditures, which may include the cost of building an additional manufacturing plant, are
expected to be significant. We cannot assure that we will successfully complete the development of such products, that we
will obtain regulatory approval for any such products, that any approved product may be produced in
commercial quantities, at reasonable costs, and be successfully marketed, or that we will
successfully negotiate future licensing or product acquisition arrangements. Because much of the
cost associated with product development and expansion of manufacturing facilities is incurred
prior to product launch, if we are unsuccessful in out-licensing, or if we are unable to launch
additional commercially-viable products that we develop or that we license or acquire from others,
we will have incurred the up-front costs associated with product development or acquisition without
the benefit of the liquidity generated by sales of those products, which could adversely affect our
long-term liquidity needs. Factors that could impact our ability to develop or acquire and launch
additional commercially-viable products are discussed under Cautionary Factors that May Impact
Future Results as well as in our Annual Report on Form 10-K for the year ended December 31, 2004. To the extent that capital requirements exceed available capital, we will seek alternative
sources of financing to fund our operations. No assurance can be given that alternative financing
will be available, if at all, in a timely manner or on favorable terms. If we are unable to obtain
satisfactory alternative financing, we may be required to delay or reduce our proposed
expenditures, including expenditures for research and development and plant and equipment, in order
to meet our future cash requirements. 29




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New Accounting Standards In November 2004, the FASB issued Statement of Financial Accounting Standard No. 151
Inventory Costs  an amendment of ARB No. 43,
Chapter 4 (SFAS 151), to clarify the accounting for abnormal
amounts of idle facility expense, freight, or wasted material (spoilage). SFAS 151 requires that
those items be recognized as current-period charges regardless of whether they meet the so
abnormal criterion outlined in Accounting Research Bulletin 43, Chapter 4, Inventory Pricing.
SFAS 151 also introduces the concept of normal capacity and requires the allocation of fixed
production overheads to inventory based on the normal capacity of the production facilities.
Unallocated overheads must be recognized as an expense in the period in which they are incurred.
This statement is effective for inventory costs incurred during fiscal years beginning after June
15, 2005. We are currently assessing SFAS 151 and we are unable to estimate the impact it will
have on our results of operations and financial condition. In
December 2004, the FASB issued SFAS No. 123(R) Share-Based Payment (Revised 2004) that
will require compensation costs related to share-based payment transactions to be recognized in the
financial statements. With limited exceptions, the amount of compensation cost will be measured
based on the grant-date fair value of the equity or liability instruments issued. Compensation
cost will be recognized over the period that an employee provides service in exchange for the
award, which is generally over the vesting period. SFAS 123(R) replaces SFAS 123, Accounting for
Stock-Based Compensation, and supersedes APB 25, Accounting for Stock Issued to Employees. For
public companies such as Noven, the statement is effective as of the beginning of the first annual
reporting period that begins after June 15, 2005 and accordingly, we anticipate adopting this
statement in the first quarter of 2006. Critical Accounting Estimates For a discussion of our critical accounting policies, see Managements Discussion and
Analysis of Financial Condition and Results of Operations  Critical Accounting Policies, which is
included in our Form 10-K for the year ended December 31, 2004. Outlook A summary of our current financial guidance is provided below. This forward-looking
information is based on our current assumptions and expectations, many of which are beyond our
control to achieve. In particular, for purposes of this guidance we have assumed that during the
remainder of 2005 (except as otherwise indicated below) there will not be any material:  
    transactions;
    changes in Novens or Novogynes accounting or accounting principles;
    regulatory, technological or clinical study developments;
    changes in the supply of, demand for, or distribution of our HT products
(including any changes resulting from product recalls, competitive HT products, or
new HT study results);
    changes in our business relationships/collaborations; or
    changes in the economy or the health care sector generally. Financial guidance is inherently uncertain. Accordingly, we cannot assure that we will
achieve results consistent with this guidance. If our assumptions or expectations concerning any
of these matters prove to be incorrect, our actual financial results could differ materially from
the expected results discussed below. For a discussion of certain factors that may impact our
actual financial results for the periods referenced, readers should carefully consider the risks,
uncertainties 30




