##### 



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 September 30, 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   
o Indicate
by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Exchange Act). Yes   x   No   
o 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 October 29, 2004Common stock $.0001 par value
    
    23,443,053




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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 and Nine Months Ended September 30, 2004 and 2003
    
    
    3Condensed Balance Sheets as of September 30, 2004 and December 31, 2003
    
    
    4Condensed Statements of Cash Flows for the Nine Months Ended September 30, 2004 and 2003
    
    
    5Notes to Unaudited Condensed Financial Statements
    
    
    6Item 2 - Managements Discussion and Analysis of Financial Condition and Results of Operations
    
    
    15Item 3 - Quantitative and Qualitative Disclosures About Market Risk
    
    
    29Item 4 - Controls and Procedures
    
    
    29PART II  OTHER INFORMATIONItem 2 - Unregistered Sales of Equity Securities and Use of Proceeds
    
    
    31Item 5 - Other Information
    
    
    31Item 6 - Exhibits
    
    
    31SIGNATURES
    
    
    33
 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 27 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, 2003, as well as
other reports filed from time to time with the Securities and Exchange
Commission. 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. 
   
 Three Months
    
    Nine Months2004
    
    2003
    
    2004
    
    2003Revenues:Product revenues  Novogyne:Product sales
    
    $
    4,364
    
    
    $
    2,756
    
    
    $
    15,058
    
    
    $
    11,772Royalties
    
    
    1,411
    
    
    
    1,182
    
    
    
    3,909
    
    
    
    3,381Total product revenues  Novogyne
    
    
    5,775
    
    
    
    3,938
    
    
    
    18,967
    
    
    
    15,153Product revenues  third parties
    
    
    3,287
    
    
    
    4,045
    
    
    
    9,828
    
    
    
    12,788Total product revenues
    
    
    9,062
    
    
    
    7,983
    
    
    
    28,795
    
    
    
    27,941License and contract revenues
    
    
    1,039
    
    
    
    1,113
    
    
    
    4,391
    
    
    
    3,441Net revenues
    
    
    10,101
    
    
    
    9,096
    
    
    
    33,186
    
    
    
    31,382Expenses:Cost of products sold
    
    
    4,984
    
    
    
    3,936
    
    
    
    15,477
    
    
    
    14,261Research and development
    
    
    2,741
    
    
    
    1,916
    
    
    
    7,730
    
    
    
    6,563Marketing, general and administrative
    
    
    4,358
    
    
    
    4,791
    
    
    
    12,024
    
    
    
    12,265Total expenses
    
    
    12,083
    
    
    
    10,643
    
    
    
    35,231
    
    
    
    33,089Loss from operations
    
    
    (1,982
    )
    
    
    (1,547
    )
    
    
    (2,045
    )
    
    
    (1,707
    )Equity in earnings of Novogyne
    
    
    6,232
    
    
    
    4,529
    
    
    
    15,097
    
    
    
    9,849Interest income, net
    
    
    279
    
    
    
    159
    
    
    
    619
    
    
    
    505Income before income taxes
    
    
    4,529
    
    
    
    3,141
    
    
    
    13,671
    
    
    
    8,647Provision for income taxes
    
    
    1,895
    
    
    
    1,130
    
    
    
    5,201
    
    
    
    3,113Net income
    
    $
    2,634
    
    
    $
    2,011
    
    
    $
    8,470
    
    
    $
    5,534Basic earnings per share
    
    $
    0.11
    
    
    $
    0.09
    
    
    $
    0.36
    
    
    $
    0.25Diluted earnings per share
    
    $
    0.11
    
    
    $
    0.09
    
    
    $
    0.35
    
    
    $
    0.24Weighted average number of common shares
outstanding:Basic
    
    
    23,416
    
    
    
    22,506
    
    
    
    23,290
    
    
    
    22,526Diluted
    
    
    24,361
    
    
    
    22,949
    
    
    
    24,344
    
    
    
    22,935
 The accompanying notes are an integral part of these statements. 3




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##### 



NOVEN PHARMACEUTICALS, INC. 
  
 September 30, 2004
    
    December 31, 2003AssetsCurrent Assets:Cash and cash equivalents
    
    $
    100,347
    
    
    $
    83,381Accounts receivable  trade (less allowance for doubtful
accounts of $72 in 2004 and $84 in 2003)
    
    
    2,083
    
    
    
    3,809Accounts receivable  Novogyne, net
    
    
    4,488
    
    
    
    6,320Inventories
    
    
    5,324
    
    
    
    5,200Net deferred income tax asset, current portion
    
    
    9,900
    
    
    
    8,000Prepaid income taxes and other current assets
    
    
    8,766
    
    
    
    3,219130,908
    
    
    
    109,929Property, plant and equipment, net
    
    
    22,005
    
    
    
    18,354Other Assets:Investment in Novogyne
    
    
    29,510
    
    
    
    28,368Net deferred income tax asset
    
    
    7,290
    
    
    
    12,175Patent development costs, net
    
    
    2,114
    
    
    
    1,977Deposits and other assets
    
    
    21
    
    
    
    18138,935
    
    
    
    42,701$
    191,848
    
    
    $
    170,984Liabilities and Stockholders EquityCurrent Liabilities:Accounts payable
    
    $
    9,576
    
    
    $
    4,060Capital lease obligations  current portion
    
    
    102
    
    
    
    Accrued compensation and related liabilities
    
    
    5,202
    
    
    
    3,734Other accrued liabilities
    
    
    1,618
    
    
    
    3,590Deferred contract revenues
    
    
    2,532
    
    
    
    772Deferred license revenues  current portion
    
    
    17,033
    
    
    
    21,11236,063
    
    
    
    33,268Long-Term Liabilities:Capital lease obligations
    
    
    136
    
    
    
    Deferred license revenues
    
    
    29,767
    
    
    
    28,89365,966
    
    
    
    62,161Commitments 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 23,439,768 at September 30, 2004 and
22,722,060 at December 31, 2003
    
    
    2
    
    
    
    2Additional paid-in capital
    
    
    87,833
    
    
    
    79,244Retained earnings
    
    
    38,047
    
    
    
    29,577125,882
    
    
    
    108,823$
    191,848
    
    
    $
    170,984
 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
    
    $
    8,470
    
    
    $
    5,534Adjustments to reconcile net income to net cash flows
provided by operating activities:Depreciation and amortization
    
    
    1,665
    
    
    
    1,683Amortization of patent costs
    
    
    285
    
    
    
    252Amortization of non-competition agreement
    
    
    167
    
    
    
