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UNITED STATES SECURITIES AND EXCHANGE COMMISSION  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, 2004 Commission file number 0-17254 NOVEN PHARMACEUTICALS, INC.   STATE OF DELAWARE
    
    59-2767632(State or other jurisdiction of
incorporation or organization)
    
    (I.R.S. Employer
Identification Number)
 11960 S.W. 144th Street, Miami, FL 33186   (305) 253-5099   Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15 (d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days.
Yes   [X]   No    [   ]. Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Exchange Act).
Yes   [X]   No   [   ]. Indicate the number of shares outstanding of each of the issuers classes
of common stock, as of the last practicable date. Class
    
    Outstanding at April 30, 2004Common stock $.0001 par value
    
    23,383,112




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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, 2004 and 2003
    
    
    3Condensed Balance Sheets as of March 31, 2004 and December 31, 2003
    
    
    4Condensed Statements of Cash Flows for the Three Months Ended
March 31, 2004 and 2003
    
    
    5Notes to Unaudited Condensed Financial Statements
    
    
    6Item 2 - Managements Discussion and Analysis of Financial
Condition and Results of Operations
    
    
    13Item 3 - Quantitative and Qualitative Disclosures About Market Risk
    
    
    25Item 4 - Controls and Procedures
    
    
    25PART II  OTHER INFORMATIONItem 2 - Changes in Securities and Use of Proceeds
    
    
    27Item 6 - Exhibits and Reports on Form 8-K
    
    
    27SIGNATURES
    
    
    29Sec. 302 Certification by Chief Executive OfficerSec. 302 Certification by Chief Financial OfficerSec. 906 Certification by Chief Executive OfficerSec. 906 Certification by Chief Financial Officer
  Trademark information:
Vivelle, Vivelle Dot, Estalis, Estradot and Menorest are trademarks
of Novartis AG or its affiliated companies; CombiPatch is a registered
trademark of Vivelle Ventures, LLC; MethyPatch is a registered trademark of
Noven Pharmaceuticals, Inc.; 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. 
 
 2004
    
    2003Revenues:Product revenues  Novogyne:Product sales
    
    $
    5,808
    
    
    $
    2,930Royalties
    
    
    890
    
    
    
    1,231Total product revenues  Novogyne
    
    
    6,698
    
    
    
    4,161Product revenues  third parties
    
    
    2,977
    
    
    
    4,957Total product revenues
    
    
    9,675
    
    
    
    9,118License and contract revenues
    
    
    1,455
    
    
    
    907Net revenues
    
    
    11,130
    
    
    
    10,025Expenses:Cost of products sold
    
    
    5,518
    
    
    
    4,285Research and development
    
    
    2,255
    
    
    
    2,493Marketing, general and administrative
    
    
    3,904
    
    
    
    4,181Total expenses
    
    
    11,677
    
    
    
    10,959Loss from operations
    
    
    (547
    )
    
    
    (934
    )Equity in earnings of Novogyne
    
    
    637
    
    
    
    1,525Interest income, net
    
    
    156
    
    
    
    148Income before income taxes
    
    
    246
    
    
    
    739Provision for income taxes
    
    
    88
    
    
    
    266Net income
    
    $
    158
    
    
    $
    473Basic earnings per share
    
    $
    0.01
    
    
    $
    0.02Diluted earnings per share
    
    $
    0.01
    
    
    $
    0.02Weighted average number of common shares outstanding:Basic
    
    
    23,066
    
    
    
    22,581Diluted
    
    
    24,281
    
    
    
    22,920
 The
accompanying notes are an integral part of these statements. 3




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NOVEN PHARMACEUTICALS, INC. 
 
 March 31, 2004
    
    December 31, 2003AssetsCurrent Assets:Cash and cash equivalents
    
    $
    101,942
    
    
    $
    83,381Accounts receivable  trade (less allowance for doubtful
accounts of $69 in 2004 and $84 in 2003)
    
    
    2,392
    
    
    
    3,809Accounts receivable  Novogyne, net
    
    
    5,055
    
    
    
    6,320Inventories
    
    
    5,289
    
    
    
    5,200Net deferred income tax asset, current portion
    
    
    6,700
    
    
    
    6,500Prepaid income taxes and other current assets
    
    
    3,920
    
    
    
    3,219125,298
    
    
    
    108,429Property, plant and equipment, net
    
    
    18,651
    
    
    
    18,354Other Assets:Investment in Novogyne
    
    
    22,961
    
    
    
    28,368Net deferred income tax asset
    
    
    15,585
    
    
    
    12,175Patent development costs, net
    
    
    2,019
    
    
    
    1,977Deposits and other assets
    
    
    85
    
    
    
    18140,650
    
    
    
    42,701$
    184,599
    
    
    $
    169,484Liabilities and Stockholders EquityCurrent Liabilities:Accounts payable
    
    $
    5,230
    
    
    $
    4,060Capital lease obligations  current portion
    
    
    92
    
    
    
    Accrued compensation and related liabilities
    
    
    2,501
    
    
    
    3,734Other accrued liabilities
    
    
    2,000
    
    
    
    2,090Deferred contract revenues
    
    
    2,153
    
    
    
    772Deferred license revenues  current portion
    
    
    21,614
    
    
    
    21,11233,590
    
    
    
    31,768Long-Term Liabilities:Capital lease obligations
    
    
    214
    
    
    
    Deferred license revenues
    
    
    33,808
    
    
    
    28,89367,612
    
    
    
    60,661Commitments and Contingencies (Note 11)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 23,382,382 in 2004 and
22,722,060 in 2003
    
    
    2
    
    
    
    2Additional paid-in capital
    
    
    87,250
    
    
    
    79,244Retained earnings
    
    
    29,735
    
    
    
    29,577116,987
    
    
    
    108,823$
    184,599
    
    
    $
    169,484
 The
accompanying notes are an integral part of these statements. 4




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NOVEN PHARMACEUTICALS, INC. 
 