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and cautionary factors discussed below under the caption Factors Affecting Our Business and
Prospects and in our Annual Report on Form 10-K for the year ended December 31, 2004. Novogyne.Based on current prescription forecasts and our estimates of trade inventory
levels, we believe that Novogynes revenues and net income for full-year 2005 should increase
modestly over 2004 levels. Potential Fentanyl Revenues. Our ANDA for our generic fentanyl patch is currently pending at
the FDA, and we are unable to predict when or if it will be approved. If our ANDA is approved and
the product is launched by Endo (the licensee of the product in the U.S.), we expect to
receive a launch-related milestone payment ranging from $5.0 million to $10.0 million, which
payment will be deferred and recognized as Noven license and contract revenues over the remainder
of the 10-year period that began on the closing of the Endo license transaction in the first
quarter of 2004. Under the terms of our agreement with Endo, we will manufacture and supply Endo
with finished product at our cost and will share in Endos profit generated from U.S. product
sales. At this time, we do not have sufficient information regarding timing of approval, number of
competitors, market share, product pricing and other factors necessary to forecast an expected
contribution of our fentanyl patch to our 2005 financial results. Research and Development.In support of our strategy to expand our product pipeline, we
expect to continue to invest in research and development in 2005 at levels comparable to 2004. In
addition, we are working to formulate certain new transdermal products that, if successfully
formulated, may enter human studies during 2005. These studies, if initiated, would be funded by
Noven and may cause our research and development expense in 2005 to increase substantially over
2004 levels. Marketing, General and Administrative Expense.We expect Novens marketing, general and
administrative expense in 2005 to increase over 2004 levels, with anticipated increases in costs
associated with facility expansion, product liability insurance, professional services fees and
other areas. Capital Expenditures. We expect that our capital expenditures will increase significantly in
2005 as we continue to expand our manufacturing and storage facilities for products under
development with Endo, Shire, P&G Pharmaceuticals and others. Cautionary Factors that May Impact Future Results Except for historical information contained herein, the matters discussed in this report are
forward-looking statements made pursuant to the safe harbor provisions of the Private Securities
Litigation Reform Act of 1995. These forward-looking statements include, but are not limited to,
statements about our and our licensees respective plans, objectives, expectations, estimates,
strategies, prospects, product approvals and development plans, and anticipated financial results.
These statements are typically identified by the use of terms such as anticipates, believes,
estimates, hopes, expects, intends, may, plans, could, should, will, would and
similar words. These statements are based on our current expectations and beliefs concerning
future events and are subject to risks and uncertainties that could cause actual results to differ
materially from those expressed herein. We do not undertake to update any of these forward-looking
statements or to announce the results of any revisions to these forward-looking statements except
as required by law. In addition to the factors described elsewhere in this report and in our Form
10-K for the year ended December 31, 2004 the risks and uncertainties in the following categories,
among others, as well as our success at managing those risks, could cause our actual results to
differ materially from those expressed in any forward-looking statements: 31