    300Income tax benefits on exercise of stock options
    
    
    3,007
    
    
    
    67Deferred income tax provision (benefit)
    
    
    2,985
    
    
    
    (3,315
    )Non-cash expense related to issuance of stock to outside
directors
    
    
    30
    
    
    
    31Recognition of deferred contract revenues
    
    
    (1,415
    )
    
    
    (296
    )Amortization of deferred license revenues
    
    
    (2,976
    )
    
    
    (3,145
    )Equity in earnings of Novogyne
    
    
    (15,097
    )
    
    
    (9,849
    )Distributions from Novogyne
    
    
    12,263
    
    
    
    16,894Changes in operating assets and liabilities:Decrease in accounts receivable  trade, net
    
    
    1,726
    
    
    
    1,076Decrease (increase) in accounts receivable  Novogyne, net
    
    
    1,832
    
    
    
    (537
    )(Increase) decrease in inventories
    
    
    (124
    )
    
    
    419Increase in prepaid income taxes and other current assets
    
    
    (3,855
    )
    
    
    (3,504
    )Increase in deposits and other assets
    
    
    (7
    )
    
    
    Increase in accounts payable
    
    
    5,516
    
    
    
    647Increase (decrease) in accrued compensation and related liabilities
    
    
    1,468
    
    
    
    (95
    )(Decrease) increase in other accrued liabilities
    
    
    (1,972
    )
    
    
    1,440Increase in deferred contract revenue
    
    
    3,175
    
    
    
    768Increase in deferred license revenue
    
    
    6,500
    
    
    
    25,000Direct expenses incurred in pursuit of
MethyPatch® product regulatory approval
    
    
    (6,729
    )
    
    
    Cash flows provided by operating activities
    
    
    16,914
    
    
    
    33,370Cash flows from investing activities:Purchases of property, plant and equipment, net
    
    
    (5,004
    )
    
    
    (3,869
    )Payments for patent development costs
    
    
    (422
    )
    
    
    (235
    )Cash flows used in investing activities
    
    
    (5,426
    )
    
    
    (4,104
    )Cash flows from financing activities:Issuance of common stock from exercise of stock options
    
    
    5,552
    
    
    
    258Purchase and retirement of common stock
    
    
    
    
    
    
    (1,289
    )Repayments of capital leases and notes payable
    
    
    (74
    )
    
    
    (6
    )Cash flows provided by (used in) financing activities
    
    
    5,478
    
    
    
    (1,037
    )Net increase in cash and cash equivalents
    
    
    16,966
    
    
    
    28,229Cash and cash equivalents, beginning of period
    
    
    83,381
    
    
    
    58,684Cash and cash equivalents, end of period
    
    $
    100,347
    
    
    $
    86,913
 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® and Vivelle-Dot® and 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 September 30, 2004, and the
results of its operations and its cash flows for the three and nine months
ended September 30, 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, as amended, for the year ended December
31, 2003 (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 and nine months ended September 30, 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 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.     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
the adoption of this interpretation has had no impact on Novens financial
statements. These conclusions are based on currently available information
and require Noven to periodically assess its investment interest and
ownership rights in Novogyne. If Novens conclusions or underlying
assumptions of factual information concerning its investment in Novogyne
prove incorrect or 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 September 30, 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): September 30,
    
    December 31,2004
    
    2003Finished goods
    
    $
    737
    
    
    $
    806Work in process
    
    
    1,427
    
    
    
    1,722Raw materials
    
    
    3,160
    
    
    
    2,672Total
    
    $
    5,324
    
    
    $
    5,200
 Included in the amounts above as of September 30, 2004 were
approximately $0.5 million in raw materials inventories to manufacture
launch supplies of Novens fentanyl patch for which FDA approval is pending.
See Note 8  License and Contract Agreements  Endo Collaboration. 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 7




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##### 



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. The following table illustrates the effect on net income and earnings
per share for the three and nine months ended September 30, 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): Three Months
    
    Nine Months2004
    
    2003
    
    2004
    
    2003Net income:As reported
    
    $
    2,634
    
    
    $
    2,011
    
    
    $
    8,470
    
    
    $
    5,534Total stock-based employee
compensation expense determined
under fair value based method for all
awards, net of related tax effects
    
    
    (1,565
    )
    
    
    (1,054
    )
    
    
    (3,289
    )
    
    
    (3,163
    )Pro forma
    
    $
    1,069
    
    
    $
    957
    
    
    $
    5,181
    
    
    $
    2,371Basic earnings per share:As reported
    
    $
    0.11
    
    
    $
    0.09
    
    
    $
    0.36
    
    
    $
    0.25Pro forma
    
    $
    0.05
    
    
    $
    0.04
    
    
    $
    0.22
    
    
    $
    0.11Diluted earnings per share:As reported
    
    $
    0.11
    
    
    $
    0.09
    
    
    $
    0.35
    
    
    $
    0.24Pro forma
    
    $
    0.04
    
    
    $
    0.04
    
    
    $
    0.21
    
    
    $
    0.10
 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 and nine
months ended September 30, 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 $5.4 million and $8.5 million for
the nine months ended September 30, 2004 and 2003, respectively. Cash
payments for interest were not material for the nine months ended September
30, 2004 and 2003. Non-cash Operating Activities In 2002, the State of New Jersey enacted legislation that requires
Novogyne to remit estimated state income tax payments on behalf of its
owners, Noven and Novartis. In April 2004 and 2003, Novogyne paid $1.7
million to the New Jersey Department of Revenue, representing Novens
portion of Novogynes estimated state income tax payment. These payments
were deemed a distribution to Noven. 8




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##### 



Non-cash Investing Activities During the nine months ended September 30, 2004, Noven entered into a
capital lease obligation of $0.3 million for new equipment. 8.     LICENSE AND CONTRACT AGREEMENTS: Endo Collaboration 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 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, the earliest its generic fentanyl patch could be
launched is January 24, 2005, assuming Food and Drug Administration (FDA)
approval is received by that time, but Noven cannot give any assurance that
it will receive FDA approval by that time or at all. Noven has begun
manufacturing launch supplies. If 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. Noven estimates that its share of such costs could be
up to approximately $5.0 million. 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 as earned 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 Collaboration In 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 IntrinsaTM, 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 has initiated studies of the first product in humans. For
the nine months ended September 30, 2004, Noven recognized as contract
revenues $1.2 million in development milestones under this collaboration
based on P&G Pharmaceuticals determination that Noven had met the
applicable performance criteria. No development milestones under this 9