 2004
    
    2003Cash flows from operating activities:Net income
    
    $
    158
    
    
    $
    473Adjustments to reconcile net income to net cash
provided by operating activities:Depreciation and amortization
    
    
    588
    
    
    
    577Amortization of patent costs
    
    
    91
    
    
    
    82Amortization of non-competition agreement
    
    
    100
    
    
    
    100Income tax benefits on exercise of stock options
    
    
    2,761
    
    
    
    6Deferred income tax (benefit) expense
    
    
    (3,610
    )
    
    
    77Recognition of deferred contract revenues
    
    
    (519
    )
    
    
    (26
    )Recognition of deferred license revenues
    
    
    (936
    )
    
    
    (881
    )Equity in earnings of Novogyne
    
    
    (637
    )
    
    
    (1,525
    )Distributions from Novogyne
    
    
    6,044
    
    
    
    10,648Changes in operating assets and liabilities:Decrease in accounts receivable  trade, net
    
    
    1,417
    
    
    
    800Decrease (increase) in accounts receivable  Novogyne, net
    
    
    1,265
    
    
    
    (1,213
    )(Increase) decrease in inventories
    
    
    (89
    )
    
    
    1,472Increase in prepaid income taxes and other
current assets
    
    
    (701
    )
    
    
    (357
    )Increase in deposits and other assets
    
    
    (4
    )
    
    
    Increase in accounts payable
    
    
    1,170
    
    
    
    1,712Decrease in accrued compensation and related
liabilities
    
    
    (1,233
    )
    
    
    (1,349
    )Decrease in other accrued liabilities
    
    
    (90
    )
    
    
    (1,283
    )Increase in deferred contract revenue
    
    
    1,900
    
    
    
    165Increase in deferred license revenue
    
    
    6,500
    
    
    
    Direct expenses incurred in pursuit of
MethyPatch® product regulatory approval
    
    
    (147
    )
    
    
    Cash flows provided by operating activities
    
    
    14,028
    
    
    
    9,478Cash flows from investing activities:Purchases of property, plant and equipment, net
    
    
    (579
    )
    
    
    (1,475
    )Payments for patent development costs
    
    
    (133
    )
    
    
    (109
    )Cash flows used in investing activities
    
    
    (712
    )
    
    
    (1,584
    )Cash flows from financing activities:Issuance of common stock
    
    
    5,245
    
    
    
    117Purchase and retirement of common stock
    
    
    
    
    
    
    (1,289
    )Repayments of notes payable
    
    
    
    
    
    
    (2
    )Cash flows provided by (used in) financing activities
    
    
    5,245
    
    
    
    (1,174
    )Net increase in cash and cash equivalents
    
    
    18,561
    
    
    
    6,720Cash and cash equivalents, beginning of period
    
    
    83,381
    
    
    
    58,684Cash and cash equivalents, end of period
    
    $
    101,942
    
    
    $
    65,404
 The
accompanying notes are an integral part of these statements. 5




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NOVEN PHARMACEUTICALS, INC. 
  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® and Vivelle Dot® and, effective March 30, 2001, Novens
transdermal combination estrogen/progestin delivery system marketed under
the brand name 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, 2004, and the
results of its operations for the three months ended March 31, 2004 and
2003. 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, 2003 (Form 10-K), and in 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,
2004 and 2003 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 2004. 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. RECENT ACCOUNTING
PRONOUNCEMENTS: In December 2003, the Financial Accounting Standards Board (FASB)
issued Interpretation No. 46R, Consolidation of Variable Interest Entities
(FIN 46). This Interpretation of Accounting Research Bulletin 51,
Consolidated Financial Statements, addresses consolidation by business
enterprises of variable interest entities which have one or both of the
following characteristics: (i) the equity investment at risk is not
sufficient to permit 6




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the entity to finance its activities without additional subordinated
financial support from other parties, which is provided through other
interests that will absorb some or all of the expected losses of the entity,
and (ii) the equity investors lack one or more of the characteristics of a
controlling financial interest. This interpretation applies immediately to
variable interest entities created after January 31, 2003, and to variable
interest entities in which an enterprise obtains an interest after that
date. It applies no later than the first reporting period ending after
March 15, 2004 to variable interest entities in which an enterprise holds a
variable interest that it acquired before February 1, 2003. Novens
investment in Novogyne is not considered a variable interest in a Variable
Interest Entity (VIE) under the provisions of FIN 46. Therefore, the
consolidation and disclosure rules of FIN 46 are not applicable to Noven and
Noven does not expect any impact on its financial statements from adopting
this interpretation. These conclusions are based on currently available
information and require Noven to assess its investment interest and
ownership rights in Novogyne. If Novens conclusions or underlying
assumptions of factual information concerning its investment in Novogyne
were to change, Novogyne may be considered a VIE and Novens investment in
Novogyne could become subject to the consolidation and disclosure rules of
FIN 46. In that case, a determination would have to be made as to the
primary beneficiary of Novogynes interest. The primary beneficiary would
then consolidate Novogyne. Noven believes that, even if a determination were
made that Novogyne was a VIE at March 31, 2004, Novartis is the primary
beneficiary due to its preferred return and 51% equity interest in Novogyne
and would continue to consolidate Novogyne. 4. RECLASSIFICATIONS: Certain reclassifications have been made to prior period financial
statements to conform to the current years presentation. 5. INVENTORIES: The following are the major classes of inventories (in thousands): March 31,
    
    December 31,2004
    
    2003Finished goods
    
    $
    1,178
    
    
    $
    806Work in process
    
    
    1,696
    
    
    
    1,722Raw materials
    
    
    2,415
    
    
    
    2,672Total
    
    $
    5,289
    
    
    $
    5,200
 6. 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. 7




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The following table illustrates the effect on net income and earnings
per share for the three months ended March 31, 2004 and 2003 if Noven had
applied the fair value recognition provisions of SFAS 123, as amended by
SFAS 148 (in thousands, except per share amounts): 2004
    
    2003Net income (loss):As reported
    
    $
    158
    
    
    $
    473Total stock-based employee
compensation expense determined
under fair value based method for all
awards, net of related tax effects
    