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HT Market,risks associated with increased competition in the HT market, including as a result
of the 2004 launches of estrogen cream and gel products, each of which is a new dosage form in this
category; any further impact on our HT business due to the announcement of additional negative
clinical results or otherwise, which could reduce or eliminate any profit contribution by Novogyne
to us and/or sales of HT products from us to Novartis Pharma; uncertainties regarding any future
regulatory developments resulting from those studies; the risk that Novogyne may not be able to
realize the full value of the marketing rights for our CombiPatch product; the European HT market
may be limited due to pricing pressures and delayed Estradot launches in certain countries due to
labeling issues; and the risk of product liability claims resulting from the use of HT products
such as the lawsuits presently pending against Noven and Novartis with respect to our products, as
well as any indemnification or contribution obligations that we may have to Novartis or Novogyne
related to product liability claims. Regulatory Matters,uncertainties relating to actions that may be taken against us by the FDA
or other regulators, whether relating to manufacturing processes, suppliers, commercialized
products, products in development or otherwise, and any related costs; uncertainties related to the
FDAs discretion to approve or not approve a product; the timing of any FDA approval for any of our
products in development, which is outside our control and which may impact the success of product
launch and market penetration; and uncertainties related to our ability to comply with Drug
Enforcement Administration regulations related to our purchase, storage and usage of controlled
substances in products we may manufacture, including our developmental methylphenidate and fentanyl
patch. Production Matters,risks related to our reliance on suppliers for the availability and
quality of raw materials used in our products; risks related to our reliance on a single supplier
for certain raw materials and compounds used in our products; uncertainties regarding the timing
and magnitude of any product recalls; the impact of the recalls or related issues on Novartis or
other partners strategy for the commercialization of our products; the possibility that our
estimates of the impact of future returns and charges may prove inaccurate, incomplete or otherwise
incorrect; the impact of detected or undetected product stability failures or other product defects
on our ability to estimate our reserves for sales returns and other associated accounting
consequences. Our Partners,the risk that our development partners may have different or conflicting
priorities than ours which may adversely impact their ability or willingness to assist in the
development and commercialization of our products or to continue the development programs in which
they and we have partnered; uncertainties regarding our ability to attract additional development
partners; the possibility that our technologies may not be approvable or suitable for use in
additional therapeutic categories, including those categories addressed through products developed
with our development partners; the possibility that we may be unsuccessful in achieving milestone
objectives under our development programs and may not receive any further payments; the possibility
that our development programs may not proceed on schedule or as expected, which could, among other
things, prevent us from achieving milestone objectives under our development programs and/or cause
delays or cancellations of programs; the possibility that our current development priorities could
render us unable to advance our other development projects or increase the cost of advancing those
projects; risks related to our dependence on Novartis to perform Novogynes financial, accounting,
inventory, distribution, revenues and sales deductions functions (including any asset impairment
decisions for Novogyne), including the risk that Novartis may perform these functions differently
than we would have, inadequately or incorrectly; risks and uncertainties related to the fact that
Vivelle-Dot comprises a substantial majority of Novogynes aggregate total prescriptions; and the
possibility that our financial results could fluctuate from period to period or otherwise be
affected by Novartis monitoring of trade inventory levels for Novogyne and its decisions related
thereto. 32




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Methylphenidate Patch,the risk that the FDA may determine that our protocols and/or clinical
strategies do not address the FDAs concerns regarding the approval of our methylphenidate patch
NDA; the risk that our filing of an amendment to our methylphenidate patch NDA could be delayed
past 2005; the possibility that the additional studies of our methylphenidate patch will not
produce results that the FDA believes support approval or that our methylphenidate patch may not
ultimately be approved or commercialized; the timing of the FDAs review of any amended NDA for our
methylphenidate patch as well as any product approval, which are outside Novens control and which
may impact the success of product launch and market penetration; risks and uncertainties related to
the 2005 study by researchers at the M.D. Anderson Cancer Center that found adverse chromosomal
effects on 12 children treated with oral methylphenidate, including risks related to the timing of
any FDA approval of our methylphenidate patch, the impact on the market for methylphenidate
products (including our patch, if approved) and any follow-on or related study finding adverse
effects from methylphenidate use; any exercise of Shires right to terminate the agreement,
including the risk that, in such event, our right to receive a $50.0 million approval milestone
would terminate, and that we may be unable or unwilling to proceed with the project or may be
unable to license our methylphenidate patch to a third party or to a party with the resources of
Shire on commercially reasonable terms; the possibility that our method of accounting for the $25.0
million received from Shire could change under certain circumstances, including if the parties
product strategy changes or if our methylphenidate patch development is discontinued; and the
likelihood that our development strategy would change if Shire were to terminate the agreement
under certain circumstances, or if our methylphenidate patch were not ultimately approved or were
abandoned. Fentanyl Patch,the risks and uncertainties associated with the FDAs review of Novens
fentanyl ANDA; the risks and uncertainties associated with the recent label change to the product,
including risks related to the delay in the approval of Novens fentanyl ANDA or the launch of our
fentanyl patch; the possibility that milestone payments may be reduced and/or that Endo may
exercise its contractual right to terminate the license agreement if the product launch is delayed
for any reason, including delay in obtaining FDA approval; patent or other strategies by third
parties could delay or prevent the launch of our fentanyl patch or other products; the possibility
that we may be unable to recover significant costs to manufacture launch supplies of fentanyl
patches prior to product launch if FDA approval is not obtained on a timely basis or at all; the
possibility that, even if approved, our fentanyl patch or other products may not be
successfully commercialized due to competitive market conditions or other factors, including
physician/patient preferences for other therapies; and in recent periods, companies offering
generic drug products have experienced significant product pricing pressure, often earlier than
expected in the products life cycle, which has negatively affected the profitability of certain of
their generic products. Other Matters,expected fluctuations in quarterly revenues and research and development
expenses; and uncertainties associated with our beliefs regarding the timing of trade customer
orders. We caution that the foregoing list of factors is not exhaustive. 
 Item 3.
Quantitative and Qualitative Disclosure About Market Risk Not Applicable. 
 Item 4.
Controls and Procedures Pursuant to Exchange Act Rule 13a-15, as of the end of the quarterly period covered by this
report, we carried out an evaluation, under the supervision and with the participation of our
management, including our Chief Executive Officer and Chief Financial Officer, of the effectiveness
of our disclosure controls and procedures. In addition, we reviewed our internal controls, and
there have been no significant changes in our internal controls or in other factors that could
significantly affect those controls subsequent to the date of the last evaluation. Based upon that
evaluation, the 33