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##### 



collaboration were recognized for the three months ended September 30,
2004 or for the three and nine months ended September 30, 2003. Potential
development milestones totaling $3.6 million remain available to be earned
under the collaboration. Shire Noven is developing a transdermal methylphenidate patch for Attention
Deficit Hyperactivity Disorder. Global rights to the developmental product
are licensed to Shire Pharmaceutical Group plc (Shire). In April 2003,
Noven received a not approvable letter from the FDA relating to Novens
MethyPatch New Drug Application (NDA). In May 2004, Noven and Shire met
with the FDA to review Novens and Shires jointly prepared development plan
intended to address issues raised in the not approvable letter. Based on
feedback resulting from the meeting, Noven and Shire are proceeding with the
development of MethyPatch. Development efforts are expected to include
additional clinical studies, including another Phase 3 study. Pursuant to
the agreements between the parties, Shire will manage these studies and
Noven has committed to fund them. Novens direct costs incurred in pursuit
of approval are expected to be deferred and offset against a portion of the
$25.0 million deferred revenue previously received from Shire. Such expenses
are not expected to impact Novens research and development expenses in
2004, although the direct expenses incurred in pursuit of MethyPatch
approval will 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 September 30, 2004, the amount of deferred revenues was
$12.4 million (which excludes the $5.0 million of deferred revenues related
to the repurchase right described below) and Noven does not expect its cost
in pursuit of approval to exceed this amount. If the additional studies are
successful and completed on schedule, the parties would intend to file an
amendment to the pending MethyPatch NDA during 2005. The amendment is
expected to receive a six-month review by the FDA, and there is no assurance
that the data to be obtained from the additional studies will address the
FDAs issues or that the FDA may not raise additional issues following any
submission of an amendment to the MethyPatch NDA. Under Novens agreements
with Shire, Shire continues to have certain rights to terminate the
MethyPatch license, 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 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 continues to have the
right to require Noven to repurchase the product rights to MethyPatch 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 Attention Deficit
Hyperactivity Disorder. 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. Noven received $0.3 million from
Shire related to this agreement for the nine months ended September 30,
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. 10




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##### 



During the three and nine months ended September 30, 2004 and 2003,
Noven had the following transactions with Novogyne (in thousands):  Three Months
    
    Nine Months2004
    
    2003
    
    2004
    
    2003Revenues:Product sales
    
    $
    4,364
    
    
    $
    2,756
    
    
    $
    15,058
    
    
    $
    11,772Royalties
    
    
    1,411
    
    
    
    1,182
    
    
    
    3,909
    
    
    
    3,381$
    5,775
    
    
    $
    3,938
    
    
    $
    18,967
    
    
    $
    15,153Reimbursed expenses
    
    $
    6,657
    
    
    $
    6,350
    
    
    $
    18,919
    
    
    $
    18,891
 As of September 30, 2004 and December 31, 2003, Noven had amounts due
from Novogyne of $4.5 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 and nine months ended September 30, 2004 and 2003 are as follows (in
thousands): Three Months
    
    Nine Months2004
    
    2003
    
    2004
    
    2003Gross revenues
    
    $
    34,314
    
    
    $
    31,584
    
    
    $
    94,463
    
    
    $
    84,321Sales allowances
    
    
    3,123
    
    
    
    2,969
    
    
    
    9,412
    
    
    
    8,764Sales return allowances
    
    
    3,676
    
    
    
    4,586
    
    
    
    3,968
    
    
    
    5,255Sales allowances and returns
    
    
    6,799
    
    
    
    7,555
    
    
    
    13,380
    
    
    
    14,019Net revenues
    
    
    27,515
    
    
    
    24,029
    
    
    
    81,083
    
    
    
    70,302Cost of sales
    
    
    5,394
    
    
    
    4,568
    
    
    
    16,926
    
    
    
    14,793Selling, general and
administrative expenses
    
    
    7,957
    
    
    
    8,113
    
    
    
    22,519
    
    
    
    23,617Amortization of intangible assets
    
    
    1,545
    
    
    
    1,545
    
    
    
    4,635
    
    
    
    4,635Income from operations
    
    
    12,619
    
    
    
    9,803
    
    
    
    37,003
    
    
    
    27,257Interest income
    
    
    50
    
    
    
    33
    
    
    
    103
    
    
    
    135Net income
    
    $
    12,669
    
    
    $
    9,836
    
    
    $
    37,106
    
    
    $
    27,392Novens equity in earnings of Novogyne
    
    $
    6,232
    
    
    $
    4,529
    
    
    $
    15,097
    
    
    $
    9,849
 The activity in the Investment in Novogyne account for the nine months
ended September 30, 2004 is as follows (in thousands): Investment in Novogyne, beginning of period
    
    $
    28,368Equity in earnings of Novogyne
    
    
    15,097Cash distributions from Novogyne
    
    
    (12,263
    )Deemed distribution by Novogyne for state
income tax payment
    
    
    (1,692
    )Investment in Novogyne, end of period
    
    $
    29,510
 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. There were no distributions from Novogyne for the
three months ended September 30, 2004. For the 11




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##### 



nine months ended September
30, 2004, Noven received cash distributions of $12.3 million. For the
three and nine months ended September 30, 2003, Noven received cash
distributions of $4.9 million and $16.9 million, respectively, from Novogyne. In
addition, as discussed in Note 7, a $1.7 million tax payment to the New
Jersey Department of Revenue made by Novogyne on Novens behalf in each of
April 2004 and 2003 were deemed distributions from Novogyne to Noven. 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 $25.0 million of
its common stock. Noven 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 nine months ended September 30, 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 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 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. As a result, in 2003, Noven and Novogyne established allowances
for the return of recalled product, which had the effect of reducing Novens
and Novogynes net revenues by approximately $1.4 million and $6.5 million,
respectively, for the year ended December 31, 2003. Based on a review of
available relevant information, including actual product returns and future
expected returns, Noven and Novogyne reduced these allowances in the first
half of 2004, which had the effect of increasing net 12