    
    (740
    )
    
    
    (1,176
    )Pro forma
    
    $
    (582
    )
    
    $
    (703
    )Basic
earnings (loss) per share:As reported
    
    $
    0.01
    
    
    $
    0.02Pro forma
    
    $
    (0.03
    )
    
    $
    (0.03
    )Diluted
earnings (loss) per share:As reported
    
    $
    0.01
    
    
    $
    0.02Pro forma
    
    $
    (0.02
    )
    
    $
    (0.03
    )
 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 its 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, 2004 and 2003, respectively, may not be representative of
the effects for future years because outstanding options vest over a period
of several years and additional awards are generally made during each year. 7. CASH FLOW INFORMATION: Cash payments for income taxes were $2.9 million and $1.3 million for
the three months ended March 31, 2004 and 2003, respectively. Cash payments
for interest were not material for the three months ended March 31, 2004 and
2003. Non-cash Investing Activities During the three months ended March 31, 2004, Noven entered into a
capital lease obligation of $0.3 million for new equipment. 8. LICENSE AND CONTRACT AGREEMENTS: Endo License of Fentanyl Patch On February 25, 2004, Noven licensed its developmental generic fentanyl
patch to Endo Pharmaceuticals Inc. (Endo). Novens fentanyl patch is
intended to be the generic equivalent of Johnson & Johnsons Duragesic®
fentanyl patch. Noven received an $8.0 million non-refundable up-front payment from
Endo on signing. Upon Endos first commercial sale of the fentanyl patch,
Noven is entitled to receive an 8




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additional payment ranging from $5.0 million to $10.0 million,
depending on the timing of launch and the number of generic fentanyl
competitors in the market. Noven will manufacture and supply the product at
its cost and will share in Endos profit from net product sales. Based on the current patent and exclusivity status of Johnson &
Johnsons Duragesic patch, Noven believes that the earliest its generic
fentanyl patch could be launched is January 2005, assuming Food
and Drug Administration (FDA) approval is
received by that time, but Noven cannot assure that it will receive FDA
approval by that time or at all. Noven and Endo may elect to manufacture
launch supplies prior to receipt of tentative FDA approval. If launch
supplies are manufactured and approval is not ultimately received or is
delayed, the agreement provides that Noven and Endo will share the cost of
manufacturing product that cannot be sold by Endo in accordance with an
agreed-upon formula. However, in that case, Noven would not be able to
offset all of its up-front production costs with sales of the product. If
the product has not been approved or Noven has not supplied Endos launch
requirements by May 2005, Endo may have the right to terminate the license,
depending on the number of generic competitors in the market. In addition to the fentanyl license, Noven has established a
collaboration with Endo to identify and develop new transdermal therapies.
Of the $8.0 million up-front payment, $1.5 million has been allocated to
fund feasibility studies to
determine whether certain compounds identified by the parties can be
delivered using Novens transdermal technology. Noven believes the $1.5
million represents the fair value of such services. 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 revenues over a 10-year period, which is the estimated
product life cycle. The remaining $1.5 million is
expected to be recognized as revenues over the course of feasibility
development of any additional patches developed under the Noven/Endo
collaboration. P&G Pharmaceuticals Contract In April 2003, Noven established a collaboration with P&G
Pharmaceuticals, Inc. (P&GP), a subsidiary of The Procter & Gamble
Company, for the development of new prescription patches. The products
under development explore follow-on product opportunities for IntrinsaTM,
P&GPs in-licensed investigational transdermal testosterone patch designed
to help restore desire in menopausal women who have Hypoactive Sexual Desire
Disorder. P&GP has initiated studies of the first product in humans. In
the first quarter of 2004, Noven received and recognized as contract
revenues a $0.4 million development milestone under this collaboration.
Potential development milestones totaling $4.4 million remain to be received
under the P&GP collaboration, a portion of which is expected to be received
in the remainder of 2004. 9. 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 2004 and 2003 to meet
Novartis annual preferred return for those years and for Noven to recognize
earnings from Novogyne under the formula. 9




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During the three months ended March 31, 2004 and 2003, Noven had the
following transactions with Novogyne (in thousands): 2004
    
    2003Revenues:Product sales
    
    $
    5,808
    
    
    $
    2,930Royalties
    
    
    890
    
    
    
    1,231$
    6,698
    
    
    $
    4,161Reimbursed expenses
    
    $
    6,289
    
    
    $
    6,183
 As of March 31, 2004 and December 31, 2003, Noven had amounts due from
Novogyne of $5.1 million and $6.3 million, respectively, for products sold
to, and marketing expenses reimbursable by, Novogyne. The unaudited condensed Statements of Operations of Novogyne for the
three months ended March 31, 2004 and 2003 are as follows (in thousands): 2004
    
    2003Gross revenues
    
    $
    25,134
    
    
    $
    30,592Sales allowances
    
    
    2,772
    
    
    
    3,464Sales return allowances
    
    
    1,009
    
    
    
    2,664Sales allowances and returns
    
    
    3,781
    
    
    
    6,128Net revenues
    
    
    21,353
    
    
    
    24,464Cost of sales
    
    
    4,835
    
    
    
    5,765Selling, general and
administrative expenses
    
    
    7,625
    
    
    
    7,883Amortization of intangible assets
    
    
    1,545
    
    
    
    1,545Income from operations
    
    
    7,348
    
    
    
    9,271Interest income
    
    
    40
    
    
    
    85Net income
    
    $
    7,388
    
    
    $
    9,356Novens equity in earnings of
Novogyne
    
    $
    637
    
    
    $
    1,525
 The activity in the Investment in Novogyne account for the three months
ended March 31, 2004 is as follows (in thousands): Investment in Novogyne, beginning of period
    
    $
    28,368Equity in earnings of Novogyne
    
    
    637Cash distributions from Novogyne
    
    
    (6,044
    )Investment in Novogyne, end of period
    
    $
    22,961
 Subject to the approval of Novogynes management committee, cash may be
distributed to Novartis and Noven based upon a contractual formula. For the
three months ended March 31, 2004 and 2003, Noven received distributions of
$6.0 million and $10.6 million from Novogyne, 10




