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UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549
 FORM 10-Q Quarterly Report Pursuant to Section 13 or 15 (d) of the Securities Exchange Act of 1934 For the quarterly period ended June 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(Address of principal executive offices)
    
    (Zip Code)
 (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 July 28, 2004Common stock $.0001 par value
    
    23,404,157




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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 Six Months Ended June 30, 2004 and 2003
    
    
    3Condensed Balance Sheets as of June 30, 2004 and December 31, 2003
    
    
    4Condensed Statements of Cash Flows for the Six Months Ended June 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
    
    
    30Item 4
    
    Controls and Procedures
    
    
    30PART II
    
    OTHER INFORMATIONItem 1
    
    Legal Proceedings
    
    
    31Item 2
    
    Changes in Securities and Use of Proceeds
    
    
    31Item 4
    
    Submission of Matters to a Vote of Security Holders
    
    
    31Item 6
    
    Exhibits and Reports on Form 8-K
    
    
    32SIGNATURES
    
    
    
    
    33
  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
    
    Six Months2004
    
    2003
    
    2004
    
    2003Revenues:Product revenues  Novogyne:Product sales
    
    $
    4,886
    
    
    $
    6,086
    
    
    $
    10,694
    
    
    $
    9,016Royalties
    
    
    1,608
    
    
    
    968
    
    
    
    2,498
    
    
    
    2,199Total product revenues  Novogyne
    
    
    6,494
    
    
    
    7,054
    
    
    
    13,192
    
    
    
    11,215Product revenues  third parties
    
    
    3,564
    
    
    
    3,786
    
    
    
    6,541
    
    
    
    8,743Total product revenues
    
    
    10,058
    
    
    
    10,840
    
    
    
    19,733
    
    
    
    19,958License and contract revenues
    
    
    1,897
    
    
    
    1,421
    
    
    
    3,352
    
    
    
    2,328Net revenues
    
    
    11,955
    
    
    
    12,261
    
    
    
    23,085
    
    
    
    22,286Expenses:Cost of products sold
    
    
    4,975
    
    
    
    6,040
    
    
    
    10,493
    
    
    
    10,325Research and development
    
    
    2,734
    
    
    
    2,154
    
    
    
    4,989
    
    
    
    4,647Marketing, general and administrative
    
    
    3,762
    
    
    
    3,293
    
    
    
    7,666
    
    
    
    7,474Total expenses
    
    
    11,471
    
    
    
    11,487
    
    
    
    23,148
    
    
    
    22,446Income (loss) from operations
    
    
    484
    
    
    
    774
    
    
    
    (63
    )
    
    
    (160
    )Equity in earnings of Novogyne
    
    
    8,228
    
    
    
    3,795
    
    
    
    8,865
    
    
    
    5,320Interest income, net
    
    
    184
    
    
    
    198
    
    
    
    340
    
    
    
    346Income before income taxes
    
    
    8,896
    
    
    
    4,767
    
    
    
    9,142
    
    
    
    5,506Provision for income taxes
    
    
    3,218
    
    
    
    1,717
    
    
    
    3,306
    
    
    
    1,983Net income
    
    $
    5,678
    
    
    $
    3,050
    
    
    $
    5,836
    
    
    $
    3,523Basic earnings per share
    
    $
    0.24
    
    
    $
    0.14
    
    
    $
    0.25
    
    
    $
    0.16Diluted earnings per share
    
    $
    0.23
    
    
    $
    0.13
    
    
    $
    0.24
    
    
    $
    0.15Weighted average number of common shares
outstanding:Basic
    
    
    23,386
    
    
    
    22,493
    
    
    
    23,226
    
    
    
    22,536Diluted
    
    
    24,387
    
    
    
    22,937
    
    
    
    24,334
    
    
    
    22,928
 The accompanying notes are an integral part of these statements. 3




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NOVEN PHARMACEUTICALS, INC. 
 
 June 30, 2004
    
    December 31, 2003AssetsCurrent Assets:Cash and cash equivalents
    
    $
    106,810
    
    
    $
    83,381Accounts receivable  trade (less allowance for doubtful
accounts of $66 in 2004 and $84 in 2003)
    
    
    2,620
    
    
    
    3,809Accounts receivable  Novogyne, net
    
    
    3,538
    
    
    
    6,320Inventories
    
    
    5,452
    
    
    
    5,200Net deferred income tax asset, current portion
    
    
    7,800
    
    
    
    6,500Prepaid income taxes and other current assets
    
    
    4,082
    
    
    
    3,219130,302
    
    
    
    108,429Property, plant and equipment, net
    
    
    19,783
    
    
    
    18,354Other Assets:Investment in Novogyne
    
    
    23,278
    
    
    
    28,368Net deferred income tax asset
    
    
    13,954
    
    
    
    12,175Patent development costs, net
    
    
    2,076
    
    
    
    1,977Deposits and other assets
    
    
    20
    
    
    
    18139,328
    
    
    