---



##### 



revenues for the nine
months ended September 30, 2004 by $0.6 million and $3.1 million for Noven
and Novogyne, respectively. The effect on Noven of these adjustments by
Noven and Novogyne was to increase Novens income before income taxes by $2.0
million for the nine months ended September 30, 2004. The effect on
Novogyne of Novogynes adjustment was to increase Novogynes income before
income taxes by $2.6 million for the nine months ended September 30, 2004.
These adjustments did not have an effect on Novens and Novogynes net
revenues nor income before income taxes for the three months ended September
30, 2004. At September 30, 2004, allowances for recall related returns were
$0.1 million at Noven. There are no remaining allowances for recall related
returns at Novogyne. In addition, Noven had $0.1 million remaining in
reserves for expected costs related to the 2003 product recalls. In late October 2004, Novens product stability testing program
indicated that one commercial lot of CombiPatch did not maintain required
specifications throughout the products shelf life due to the formation of
crystals. This issue is unrelated to the issue that led to the 2003 product
recalls referenced above. CombiPatch, approved in 1998, was the first
two-drug patch approved by the FDA. It is unique among Novens current
products in that it requires refrigeration until dispensed to the patient,
and then has a limited shelf-life at room temperature. The stability of
CombiPatch can be affected by environmental conditions during the production
process, in particular moisture/humidity, which can lead to the formation of
crystals. Novartis has advised Noven that Novartis will recall this lot,
but Noven does not expect the costs related to the recall of this lot to
have a material impact on Novens or Novogynes financial results. Noven
continues to manufacture and ship CombiPatch to Novogyne. Noven continues to maintain its 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 specification or are affected by the issue impacting the lot to be
recalled, there could be additional recalls. Although Noven and Novartis
work together in assessing 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, 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. CombiPatch represented approximately 14% of Novogynes total U.S.
prescriptions for the third quarter of 2004. 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. 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 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 13




---



##### 



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, in January 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. 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 addition, Novartis has advised
Noven that Novartis has been named as a defendant in
at least ten additional lawsuits alleging liability in connection with
personal injury claims allegedly arising from the use of HT patches
distributed and sold by Novartis and Novogyne, including Noven products,
Vivelle, Vivelle-Dot and CombiPatch. To date neither Noven nor Novogyne
has, to Novens knowledge, been named as a party to these additional
lawsuits. 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. The outcome of these product liability
lawsuits cannot be predicted, and it is not presently possible to determine
to what extent Noven or Novogyne may ultimately be impacted by these
lawsuits. 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. 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. Noven has established accruals for pending matters
that it believes are probable and reasonably estimable. Management believes
that any liability that may ultimately result from the resolution of pending
matters in excess of amounts provided will not have a material adverse
effect on the financial position or results of operations of Noven. 14




---



##### 



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 September 30, 2004, and the results of operations for the three
and nine months ended September 30, 2004 and 2003. The contents of this
section include:  
    
    An overview of Noven and recent developments related to:  -
    
    our menopausal hormone therapy business;-
    
    our developmental generic fentanyl patch; and-
    
    production issues;  
    
    An analysis of material aspects 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 and nine months ended September 30, 2004 and 2003 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 combination
therapy arm of the WHI study) to the third quarter of 2004, total prescriptions
dispensed in the HT market in the United States declined by 48%. For the same
period, aggregate prescriptions for Novens United States products decreased
12%. The estrogen segment of the HT market in the United States declined 42%,
while our Vivelle product family decreased 3%. Vivelle-Dot, which represented
80% of our total United States prescriptions in the third quarter of 2004,
increased 18% from the second quarter of 2002 to the third quarter of 2004. We
believe Vivelle-Dot patch prescriptions have benefited from patient conversions
from original Vivelle. 15




---



##### 



United States prescriptions for our CombiPatch product (which represented
approximately 14% of our total United States prescriptions in the third quarter
of 2004) declined 45% from the second quarter of 2002 to the second quarter of
2004, while prescriptions for the total United States market for fixed
combination hormone therapy declined 67%. The combination therapy arm of WHI
involved an oral combination estrogen/progestin product and, accordingly, that
segment of the HT market has experienced the most significant decline. Further
declines 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 harm both our and Novogynes results of
operations. Transdermal Fentanyl System In February 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® patch. Based on the current patent and exclusivity status
of Johnson & Johnsons Duragesic® patch, the earliest our generic fentanyl
patch could be launched is January 24, 2005, assuming FDA approval is received by
that time, but we cannot predict whether we will receive FDA approval by that
time or at all. Several parties have filed citizen petitions with the FDA
seeking to prevent or delay FDA approval of generic versions of Duragesic®, and
other citizen petitions may be filed in the future and other regulatory
strategies may be employed to prevent or delay such approvals. We cannot
predict whether or to what extent current or future petitions or regulatory
strategies will be successful in preventing or delaying FDA approval of our
fentanyl product. In the third quarter of 2004, we began manufacturing our fentanyl patch in
advance of FDA approval. To the extent 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. We estimate that our share
of such costs could be up to approximately $5.0 million. 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. Production Issues In 2003, our 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. As a
result, in 2003, Noven and Novogyne established allowances for the return of
recalled product, which had the effect of reducing Novens and Novogynes net
revenues by $1.4 million and $6.5 million, respectively, for the year ended
December 31, 2003. Based on a review of available relevant information,
including actual product returns and future expected returns, Noven and
Novogyne reduced these allowances during the nine months ended September 30,
2004, which had the effect of increasing net revenues for the nine months ended
September 30, 2004 by $0.6 million and $3.1 million for Noven and Novogyne,
respectively. The effect on Noven of these adjustments by Noven and Novogyne
was to increase Novens income before income taxes by $2.0 million for the nine
months ended September 30, 2004. The effect on Novogyne of Novogynes
adjustment was to increase Novogynes income before income taxes by $2.6
million for the nine months ended September 30, 2004. These adjustments did
not have an effect on Novens and Novogynes net revenues nor income before
income taxes for the three months ended September 30, 2004. At September 30,
2004, allowances for recall related returns were $0.1 million at Noven. There
are no remaining allowances for recall related returns at Novogyne. In
addition, Noven had $0.1 million remaining in reserves for expected costs
related to the 2003 product recalls. In late October 2004, our product stability testing program indicated that one commercial lot of CombiPatch did not maintain required
specifications throughout the products shelf life due to the 16




---



##### 



formation of crystals. This issue is unrelated to the issue that led to the
2003 product recalls referenced above. CombiPatch, approved in 1998, was the
first two-drug patch approved by the FDA. It is unique among our current
products in that it requires refrigeration until dispensed to the patient, and
then has a limited shelf-life at room temperature. The stability of CombiPatch
can be affected by environmental conditions during the production process, in
particular moisture/humidity, which can lead to the formation of crystals.
Novartis has advised us that they will recall this lot, but we do not expect
the costs related to the recall of this lot to have a material impact on
Novens or Novogynes financial results. 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
specification or are affected by the issue impacting the lot to be recalled,
there could be additional recalls. Although Noven and Novartis work together
in assessing 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. CombiPatch represented approximately 14% of Novogynes total U.S.
prescriptions for the third quarter of 2004. 17