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respectively. These amounts were recorded as reductions in the
investment in Novogyne when deemed received. 10. 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 million of
its common stock. As a result, Noven had repurchased 105,000 shares of its
common stock at an aggregate price of approximately $1.3 million during the
three months ended March 31, 2003. These shares were retired on March 31,
2003. No shares were repurchased during the three months ended March 31,
2004. 11. COMMITMENTS AND CONTINGENCIES: HT Studies In 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
followed by publication in 2002 and 2003 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 of 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. This arm of the WHI study
also found that the use of an estrogen-only oral formulation appeared to
decrease the risk of hip fracture, and did not appear to affect heart
disease or to increase the risk of breast cancer. 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®,
our 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 Issues In 2003, Novens product stability testing program revealed that
certain lots of CombiPatch and Vivelle Dot patches did not maintain required
specifications throughout the products shelf lives, resulting in product
recalls. The CombiPatch stability failures resulted from a production issue
related to a problematic raw material supplied by one vendor. After
addressing the issues with the specific raw material, Noven continues to
manufacture and ship CombiPatch to Novogyne and there was no interruption of
trade supplies. 11




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Based on results of Novens testing and analysis to date, Noven
believes the probable cause of the Vivelle Dot production issue related to
the use of certain rolls of patch backing material provided by a raw
material supplier. Based on this testing and analysis, Noven further
believes that the Vivelle Dot product that is currently in distribution and
in its inventory will maintain required stability. If the root cause
determination or additional testing indicates that the production issue
affects more product than Novens current testing and analysis suggests,
additional recalls may be required. If Novens estimate concerning the
scope of, or amount of, the product returns is incorrect or if Novartis
should initiate further unexpected recalls, then Novens results of
operations could be materially different. Supply Agreement Novens supply agreement with Novogyne for Vivelle and Vivelle Dot
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. Failure to
extend the agreement or to continue to operate under the agreements
commercial terms could have a material adverse effect on Novens financial
position and results of operations. Litigation, Claims and Assessments On August 7, 2003, an individual filed a lawsuit on behalf of a
purported class of purchasers of Novens common stock during the period from
October 29, 2001 through April 28, 2003. The complaint alleges that, during
the subject period, Noven and its officers named as defendants violated the
Securities Exchange Act of 1934 by making false and misleading statements in
its public disclosures regarding Novens MethyPatch product. Following the
filing of Plaintiffs complaint, five other substantially similar complaints
were filed against Noven and its officers named as defendants in the above
referenced action. In response to a joint motion, on or about January 6,
2004, the Court entered an order consolidating the six related actions.
Pursuant to this order, plaintiffs must file a consolidated class action
complaint not later than 60 days after the entry of an order appointing lead
plaintiff and lead counsel. An order appointing lead plaintiff and lead
counsel has not yet been entered. This development did not have a material
effect on the action or on Novens financial position or results of
operations. Noven believes the lawsuit is without merit, and intends to vigorously
defend the lawsuit, but its outcome cannot be predicted. The lawsuit, if
determined adversely to Noven, could have a material adverse effect on
Novens financial position and results of operations. Novens ultimate
liability, if any, with respect to the lawsuit is presently not
determinable. 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. 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. 12




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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, 2004, and the results of operations for the three months
then ended. The contents of this section include:  
    
    An overview of Noven and:  °
    
    the license of our fentanyl patch to Endo during the first
quarter of 2004,°
    
    our collaboration with P&G Pharmaceuticals, and°
    
    MethyPatch®, our methylphenidate patch for the treatment of ADHD;  
    
    An analysis of our results of operations and our liquidity and capital resources;
    
    A review of recent accounting pronouncements;
    
    An outlook that includes our current financial guidance and
certain factors that we believe may influence our financial results
for the remainder of 2004; and
    
    A discussion of forward-looking statements used in this
report and a summary 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, 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, 2003. 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 (HT). In the United States, our HT
products are marketed and sold by Novogyne, the joint venture that we formed
with Novartis in 1998. In all countries other than the United States, Canada
and Japan, our HT products are marketed and sold by Novartis Pharma AG
(Novartis Pharma), an affiliate of Novartis. 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. 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 discontinuation of the
combined arm of the WHI study) to the first quarter of 2004,
total prescriptions dispensed in the HT market in the United States declined by
45%. For the same period, aggregate prescriptions for Novens United States
products decreased 15%. The estrogen segment of the HT market in the United
States declined 39%, while our Vivelle product family decreased 8%. Vivelle
Dot, which represented 75% of our total United States prescriptions in the
first quarter of 2004, increased 8% from the second quarter of 2002 to the
first quarter of 2004. We believe Vivelle Dot patch prescriptions have
benefited from patient conversions from original Vivelle. At the end of the
first quarter of 2004, the Vivelle family held a 41% share of total estrogen
patch prescriptions, compared to a 35% share at the end of the second quarter
of 2002. Our Vivelle Dot estrogen patch is currently the most frequently
dispensed estrogen patch in the United States. We believe this is due in part
to the beneficial wear characteristics made possible by our technology. United States prescriptions for our CombiPatch product (which represented
approximately 15% of our total United States prescriptions in the first quarter
of 2004) declined 40% from the second quarter of 2002 to the first quarter of
2004, while prescriptions for the total United States market for fixed
combination hormone therapy declined 60%. The combination therapy arm of WHI
involved an 13