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Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and
procedures are effective in timely alerting them to material information relating to Noven required
to be included in our periodic Securities and Exchange Commission filings. However, that
conclusion should be considered in light of the various limitations described below on the
effectiveness of those controls and procedures, some of which pertain to most if not all business
enterprises, and some of which arise as a result of the nature of our business. Our management,
including the Chief Executive Officer and Chief Financial Officer, does not expect that our
disclosure controls and procedures will prevent all error and all improper conduct. A control
system, no matter how well conceived and operated, can provide only reasonable, not absolute,
assurance that the objectives of the control system are met. Further, the design of a control
system must reflect the fact that there are resource constraints, and the benefits of controls must
be considered relative to their costs. Because of the inherent limitations in all control systems,
no evaluation of controls can provide absolute assurance that all control issues and instances of
improper conduct, if any, have been detected. These inherent limitations include the realities that
judgments in decision-making can be faulty, and that breakdowns can occur because of simple error
or mistake. Additionally, controls can be circumvented by the individual acts of some persons, by
collusion of two or more people, or by management override of the control. Further, the design of
any system of controls also is based in part upon assumptions about the likelihood of future
events, and there can be no assurance that any design will succeed in achieving its stated goals
under all potential future conditions; over time, controls may become inadequate because of changes
in conditions, or the degree of compliance with the policies or procedures may deteriorate.
Because of the inherent limitations in a cost-effective control system, misstatements due to error
or fraud may occur and not be detected. Furthermore, our level of historical and current equity
participation in Novogyne may substantially impact the effectiveness of our disclosure controls and
procedures. Because we do not control Novogyne, and all of Novogynes financial, accounting,
inventory, distribution, revenues and sales deductions functions are performed by Novartis, our
disclosure controls and procedures with respect to Novogyne are necessarily more limited than those
we maintain with respect to ourselves. No significant changes were made in our internal controls
or in other factors that could significantly affect these controls subsequent to the date of the
Chief Executive Officers and Chief Financial Officers evaluation. Provided with this quarterly report on Form 10-Q are certificates of our Chief Executive
Officer and Chief Financial Officer. We are required to provide those certifications by Section
302 of the Sarbanes-Oxley Act of 2002 and the Securities and Exchange Commissions implementing
regulations. This Item 4 of this quarterly report is the information concerning the evaluation
referred to in those certifications, and you should read this information in conjunction with those
certifications for a more complete understanding of the topics presented. We do not control Novogyne and Novartis performs all of Novogynes financial, accounting,
inventory, sales and sales deductions functions. As previously disclosed, in the course of its
audit of Novogynes financial statements for the year ended December 31, 2004, Novogynes
independent registered public accounting firm identified what it believes is a significant
deficiency in Novogynes internal controls which related to oversights by Novartis in connection
with Novogynes accounting for certain rebate accruals. These oversights resulted in an immaterial
adjustment at Novogyne in the fourth quarter of 2004. We have been advised that the Audit and
Compliance Committee of Novartis AG has engaged outside counsel and is conducting an ongoing
internal investigation of this matter. It is not possible for us to predict what impact, if any,
Novartis internal investigation may have. To our knowledge, none of the issues that are the
subject of the investigation involves Noven, Novens accounting policies or practices, or any of
Novens officers, directors or employees. 34