---



##### 



Results of Operations Three and nine months ended September 30, 2004 compared to the three and nine
months ended September 30, 2003 Revenues Total revenues for the three and nine months ended September 30, 2004 and
2003 are summarized as follows (dollar amounts in thousands): Three Months
    
    Nine Months2004
    
    2003
    
    % Change
    
    2004
    
    2003
    
    % ChangeProduct revenues  Novogyne:Product sales
    
    $
    4,364
    
    
    $
    2,756
    
    
    
    58
    %
    
    $
    15,058
    
    
    $
    11,772
    
    
    
    28
    %Royalties
    
    
    1,411
    
    
    
    1,182
    
    
    
    19
    %
    
    
    3,909
    
    
    
    3,381
    
    
    
    16
    %5,775
    
    
    
    3,938
    
    
    
    47
    %
    
    
    18,967
    
    
    
    15,153
    
    
    
    25
    %Product revenues  third parties:Product sales
    
    
    3,287
    
    
    
    4,035
    
    
    
    (19
    %)
    
    
    9,614
    
    
    
    12,748
    
    
    
    (25
    %)Royalties
    
    
    
    
    
    
    10
    
    
    
    N/M
    
    
    214
    
    
    
    40
    
    
    
    N/M3,287
    
    
    
    4,045
    
    
    
    (19
    %)
    
    
    9,828
    
    
    
    12,788
    
    
    
    (23
    %)Total product revenues
    
    
    9,062
    
    
    
    7,983
    
    
    
    14
    %
    
    
    28,795
    
    
    
    27,941
    
    
    
    3
    %License and contract revenues:Contract
    
    
    43
    
    
    
    231
    
    
    
    N/M
    
    
    1,415
    
    
    
    296
    
    
    
    N/MLicense
    
    
    996
    
    
    
    882
    
    
    
    13
    %
    
    
    2,976
    
    
    
    3,145
    
    
    
    (5
    %)1,039
    
    
    
    1,113
    
    
    
    (7
    %)
    
    
    4,391
    
    
    
    3,441
    
    
    
    28
    %Net revenues
    
    $
    10,101
    
    
    $
    9,096
    
    
    
    11
    %
    
    $
    33,186
    
    
    $
    31,382
    
    
    
    6
    %
 N/M  not meaningful Net Revenues As described in more detail below, the increase in net revenues for the
three and nine months ended September 30, 2004 as compared to the same periods
in 2003 was primarily attributable to higher sales of our United States
products, partially offset by a decline in sales of our international products.
In addition, contract revenues increased for the nine months ended September
30, 2004 as compared to the same period in 2003 due to the attainment of
certain product development milestones. Net revenues for the nine months ended
September 30, 2004 also benefited from a reduction in allowances for returns. 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 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-Dot. The $1.8 million increase in product revenues from Novogyne for the three
months ended September 30, 2004 as compared to the same period in the prior
year primarily related to a $0.9 million allowance for returns established in
the third quarter of the prior year related to product recalls, as well as
higher unit sales of Vivelle-Dot. 18




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##### 



The $3.8 million increase in product revenues from Novogyne for the nine
months ended September 30, 2004 as compared to the same period in the prior
year primarily relates to $2.6 million in higher sales for Vivelle-Dot and $1.2
million in higher sales of Estradot to Canada. The higher sales of Estradot
was primarily due to higher unit sales due to timing of orders. The increase
in Vivelle-Dot sales was primarily attributable to inventory reduction
initiatives in the first half of the prior year, which reduced our sales to
Novogyne during that period. In addition, product revenues in the prior period
included a $0.9 million allowance for returns established in the third quarter
of the prior year related to product recalls. Based upon our review and
analysis of the most current information regarding historical and expected
future returns, we reduced this allowance by $0.6 million for the nine months
ended September 30, 2004. The net effect of these two events accounts for $1.5
million of the increase in net revenues for the nine months ended September 30,
2004 as compared to the same period in the prior year. Product Revenues  Third Parties Product revenues  third
parties consists substantially 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 $0.8 million decrease in product revenues from third parties for the
three months ended September 30, 2004 as compared to the same period in the
prior year primarily related to $1.2 million in lower unit sales of all
products, partially offset by a $0.4 million in higher sales of Estradot, primarily related to a price adjustment payment
which was recorded upon determining that Novartis Pharmas sales price of
Estradot entitled Noven to receive amounts in excess of the minimum transfer
price. The decline in sales
reflected lower prescription trends following the publication of the
combination therapy arm of the WHI study and other studies. The $3.0 million decrease in product revenues from third parties for the
nine months ended September 30, 2004 as compared to the same period in the
prior year primarily related to $3.8 million in lower sales of Estalis,
primarily related to lower unit sales. This decrease was partially offset by
$1.2 million in higher sales of Estradot, primarily related to a price
adjustment payment as noted above for the three months ended September 30, 2004. The lower unit sales of
Estalis reflected lower prescription trends following the publication of the
combination therapy arm of the WHI study and other studies. License and Contract Revenues The decrease in contract revenues for the three months ended September 30,
2004 as compared to the same period in the prior year was primarily
attributable to the attainment of certain product development milestones and
the completion of certain product development contracts in the prior period,
which were not repeated in the current period. The increase in license revenue
for the three months ended September 30, 2004 as compared to the same period in
the prior year was due to the recognition of license revenue in connection with
our collaboration with Endo in the current period. The increase in contract revenues for the nine months ended September 30,
2004 as compared to the same period in the prior year was primarily
attributable to the attainment of certain product development milestones and
the completion of certain product development contracts in the current period.
The decrease in license revenues for the nine months ended September 30, 2004
as compared to the same period in the prior year was due to the recognition of
license revenue in connection with the Shire transaction in the prior year,
which was not repeated in the current year. Beginning in the third quarter of
2003, we ceased amortizing the unamortized balance of license revenue we
received in the Shire transaction due to the planned initiation of additional
clinical trials 19




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##### 



and the significant costs expected to be incurred in pursuing
MethyPatch® approval. As previously
 disclosed, our direct costs incurred in pursuit of approval are currently
being deferred and offset against a portion of the $25.0 million deferred revenue
previously received from Shire. Gross Margin Gross margin for the three and nine months ended September 30, 2004 and
2003 are summarized as follows (dollar amounts in thousands): Three Months
    
    Nine Months2004
    
    2003
    
    % Change
    
    2004
    
    2003
    
    % ChangeTotal product revenues
    
    $
    9,062
    
    
    $
    7,983
    
    
    