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oral combination estrogen/progestin product and, accordingly, that segment
of the HT market has experienced the most significant decline. As noted above,
prescriptions for our CombiPatch combination estrogen/progestin patch, like
most combination HT therapies, have declined significantly since WHI. Further
declines for our CombiPatch product could require Novogyne (which holds the
CombiPatch marketing rights) to record an impairment loss related to the these
marketing rights, which would harm both our and Novogynes results of
operations. Endo An important part of our business strategy is to seek to diversify our
product offerings beyond the HT market through strategic collaborations and new
product developments. On February 25, 2004, we licensed our developmental
generic fentanyl patch to Endo. Our fentanyl patch is intended to be the
generic equivalent of Johnson & Johnsons Duragesic® fentanyl patch. We
received an $8.0 million non-refundable up-front payment from Endo on
signing. Upon Endos first commercial sale of the fentanyl patch, we are
entitled to receive an additional payment ranging from $5.0 million to $10.0
million, depending on the timing of launch and the number of generic fentanyl
competitors in the market. We will manufacture and supply the product at our
cost and will share in Endos profit from product sales. Based on the current patent and exclusivity status of Johnson & Johnsons
Duragesic® patch, we believe that the earliest our generic fentanyl patch
could be launched is January 2005, assuming FDA approval is received by that
time, but we cannot assure that we will receive FDA approval by that time or at
all. Noven and Endo may elect to manufacture launch supplies prior to receipt
of tentative FDA approval. If launch supplies are manufactured and approval is
not ultimately received or is delayed, the agreement provides that Noven and
Endo will share the cost of manufacturing product that cannot be sold by Endo
in accordance with an agreed-upon formula, but we would be unable to offset all
of our up-front production costs with sales of the product. If the product has
not been approved or we have not supplied Endos launch requirements by May
2005, Endo may have the right to terminate the license, depending on the number
of generic competitors in the market. In addition to the fentanyl license, we have established a collaboration
with Endo to seek to identify and develop new transdermal therapies. Of the
$8.0 million up-front payment, $1.5 million will be allocated to fund
feasibility studies to determine whether
certain compounds identified by the parties can be delivered using our
transdermal 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 revenues over a 10-year period, which is the estimated product
life cycle. The remaining $1.5 million is expected to
be recognized as revenues over the course of feasibility development of any
additional patches developed under the Noven/Endo collaboration. P&G Pharmaceuticals In April 2003, we established a collaboration with P&G Pharmaceuticals,
Inc. (P&GP), a subsidiary of The Procter & Gamble Company, for the
development of new prescription patches. The products under development
explore follow-on product opportunities for IntrinsaTM, P&GPs in-licensed
investigational transdermal testosterone patch designed to help restore desire
in menopausal women who have Hypoactive Sexual Desire Disorder. P&GP has
initiated studies of the first product in humans. In the first quarter of
2004, Noven received and recognized as contract revenues a
$0.4 million development
milestone under this collaboration. Potential development milestones totaling
$4.4 million remain to be received under the P&GP collaboration, a portion of
which is expected to be received in the remainder of 2004. 14




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Shire In April 2003, we received a not approvable letter from the FDA relating
to our MethyPatch New Drug Application (NDA). Together with Shire, we have been in
dialogue with the FDA regarding our strategy to address the clinical
risk-benefit and other issues raised in the not approvable letter, and we
expect to meet with the FDA in the second quarter of 2004 in this regard.
Assuming we can reach agreement with the FDA on an appropriate strategy, Noven
and Shire expect to undertake additional MethyPatch clinical studies during
2004. Noven has committed to fund the additional studies. Novens direct costs
incurred in pursuit of approval are expected to be deferred and offset against
a portion of the $25 million deferred revenue previously received from Shire,
and therefore such expenses are not expected to impact our research and
development expenses in 2004. It is possible that we will not reach agreement
with the FDA on an appropriate strategy, development will not be completed
and/or that our MethyPatch product will not be approved or launched, and we may
not receive additional milestone payments or manufacturing revenues from Shire. 15




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Results of Operations Three months ended March 31, 2004 compared to the three months ended March 31, 2003 Revenues Total revenues for the three months ended March 31, 2004 and 2003 are
summarized as follows (dollar amounts in thousands): 2004
    
    2003
    
    % ChangeProduct revenues  Novogyne:Product sales
    
    $
    5,808
    
    
    $
    2,930
    
    
    
    98
    %Royalties
    
    
    890
    
    
    
    1,231
    
    
    
    (28
    %)6,698
    
    
    
    4,161
    
    
    
    61
    %Product revenues  third parties:Product sales
    
    
    2,838
    
    
    
    4,960
    
    
    
    (43
    %)Royalties
    
    
    139
    
    
    
    (3
    )
    
    
    2,977
    
    
    
    4,957
    
    
    
    (40
    %)Total product revenues
    
    
    9,675
    
    
    
    9,118
    
    
    
    6
    %License and contract revenues:Contract
    
    
    519
    
    
    
    26
    
    
    
    License
    
    
    936
    
    
    
    881
    
    
    
    6
    %1,455
    
    
    
    907
    
    
    
    60
    %Net revenues
    
    $
    11,130
    
    
    $
    10,025
    
    
    
    11
    %
 Net Revenues As described in more detail below, the increase in total revenues for the
three months ended March 31, 2004 as compared to the same period in 2003 was
primarily attributable to higher unit sales for our U.S. products and an
increase in our contract revenue due to the attainment of certain product
development milestones in the current period. These increases were partially
offset by a decline in unit sales for our international products. Product Revenues  Novogyne Product revenues  Novogyne consists of our sales of Vivelle, Vivelle
Dot/Estradot and CombiPatch to Novogyne at a fixed price for resale primarily
in the United States as well as the royalties we receive as a result of
Novogynes sales of Vivelle and Vivelle Dot. The $2.5 million increase in product revenues from Novogyne for the
three months ended March 31, 2004 as compared to the same period in the prior
year primarily relates to $1.7 million in higher unit sales for Vivelle Dot.
This increase is primarily due to lower sales in the prior period as a result
of the impact of inventory reduction initiatives intended to align inventories
with post-WHI demand. 16