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PART II. OTHER INFORMATION 
 Item 1. Legal Proceedings On March 15, 2005, the United States District Court for the Southern District of Florida
issued an order dismissing without prejudice the lawsuit filed against Noven and certain individual
defendants styled In re: Noven Pharmaceuticals, Inc. Securities Litigation. The notice of
voluntary dismissal (attached to the order of dismissal) indicated that the lead plaintiffs and
their counsel, after further investigation, concluded that the complaint should be voluntarily
dismissed. Noven agreed to the dismissal, with each party bearing its own costs. In July 2004, an individual plaintiff and her husband filed a complaint in Superior Court of
New Jersey Law Division, Atlantic County, against Noven, Novartis, Wyeth Pharmaceuticals, Inc. and
others alleging liability in connection with personal injury claims allegedly arising from the use
of HT products, including CombiPatch®, which is manufactured by Noven and distributed by
Novogyne. The plaintiffs claim compensatory, punitive and other damages in an unspecified amount.
In April 2005, the plaintiff agreed to substitute Aventis Pharmaceuticals, Inc. for Noven and
Novartis in this case and to dismiss Noven and Novartis without prejudice for a period of six
months and with prejudice thereafter. In addition, Novartis has advised Noven that Novartis has
been named as a defendant in at least 13 additional lawsuits that include approximately
23 plaintiffs that allege liability in connection with personal injury claims allegedly
arising from the use of HT patches distributed and sold by Novartis
and Novogyne, including Novens
Vivelle®,
Vivelle-Dot
and
CombiPatch®
products. To date, Noven
has been named in one lawsuit and, to Novens knowledge, Novogyne has not been named in any.
Novartis has indicated that it will seek indemnification from Noven and Novogyne to the extent
permitted by the agreements between and among Novartis, Novogyne and
Noven. Novogynes accrual for expected legal fees and
settlements of these lawsuits was $2.4
million as of March 31, 2005, for which there was a related
insurance receivable of $1.4 million. This accrual represents Novartis
managements best estimate as of March 31, 2005. The ultimate outcome of these product liability
lawsuits cannot be predicted. 35




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Item 2.
Unregistered Sales of Equity Securities and Use of Proceeds The following table provides information with respect to our stock repurchases during the
first quarter of 2005: Total Number ofShares
    
    
    ApproximatePurchased as
    
    
    Dollar ValuePart of
    
    
    That May YetTotal Number of
    
    
    Average Price
    
    
    Publicly
    
    
    be PurchasedShares
    
    
    Paid
    
    
    Announced
    
    
    under thePurchased
    
    
    Per Share
    
    
    Program
    
    
    Program(1)January 1, 2005 to
January 31, 2005
    
    
    
    
    
    
    
    
    
    
    
    
    
    $
    23,711,040February 1, 2005 to
February 28, 2005
    
    
    
    
    
    
    
    
    
    
    
    
    
    $
    23,711,040March 1, 2005 to
March 31, 2005
    
    
    
    
    
    
    
    
    
    
    
    
    
    $
    23,711,040Totals
    
    
    
    
    
    
    
    
    
    
    
    
    
    $
    23,711,040
   (1)
    
    In March 2003, we announced a stock repurchase program authorizing the repurchase of up to
$25.0 million of our Common Stock. There is no expiration date specified for this program. 
 Item 6.
Exhibits  31.1
    Certification of Robert C. Strauss, President, Chief Executive Officer
and Chairman of the Board, pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant
to Section 302 of the Sarbanes-Oxley Act of 200231.2
    Certification of Diane M. Barrett, Vice President and Chief Financial
Officer, pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 302 of
the Sarbanes-Oxley Act of 200232.1
    Certification of Robert C. Strauss, President, Chief Executive Officer
and Chairman of the Board, pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant
to Section 906 of the Sarbanes-Oxley Act of 200232.2
    Certification of Diane M. Barrett, Vice President and Chief Financial
Officer, pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of
the Sarbanes-Oxley Act of 2002 36




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Signatures Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused
this report to be signed on its behalf by the undersigned thereunto duly authorized. NOVEN PHARMACEUTICALS, INC.Date: May 4, 2005
    
    By:
    
    /s/ Diane M. BarrettDiane M. BarrettVice President andChief Financial Officer
 37