    14
    %
    
    $
    28,795
    
    
    $
    27,941
    
    
    
    3
    %Gross profit (product revenues
less cost of products sold)
    
    
    4,078
    
    
    
    4,047
    
    
    
    1
    %
    
    
    13,318
    
    
    
    13,680
    
    
    
    (3
    %)Gross margin (gross profit as a
percentage of product revenues)
    
    
    45%
    
    
    
    51%
    
    
    
    
    
    
    
    46%
    
    
    
    49%
 The decrease in gross margin for the three and nine months ended September
30, 2004 as compared to the same period in the prior year was primarily due to
an increase in deferred profit related to sales of product to Novogyne which
reflected our increased sales to Novogyne in the current period in comparison
to the same period in the prior year. 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 margin for that period. Novens cost of
products sold is adjusted from period to period to reflect changes in deferred
profit. As a result, Novens gross margin can vary significantly from period
to period. The decrease in gross margin for the three and nine months ended September
30, 2004 was partially offset by the impact of allowances for reserves for
product recalls established at Noven in the three months ended September 30,
2003 and subsequently reduced in the first half of 2004, which increased
product revenues in the current period without affecting cost of products sold.
The decrease was also partially offset by an increase in product royalties for
the three months ended September 30, 2004 as compared to the prior period,
which also increased product revenues without affecting cost of products sold. Operating Expenses Operating expenses for the three and nine months ended September 30, 2004
and 2003 are summarized as follows (dollar amounts in thousands): Three Months
    
    Nine Months2004
    
    2003
    
    % Change
    
    2004
    
    2003
    
    % ChangeResearch and development
    
    $
    2,741
    
    
    $
    1,916
    
    
    
    43
    %
    
    $
    7,730
    
    
    $
    6,563
    
    
    
    18
    %Marketing, general and
administrative
    
    
    4,358
    
    
    
    4,791
    
    
    
    (9
    %)
    
    
    12,024
    
    
    
    12,265
    
    
    
    (2
    %)
 Research and Development The $0.8 million increase in research and development expenses for the
three months ended September 30, 2004 as compared to the same period in 2003
was primarily attributable to an increase 20




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##### 



in development expenses for hormone therapy products as well as
non-clinical development related to our fentanyl transdermal system. The $1.2 million increase in research and development expenses for the
nine months ended September 30, 2004 as compared to the same period in 2003 was
primarily attributable to a $2.0 million increase in development expenses for
hormone therapy products as well as non-clinical development related to our
fentanyl transdermal system. This increase was partially offset by $0.8
million reduction in clinical expenses related to MethyPatch. As previously
disclosed, our direct costs incurred in pursuit of MethyPatch approval are
currently being deferred and offset against a portion of the $25.0 million
deferred revenue previously received from Shire. Marketing, General and Administrative The $0.4 million decrease in marketing, general and administrative
expenses for the three months ended September 30, 2004 as compared to the same
period in 2003 was primarily attributable to the $0.9 million in accrual
established in the prior year related to expected costs associated with product
recalls, partially offset by $0.4 million in increased compensation costs in
the current period. The $0.2 million decrease in marketing, general and administrative
expenses for the nine months ended September 30, 2004 as compared to the same
period in 2003 was primarily attributable to a $1.5 million reduction in costs
due to the elimination of pre-launch marketing expenses for MethyPatch, which
ceased during the second quarter of 2003 as a result of the license of
MethyPatch to Shire, and $0.9 million in allowances established in the prior
year related to expected costs associated with product recalls. This decrease
was partially offset by $1.0 million of increased compensation costs, $0.6
million of increased consulting and professional fees primarily related to new
requirements resulting from the Sarbanes-Oxley Act of 2002, and $0.4 million of
increased insurance costs. Income Taxes Our effective tax rate was approximately 42% and 38% for the three and
nine months ended September 30, 2004 and 36% for each of the three and nine
months ended September 30, 2003. The provision for income taxes is based on the
Federal statutory and state income tax rates. The increase for our effective tax rate for the three and nine months ended
September 30, 2004 as compared to the prior year relates primarily to a shift
in income to higher state tax rate jurisdictions and tax uncertainties related
to outstanding Internal Revenue Service audits.
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 September 30, 2004, we had a net deferred tax asset of $17.2
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. 21




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##### 



The financial results of Novogyne for the three and nine months ended
September 30, 2004 and 2003 are summarized as follows (dollar amounts in
thousands): Three Months
    
    Nine Months2004
    
    2003
    
    % Change
    
    2004
    
    2003
    
    % ChangeGross
revenues(1)
    
    $
    34,314
    
    
    $
    31,584
    
    
    
    9
    %
    
    $
    94,463
    
    
    $
    84,321
    
    
    
    12
    %Sales allowances
    
    
    3,123
    
    
    
    2,969
    
    
    
    5
    %
    
    
    9,412
    
    
    
    8,764
    
    
    
    7
    %Sales returns allowances
    
    
    3,676
    
    
    
    4,586
    
    
    
    (20
    %)
    
    
    3,968
    
    
    
    5,255
    
    
    
    (24
    %)Sales allowances and returns
    
    
    6,799
    
    
    
    7,555
    
    
    
    (10
    %)
    
    
    13,380
    
    
    
    14,019
    
    
    
    (5
    %)Net revenues
    
    
    27,515
    
    
    
    24,029
    
    
    
    15
    %
    
    
    81,083
    
    
    
    70,302
    
    
    
    15
    %Cost of sales
    
    
    5,394
    
    
    
    4,568
    
    
    
    18
    %
    
    
    16,926
    
    
    
    14,793
    
    
    
    14
    %Gross profit
    
    
    22,121
    
    
    
    19,461
    
    
    
    14
    %
    
    
    64,157
    
    
    
    55,509
    
    
    
    16
    %Gross margin percentage
    
    
    80%
    
    
    
    81%
    
    
    
    
    
    
    
    79%
    
    
    
    79%Selling, general and
administrative expenses
    
    
    7,957
    
    
    
    8,113
    
    
    
    (2
    %)
    
    
    22,519
    
    
    
    23,617
    
    
    
    (5
    %)Amortization of intangible asset
    
    
    1,545
    
    
    
    1,545
    
    
    
    
    
    
    
    4,635
    
    
    
    4,635
    
    
    
    Income from operations
    
    
    12,619
    
    
    
    9,803
    
    
    
    29
    %
    
    
    37,003
    
    
    
    27,257
    
    
    
    36
    %Interest income
    
    
    50
    
    
    
    33
    
    
    
    52
    %
    
    
    103
    
    
    