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Product Revenues  Third Parties Product revenues  third parties substantially consists of sales of
Menorest, Estradot and Estalis to Novartis Pharma at a price based on a
percentage of the licensee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 $2.0 million decline in product revenues from third parties for
the three months ended March 31, 2004 as compared to the same period in the
prior year primarily relates to $1.6 million in lower unit sales of Estalis.
The decline in Estalis reflects lower prescription trends following the
publication of the WHI study. License and Contract Revenues The increase in contract revenues for the three months ended March 31,
2004 as compared to the same period in the prior year is primarily attributable
to the attainment of certain product development milestones and the completion
of certain product development contracts in the current period. The increase
in license revenues for the three months ended March 31, 2004 as compared to
the same period in the prior year is due to the recognition of license revenue
in connection with the Endo transaction. Gross Margin Gross margin for the three months ended March 31, 2004 and 2003 are
summarized as follows (dollar amounts in thousands): 2004
    
    2003Total product revenues
    
    $
    9,675
    
    
    $
    9,118Gross profit (product revenues
less cost of products sold)
    
    
    4,157
    
    
    
    4,833Gross margin (gross profit as a
percentage of product revenues)
    
    
    43
    %
    
    
    53
    %
 The
decline in gross margin for the three months ended March 31, 2004 as
compared to the same period in the prior year is primarily due to an increase
of $1.1 million in the deferred profit related to sales of product to Novogyne.
We defer 49% of the profit on product we sell to Novogyne until that product
is sold by Novogyne to trade customers. As a result, if Novogyne sells more
product than we provide it in a given period (i.e. if Novogynes inventories
decline), we will defer less profit from Novogyne, which increases
our gross margins. The increase in deferred profit on sales to Novogyne for
the current period compared to the prior period reflects Novogynes inventory
reduction initiatives in the prior period. That initiative reduced Novogynes
inventories at the end of the prior period and, consequently, caused a
reduction in our costs of products sold and thus increased the gross margin in
the prior period. 17




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Operating Expenses Operating expenses for the three months ended March 31, 2004 and 2003 are
summarized as follows (dollar amounts in thousands): 2004
    
    2003
    
    % ChangeResearch and development
    
    $
    2,255
    
    
    $
    2,493
    
    
    
    (10
    %)Marketing, general and
administrative
    
    
    3,904
    
    
    
    4,181
    
    
    
    (7
    %)
 Research and Development The $0.2 million decline in research and development expenses for the
three months ended March 31, 2004, as compared to the same period in 2003 was
primarily attributable to a decrease in development expenses for our
MethyPatch product. We licensed MethyPatch to Shire in April 2003 at which
time Shire assumed certain development expenses for this product. Marketing, General and Administrative The $0.3 million decrease in marketing, general and administrative
expenses for the three months ended March 31, 2004 as compared to the same
period in 2003 was primarily attributable to a $0.9 million reduction in costs
due to the elimination of pre-launch marketing expenses for MethyPatch, which
ceased the second quarter of 2003 as a result of license of MethyPatch to Shire
Pharmaceuticals Group plc, partially offset by $0.4 million of increased
compensation costs, $0.2 million of increased consulting and professional fees
primarily related to new requirements resulting from Sarbanes-Oxley, and $0.2
million of increased insurance costs. Income Taxes Our effective tax rate was approximately 36% for each of the three months
ended March 31, 2004 and 2003. The provision for income taxes is based on the
Federal statutory and state income tax rates. 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, 2004, we had a net deferred tax asset of $22.3 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 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, up to 49%, after satisfaction of an
annual preferred return of $6.1 million to Novartis, according to an
established formula. Novogyne produced sufficient income in the first quarters
of 2004 and 2003 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. 18




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The financial results of Novogyne for the three months ended March 31,
2004 and 2003 are summarized as follows (dollar amounts in thousands): 2004
    
    2003
    
    % ChangeGross revenues1
    
    $
    25,134
    
    
    $
    30,592
    
    
    
    (18
    %)Sales allowances
    
    
    2,772
    
    
    
    3,464
    
    
    
    (20
    %)Sales returns allowances
    
    
    1,009
    
    
    
    2,664
    
    
    
    (62
    %)Sales allowances and returns
    
    
    3,781
    
    
    
    6,128
    
    
    
    (38
    %)Net revenues
    
    
    21,353
    
    
    
    24,464
    
    
    
    (13
    %)Cost of sales
    
    
    4,835
    
    
    
    5,765
    
    
    
    (16
    %)Gross profit
    
    
    16,518
    
    
    
    18,699
    
    
    
    (12
    %)Gross margin percentage
    
    
    77
    %
    
    
    76
    %Selling, general and
administrative expenses
    
    
    7,625
    
    
    
    7,883
    
    
    
    (3
    %)Amortization of intangible
asset
    
    
    1,545
    
    
    
    1,545
    
    
    
    Income from operations
    
    
    7,348
    
    
    
    9,271
    
    
    
    (21
    %)Interest income
    
    
    40
    
    
    
    85
    
    
    
    (53
    %)Net income
    
    $
    7,388
    
    
    $
    9,356
    
    
    
    (21
    %)Novens equity in earnings
of Novogyne
    
    $
    637
    
    
    $
    1,525
    
    
    
    (58
    %)
 1Novogynes gross revenues, which are calculated by adding sales
allowances and sales returns allowances to net revenues, is 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 Gross revenues decreased for the three months ended March 31, 2004
compared to the prior year, primarily due to $2.2 million in decreased sales of
Vivelle and $5.4 million in decreased sales of Vivelle Dot. Vivelle is in a
declining trend due to product maturity. Since underlying prescriptions were
relatively consistent from period to period, we believe the decline in Vivelle
Dot is related to the timing of orders from trade customers. The decrease was
partially offset by a $2.0 million increase in sales of Estradot to Canada
primarily due to the timing of orders. Price changes were not a significant
factor from quarter to quarter. 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 11%
of gross revenues for each of the three months ended March 31, 2004 and
2003. The declines in sales returns allowances for the three months ended March
31, 2004 compared to the prior year were attributable to higher returns of
Vivelle Dot in the prior period. 19




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##### Table of Contents



Novogyne Gross Margin The increase in gross margin for the three months ended March 31, 2004 as
compared to the prior period was primarily due to lower sales allowances and
returns, which increased net revenues without affecting cost of goods sold. Novogyne Selling, General and Administrative Expenses There were no material fluctuations in selling, general and administrative
expenses for the three months ended March 31, 2004. 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, 2004 and
2003. Our CombiPatch product was licensed by Novogyne in March 2001. Liquidity and Capital Resources As of March 31, 2004 and December 31, 2003, we had $101.9 million and
$83.4 million in cash and cash equivalents, and working capital of $91.7
million and $76.7 million, respectively. Cash provided by (used in) operating, investing and financing activities
for the three months ended March 31, 2004 and 2003 is summarized as follows
(amounts in thousands): 2004
    
    2003Cash flows:Operating activities
    
    $
    14,028
    
    
    $
    9,478Investing activities
    
    
    (712
    )
    
    
    (1,584
    )Financing activities
    
    
    5,245
    
    
    
    (1,174
    )
 Operating Activities Net cash provided by operating activities for the three months ended March
31, 2004 primarily resulted from the receipt of an $8.0 million payment upon
the closing of the Endo transaction in February 2004 and $6.0 million in
distributions from Novogyne. Net cash provided by operating activities for the three months ended March
31, 2003 primarily resulted from a $10.6 million distribution from Novogyne,
partially offset by changes in working capital due to the timing and amount of
product shipments and payments for inventory and income taxes. Investing Activities Net cash used in investing activities for the three months ended March 31,
2004 and 2003 was primarily attributable to the purchase of fixed assets to
expand production capacity for future products and payment of patent
development costs. Financing Activities Net cash provided by financing activities for the three months ended March
31, 2004 was primarily attributable to $5.2 million received in connection with
the issuance of common stock from the exercise of stock options. 20




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##### Table of Contents



Net cash used in financing activities for the three months ended March 31,
2003 was primarily attributable to the repurchase of 105,000 shares of our
common stock, partially offset by cash 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, 2004, all of our income before income taxes was comprised of equity in
earnings of Novogyne, a non-cash item. 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. In February 2004, Endo
paid us $8.0 million upon closing of the fentanyl patch licensing transaction. 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 recent
or ongoing 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. We also expect our funding of any additional studies for our MethyPatch
product will have a negative impact on our short-term liquidity. We cannot
assure that MethyPatch will be approved by the FDA, particularly in light of
the not approvable letter we received from the FDA in April 2003, or that, even
if approved, Shire will generate MethyPatch product sales at levels that would
trigger our milestone payments; therefore, we cannot assure that we will
receive any further payments from Shire. Our short-term liquidity may also be
adversely affected in 2004 prior to the launch of our transdermal fentanyl
system as we expect to incur new and additional expenses and capital
expenditures during 2004 related to the manufacture of the new product as well
as the cost for pre-launch inventories. However, we cannot assure that we will
recover all or any portion of these expenditures in our expected time-frame or
at all. We believe that we will have sufficient liquidity available to meet our
operating needs and anticipated short-term capital requirements. 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 direct sales of our own products. We expect
that our cash requirements will continue to increase, primarily to fund
clinical studies for products under development and for plant and equipment to
expand production capacity for new products. 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 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. 21




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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. Recent Accounting Pronouncements In December 2003, the FASB issued Interpretation No. 46R, Consolidation of
Variable Interest Entities (FIN 46). This Interpretation of Accounting
Research Bulletin 51, Consolidated Financial Statements, addresses
consolidation by business enterprises of variable interest entities which have
one or both of the following characteristics: (i) the equity investment at risk
is not sufficient to permit the entity to finance its activities without
additional subordinated financial support from other parties, which is provided
through other interests that will absorb some or all of the expected losses of
the entity, and (ii) the equity investors lack one or more of the
characteristics of a controlling financial interest. This interpretation
applies immediately to variable interest entities created after January 31,
2003, and to variable interest entities in which an enterprise obtains an
interest after that date. It applies no later than the first reporting period
ending after March 15, 2004 to variable interest entities in which an
enterprise holds a variable interest that it acquired before February 1, 2003.
Our investment in Novogyne is not considered a variable interest in a Variable
Interest Entity (VIE) under the provisions of FIN 46. Therefore, the
consolidation and disclosure rules of FIN 46 are not applicable to us and we do
not expect any impact on our financial statements from adopting this
interpretation. These conclusions are based on currently available information
and require us to assess our investment interest and ownership rights in
Novogyne. If our conclusions or our underlying assumptions of factual
information concerning our investment in Novogyne were to change, Novogyne may
be considered a VIE and our investment in Novogyne could become subject to the
consolidation and disclosure rules of FIN 46. In that case, a determination
would have to be made as to the primary beneficiary of Novogynes interest.
The primary beneficiary would then consolidate Novogyne. We believe
that, even
if a determination were made that Novogyne was a VIE at March 31, 2004,
Novartis is the primary beneficiary due to its preferred return and 51% equity
interest in Novogyne and would continue to consolidate Novogyne. Critical Accounting Policies 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, 2003. Outlook A summary of our current financial guidance and outlook for 2004 is
provided below. This information is based on our current assumptions and
expectations, many of which are beyond our control to achieve. This
information is also premised on our current assumption that during 2004 there
will not be any unforeseen material:  
    
    transactions;
    
    changes in Novens or Novogynes accounting or accounting principles;
    
    regulatory or clinical study developments;
    
    changes in the supply of, demand for, or distribution
of our HT products (including any changes resulting from the
impact of competitive HT products that we expect others to launch
in 2004);
    
    changes in our business relationships/collaborations; or 22




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
    
    changes in the economy or the health care sector generally. If our assumptions or expectations concerning these matters prove to be
incorrect, our actual financial results could differ materially from the
expected results discussed below. Accordingly, we cannot assure that we will
achieve results consistent with this guidance. For a discussion of these and
other factors that may impact our actual financial results for 2004, we refer
you to the risks, uncertainties and cautionary factors discussed below under
the caption Cautionary Factors that May Impact Future Results as well as
those discussed in our Form 10-K for the year ended December 31, 2003. For full-year 2004, we currently expect:  
    