    135
    
    
    
    (24
    %)Net income
    
    $
    12,669
    
    
    $
    9,836
    
    
    
    29
    %
    
    $
    37,106
    
    
    $
    27,392
    
    
    
    35
    %Novens equity in earnings of Novogyne
    
    $
    6,232
    
    
    $
    4,529
    
    
    
    38
    %
    
    $
    15,097
    
    
    $
    9,849
    
    
    
    53
    %
  (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 Gross revenues increased $2.7 million for the three months ended September
30, 2004 compared to the prior year, primarily due to $4.5 million in increased
sales of Vivelle-Dot partially offset by a decrease of $1.3 million in sales of
CombiPatch. Approximately $1.7 million of the Vivelle-Dot increase was due to
price, while the remaining $2.8 million increase related to increased unit
sales. Because underlying prescriptions for our products declined slightly
period to period, we believe the increase in gross revenues was related to the timing of
orders from trade customers. Novogyne sells its products to trade customers,
including wholesalers, distributors and chain pharmacies. As has historically
been the case, the timing of purchases by trade customers is driven by the
inventory needs of each customer and other factors, and does not necessarily
track underlying prescription trends in any given period or coincide with
Novogynes quarterly financial reporting periods. As a result, the timing of
orders by trade customers is difficult to predict and can lead to significant
variability in Novogynes quarterly results. 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. Gross revenues increased $10.1 million for the nine months ended September
30, 2004 compared to the prior year, primarily due to $11.1 million in
increased sales of Vivelle-Dot and $2.5 million in increased sales of Estradot
to Canada. We believe the increase in Estradot sales to Canada was due to
Novartis Pharma restocking inventory. Approximately $6.2 million of the
Vivelle-Dot increase was due to price, while the remaining $4.9 million
increase related to increased unit sales. This increase in sales was partially
offset by a $1.3 million decrease in sales of Vivelle, our first generation
estrogen patch, and a $2.2 million decrease in sales of CombiPatch due to a
continuing 22




---



##### 



decline in the market for combination therapies after the publication of
the combination arm of the WHI study. 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 9%
of gross revenues for the three months ended September 30, 2004 and 2003, and
10% of gross revenues for the nine months ended September 30, 2004 and 2003,
respectively. Sales returns allowances consist of: (i) allowances for returns of
expiring product, and (ii) allowances for returns for product recalls. For the
three months ended September 30, 2004, sales return allowances were $3.7
million, all of which related to allowances for returns of expiring product.
Novogyne increased its allowances for returns of expiring product primarily due
to higher actual returns for Vivelle. Actual returns are one of the
significant factors considered in assessing the adequacy of allowances for
returns of expiring product. For the three months ended September 30, 2003,
sales return allowances were $4.6 million, reflecting $5.0 million in
allowances for product recalls, partially offset by $0.4 million in allowances
for returns for expiring product. For the nine months ended September 30, 2004, sales return allowances were
$4.0 million, reflecting an increase in allowances for expiring product of $7.1
million, partially offset by a $3.1 million decrease in allowances for returns
for product recalls. Novogyne increased its allowances for expiring product
primarily due to higher actual returns for Vivelle. Novogyne decreased its
allowances for returns for product recalls in the nine months ended September
30, 2004 based on its actual returns to date and expected future returns. For
the nine months ended September 30, 2003, sales return allowances were $5.3
million, reflecting $5.0 million in allowances for returns for product recalls
and $0.3 million in allowances for expiring product. Novogyne Gross Margin Gross margin was consistent for the three and nine months ended September
30, 2004 as compared to the same periods in 2003. Novogyne Selling, General and Administrative Expenses Selling, general and administrative expenses for the three and nine months
ended September 30, 2004 decreased $0.2 million and $1.1 million, respectively,
which was primarily attributable to timing of sample orders by Novogyne. 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 September 30, 2004
and 2003 and $4.6 million for each of the nine month periods ended September
30, 2004 and 2003. Our CombiPatch product was licensed by Novogyne in March
2001. Liquidity and Capital Resources As of September 30, 2004 and December 31, 2003, we had $100.3 million and
$83.4 million in cash and cash equivalents, and working capital of $94.8
million and $76.7 million, respectively. 23




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##### 



Cash provided by (used in) operating, investing and financing activities
for the nine months ended September 30, 2004 and 2003 is summarized as follows
(amounts in thousands): 2004
    
    2003Cash flows:Operating activities
    
    $
    16,914
    
    
    $
    33,370Investing activities
    
    
    (5,426
    )
    
    
    (4,104
    )Financing activities
    
    
    5,478
    
    
    
    (1,037
    )
 Operating Activities Net cash provided by operating activities for the nine months ended
September 30, 2004 primarily resulted from the receipt of an $8.0 million
payment upon the closing of the Endo transaction in February 2004 and $12.3
million in distributions from Novogyne, partially offset by $6.7 million in
expenses incurred in pursuit of MethyPatch product regulatory approval. Net cash provided by operating activities for the nine months ended
September 30, 2003 primarily resulted from the receipt of a $25.0 million
license payment from Shire and a $16.9 million distribution from Novogyne. The
increase was partially offset by changes in working capital due to the timing
and amount of product shipments, payment of Directors and Officers insurance
premiums and payment of income taxes. Investing Activities Net cash used in investing activities for the nine months ended September
30, 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 nine months ended
September 30, 2004 was primarily attributable to $5.6 million received in
connection with the issuance of common stock from the exercise of stock
options. Net cash used in financing activities for the nine months ended September
30, 2003 was primarily attributable to the repurchase of 105,000 shares of our
common stock for $1.3 million, 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. In February 2004, Endo paid us
$8.0 million upon closing of the fentanyl patch licensing transaction. For the
nine months ended September 30, 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. 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 24




---



##### 



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. For the nine
months ended September 30, 2004, $6.7 million in deferred license revenues were
used to offset MethyPatch development expenses. 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, and there is no
assurance that the additional studies will address the FDAs issues or that the
FDA may not raise additional issues following any submission of an amendment to
the MethyPatch NDA. Additionally, even if the FDA approves MethyPatch, we
cannot assure that 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 with respect to MethyPatch. Our short-term liquidity will be affected in 2004 as we expect to incur
additional funds in capital expenditures during the remainder of 2004 primarily
in preparation for the expected launch of new products, including our fentanyl
patch, but we can not predict when, or if, any of the products may be launched.
We have begun manufacturing launch supplies for our fentanyl patch. In the
fourth quarter of 2004, we expect that we may incur up to $10.0 million for the
cost of pre-launch inventories for our fentanyl patch. If 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. We estimate that our share of such
costs could be up to approximately $5.0 million. 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. 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 plant
and equipment to expand production capacity for new products. If our products
under development, including those being developed with Shire and P&G
Pharmaceuticals, are successful, these expenditures, which may include an
additional manufacturing plant, may 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 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. 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. 25