    Novens net revenues to approximate 2003 results;
    
    Novens research and development spending in 2004 to increase compared to 2003;
    
    Novens fully diluted earnings per share to be in the $0.40 to $0.45 range; and
    
    Novogynes 2004 net revenues and net income to approximate 2003 results. Novogynes operating results are expected to fluctuate by quarter during
2004 in part due to the timing of orders placed by trade customers. We expect
that Novogynes 2004 second quarter contribution to Novens profit will be
higher than in the 2004 first quarter, due in part to the satisfaction in the
first quarter of a $6.1 million preferred return to Novartis under the joint
venture agreements, and to the timing of orders placed by trade customers,
which we believe had a negative impact on Novogynes 2004 first quarter sales. In the first quarter of 2004, we received and recognized as contract
revenues a $0.4 million development milestone under our collaboration with P&GP.
Potential development milestones totaling $4.4 million remain to be received
under the P&GP collaboration, a portion of which is expected to be received in
the remainder of 2004. We expect that Noven and Shire will meet with the FDA during the second
quarter of 2004 to address the clinical risk-benefit and other issues raised in
the FDAs not approvable letter relating to our MethyPatch New
Drug Application. If we can reach agreement with the FDA on an appropriate
strategy, we expect to undertake additional MethyPatch clinical studies during
2004. Under our agreement with Shire, we have committed to fund any additional
studies, and we expect to defer and offset our direct costs incurred in any additional
studies against a portion of the $25 million deferred revenue that we
previously received from Shire. As a result, we do not expect any MethyPatch
clinical study expenses to impact our research and development expenses in
2004. If we do not reach an agreement with the FDA on an appropriate strategy,
or if development is not successfully completed, or if MethyPatch is not
approved or launched, we will not receive additional milestone payments or
manufacturing revenues from Shire. Based on the current patent and exclusivity status of Johnson & Johnsons
Duragesic fentanyl patch, we believe that the earliest our generic fentanyl
patch (licensed to Endo) could be launched in the United States is January
2005, assuming FDA approval is received by that time, but we cannot assure that
we will receive FDA approval by that time or at all. In addition to the
fentanyl license, we have established a collaboration with Endo to seek to
identify and develop new transdermal therapies and we expect to undertake
feasibility studies for selected compounds in 2004. Of the $8.0 million
received from Endo at closing of the fentanyl license, $6.5 million will be
recognized as revenues over a 10-year period, which is the
estimated product life cycle. The remaining $1.5 million
will be recognized as revenues over the course of feasibility development
of any additional patches developed under the Noven/Endo collaboration. 23




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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, 2003, 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: 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; and the European HT market may be limited
due to pricing pressures and delayed Estradot launches in certain countries due
to labeling issues. 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; and 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. 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;
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 24




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increase the cost of advancing those projects; risks related to our
dependence on Novartis to perform Novogynes financial, accounting, inventory,
distribution 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; 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. MethyPatch,the risk that the FDA may determine that our proposed protocols
and/or proposed clinical strategies are not acceptable or do not address the
FDAs concerns regarding the approval of the MethyPatch product NDA; the
possibility that additional MethyPatch product studies may not be commenced in
a timely manner or at all due to FDA concerns or otherwise; Shires control
over the management of any additional MethyPatch product clinical trials,
including the risk that Shire may elect to manage any such studies differently
than we might have, incorrectly or inadequately; the possibility that any
additional studies of MethyPatch will not produce results that support approval
or that, even if the additional studies are completed and are successful,
MethyPatch may not ultimately be approved or commercialized; the availability
of non-stimulant or other once-daily ADHD therapies could negatively impact
market penetration of MethyPatch; the possibility that the cost of any
additional MethyPatch product study and related expenses may be higher than
anticipated and may exceed the total amount of license revenues available to
offset such costs and expenses; the possibility that our method of accounting
for the $25 million received from Shire could change under certain
circumstances, including if the parties MethyPatch product strategy changes or
if our MethyPatch product 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 MethyPatch product were not ultimately
approved or were abandoned. Fentanyl Patch,the risks and uncertainties associated with the FDAs
review of Novens fentanyl Abbreviated New Drug Application; 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
fentanyl patches prior to product launch if FDA approval is not obtained on a
timely basis or at all; and 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. 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. 
 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 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 25




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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
Novogynes financial, accounting, inventory 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. 26




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PART II. OTHER INFORMATION 
 Item 2. Changes in Securities and Use of Proceeds The following table provides information with respect to our stock
repurchases during the first quarter of 2004: Total Number of
    
    ApproximateShares
    
    Dollar ValuePurchased as Part of
    
    That May Yet beTotal Number of
    
    Average Price Paid
    
    Publicly Announced
    
    PurchasedShares Purchased
    
    Per Share
    
    Program
    
    under the Program(1)January 1, 2004 to
January 31, 2004
    
    
    
    
    
    
    
    
    
    
    
    
    
    $
    23,711,040February 1, 2004 to
February 29, 2004
    
    
    
    
    
    
    
    
    
    
    
    
    
    $
    23,711,040March 1, 2004 to
March 31, 2004
    
    
    
    
    
    
    
    
    
    
    
    
    
    $
    23,711,040Totals
    
    
    
    
    
    
    
    
    
    
    
    
    
    $
    23,711,040
  (1)
    
    In March 2003, we announced a stock repurchase program authorizing the
buy back of up to $25 million of our Common Stock. There is no expiration
date specified for this program. 
 Item 6. Exhibits and Reports on Form 8-K (a)
    
    Exhibits31.1
    
    
    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
 27




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(b)
    
    Reports on Form 8-KDuring the three months ended March 31, 2004, we filed one report on
Form 8-K on February 26, 2004, Item 5. Other Events with respect to a
license agreement that we entered into with Endo Pharmaceuticals Inc.
 28




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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 3, 2004
    
    By:
    /s/
    Diane M. BarrettDiane M. BarrettVice President andChief Financial Officer
 29