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##### 



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 prove incorrect or 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
September 30, 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 is provided below.
This information is based on our current assumptions and expectations, many of
which are beyond our control. This information is also premised on our current
assumption that for the periods referenced there will not be any unforeseen
material:  
    
    transactions;
    
    changes in Novens or Novogynes accounting or accounting principles;
    
    regulatory, technological or clinical study developments;
    
    changes in the demand for or the supply, distribution
or inventory levels of our HT products (including any changes
resulting from the impact of competitive HT products that have
been launched in 2004);
    
    recalls of CombiPatch beyond the one lot discussed
under the caption Production Issues;
    
    changes in our business relationships/collaborations; or
    
    changes in the economy or the health care sector generally. If our assumptions or expectations concerning these matters prove to be
incorrect, or if other unexpected circumstances should arise, 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 full-year 2004, we refer you to the
risks, uncertainties and cautionary factors 26




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##### 



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, as amended. 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 2004 net revenues are expected to reach the upper end of our
expectations, and Novogyne expects to initiate promotional programs during the
fourth quarter of 2004, which programs will increase Novogynes fourth quarter selling,
general and administrative expenses over third quarter 2004 levels.
Novogyne sells three products, one of which (Vivelle-Dot) represented over
75% of total prescriptions for Novogynes products during the first nine months
of 2004. These products are sold to a relatively small number of trade
customers, including large wholesalers and others who may vary their inventory
levels based on factors that do not necessarily track underlying prescription
trends. In light of these circumstances, the timing and quantity of purchases
by one or more trade customers is difficult to predict and can cause Novogynes
operating results to fluctuate by quarter, and do not necessarily track
underlying prescription trends or coincide with Novogynes quarterly financial
reporting period. For full year 2004, we expect that a decline in Novens international
product revenues should be approximately offset by an increase in Novens other
revenue sources. We expect capital expenditures in 2004 to increase over 2003
levels as we prepare for the possible launch of our fentanyl patch. We expect
that capital expenditures will increase significantly beginning in 2005 in
connection with the development of other new products, including products under
our collaborations with Shire, Endo and P&G Pharmaceuticals. Based on the current patent and exclusivity status of Johnson & Johnsons
Duragesic fentanyl patch, the earliest that our generic fentanyl patch
(licensed to Endo) could be launched in the United States is January 24, 2005,
assuming FDA approval is received by that time. If our fentanyl patch is
approved and commercialized in the January 2005 timeframe, we would expect
Novens revenues and net income for full-year 2005 to increase significantly
over 2004 levels, but we cannot assure that we will receive FDA approval and
launch the product with Endo in that timeframe or at all. 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, as
amended, 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 27




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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
MethyPatch 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, including those which may be related to the October 2004 CombiPatch
stability issue; 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. MethyPatch,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
the MethyPatch product NDA; the risk that planned additional studies may not be
commenced or completed in a timely manner, due to an inability to enroll a
sufficient number of subjects for the additional studies or otherwise, which
could delay the filing of an amendment to the MethyPatch product NDA past 2005;
the possibility that 28




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planned 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
timing of the FDAs review of any amended NDA for MethyPatch as well as any product
approval, which are outside Novens control and which may impact the success of
product launch and market penetration; Shires control over the management of
the planned additional MethyPatch product clinical trials, including the risk
that Shire may elect to manage such studies differently than Noven might have,
incorrectly or inadequately; the possibility that the additional studies may be
more extensive, lengthier or more costly than anticipated and may exceed the
total amount of license revenues available to offset such costs and expenses;
any exercise of Shires right to terminate the agreement following its review
of the results of the additional studies, 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 MethyPatch 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 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 risks and
uncertainties associated with citizen petitions, including the citizen
petitions that have been filed with respect to generic fentanyl patches; 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 during 2004, 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 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 29




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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, 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. 30




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PART II. OTHER INFORMATION 
 Item 2. Unregistered Sales of Equity Securities and Use of Proceeds The following table provides information with respect to our stock
repurchases during the third quarter of 2004: Total Number ofShares
    
    ApproximatePurchased as
    
    Dollar ValuePart of
    
    That May YetPublicly
    
    be PurchasedTotal Number of
    
    Average Price Paid
    
    Announced
    
    under theShares Purchased
    
    Per Share
    
    Program
    
    Program(1)July 1, 2004 to
July 31, 2004
    
    
    
    
    
    
    
    
    
    
    
    
    
    $
    23,711,040August 1, 2004 to
August 31, 2004
    
    
    
    
    
    
    
    
    
    
    
    
    
    $
    23,711,040September 1, 2004 to
September 30, 2004
    
    
    
    
    
    
    
    
    
    
    
    
    
    $
    23,711,040Totals
    
    
    
    
    
    
    
    
    
    
    
    
    
    $
    23,711,040
  (1)
    
    In March 2003, we announced a stock repurchase program authorizing the
buy back of up to $25.0 million of our Common Stock. There is no expiration
date specified for this program. 
 Item 5. Other Information Since
1999, we have entered into Employment Agreements (Change of Control)
with certain of our officers. On
November 8, 2004, we entered into amended Employment Agreements (Change
of Control) with 10 Noven officers, including the following named executive
officers (as defined in Item 401 of Regulation S-K): Juan A. Mantelle,
Jeffrey F. Eisenberg, W. Neil Jones and Diane M. Barrett. The sole
purpose of the amended agreements was to conform the definition of Change of Control in these
agreements with the definition of Change of Control in the Noven
Pharmaceuticals, Inc. 1999 Long-Term Incentive Plan. 
 Item 6. Exhibits 10.1
    
    Form of Incentive Stock Option Agreement10.2
    
    Form of Non-Qualified Stock Option Agreement10.3
    
    Form of Non-Qualified Stock Option Agreement (Non-Employee Director)10.4
    
    Employment Agreement (Change in Control), dated as of
November 8, 2004, between Noven and each of Jeffrey F. Eisenberg,
W. Neil Jones, Juan A. Mantelle and Diane M. Barrett31.1
    
    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 2002
 31




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31.2
    
    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
 32




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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: November 9, 2004
    By:
    /s/ Diane M. BarrettDiane M. BarrettVice President and
Chief Financial Officer 33