    42,701$
    189,413
    
    
    $
    169,484Liabilities and Stockholders EquityCurrent Liabilities:Accounts payable
    
    $
    6,549
    
    
    $
    4,060Capital lease obligations  current portion
    
    
    101
    
    
    
    Accrued compensation and related liabilities
    
    
    2,891
    
    
    
    3,734Other accrued liabilities
    
    
    1,218
    
    
    
    2,090Deferred contract revenues
    
    
    2,575
    
    
    
    772Deferred license revenues  current portion
    
    
    22,415
    
    
    
    21,11235,749
    
    
    
    31,768Long-Term Liabilities:Capital lease obligations
    
    
    162
    
    
    
    Deferred license revenues
    
    
    30,764
    
    
    
    28,89366,675
    
    
    
    60,661Commitments and Contingencies (Note 11)Stockholders Equity:Preferred stock  authorized 100,000 shares of $.01 par
value; no shares issued or outstanding
    
    
    
    
    
    
    Common stock  authorized 80,000,000 shares,
par value $.0001 per share; issued and
outstanding 23,393,697 at June 30, 2004 and
22,722,060 at December 31, 2003
    
    
    2
    
    
    
    2Additional paid-in capital
    
    
    87,323
    
    
    
    79,244Retained earnings
    
    
    35,413
    
    
    
    29,577122,738
    
    
    
    108,823$
    189,413
    
    
    $
    169,484
 The accompanying notes are an integral part of these statements. 4




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NOVEN PHARMACEUTICALS, INC. 
 
 2004
    
    2003Cash flows from operating activities:Net income
    
    $
    5,836
    
    
    $
    3,523Adjustments to reconcile net income to net cash
provided by operating activities:Depreciation and amortization
    
    
    1,173
    
    
    
    1,146Amortization of patent costs
    
    
    186
    
    
    
    166Amortization of non-competition agreement
    
    
    167
    
    
    
    200Income tax benefits on exercise of stock options
    
    
    2,728
    
    
    
    17Deferred income tax benefit
    
    
    (3,079
    )
    
    
    (8,782
    )Non-cash expense related to issuance of stock to outside
directors
    
    
    30
    
    
    
    31Recognition of deferred contract revenues
    
    
    (1,372
    )
    
    
    (65
    )Amortization of deferred license revenues
    
    
    (1,980
    )
    
    
    (2,263
    )Equity in earnings of Novogyne
    
    
    (8,865
    )
    
    
    (5,320
    )Distributions from Novogyne
    
    
    12,263
    
    
    
    11,980Changes in operating assets and liabilities:Decrease in accounts receivable  trade, net
    
    
    1,189
    
    
    
    187Decrease (increase) in accounts receivable  Novogyne, net
    
    
    2,782
    
    
    
    (3,392
    )(Increase) decrease in inventories
    
    
    (252
    )
    
    
    1,362Decrease (increase) in prepaid income taxes and other current assets
    
    
    829
    
    
    
    (1,410
    )Increase in deposits and other assets
    
    
    (6
    )
    
    
    Increase in accounts payable
    
    
    2,489
    
    
    
    189Decrease in accrued compensation and related liabilities
    
    
    (843
    )
    
    
    (1,298
    )(Decrease) increase in other accrued liabilities
    
    
    (872
    )
    
    
    55Increase in current tax payable
    
    
    
    
    
    
    7,537Increase in deferred contract revenue
    
    
    3,175
    
    
    
    665Increase in deferred license revenue
    
    
    6,500
    
    
    
    25,000Direct expenses incurred in pursuit of
MethyPatch® product regulatory approval
    
    
    (1,346
    )
    
    
    Cash flows provided by operating activities
    
    
    20,732
    
    
    
    29,528Cash flows from investing activities:Purchases of property, plant and equipment, net
    
    
    (2,290
    )
    
    
    (3,109
    )Payments for patent development costs
    
    
    (285
    )
    
    
    (168
    )Cash flows used in investing activities
    
    
    (2,575
    )
    
    
    (3,277
    )Cash flows from financing activities:Issuance of common stock
    
    
    5,321
    
    
    
    147Purchase and retirement of common stock
    
    
    
    
    
    
    (1,289
    )Repayments of capital leases and notes payable
    
    
    (49
    )
    
    
    (4
    )Cash flows provided by (used in) financing activities
    
    
    5,272
    
    
    
    (1,146
    )Net increase in cash and cash equivalents
    
    
    23,429
    
    
    
    25,105Cash and cash equivalents, beginning of period
    
    
    83,381
    
    
    
    58,684Cash and cash equivalents, end of period
    
    $
    106,810
    
    
    $
    83,789
 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 June 30, 2004, and the
results of its operations for the three and six months ended June 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 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 six
months ended June 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. 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 the entity to finance its activities without additional
subordinated financial support from other 6




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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 June 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): June 30,
    
    December 31,2004
    
    2003Finished goods
    
    $
    1,546
    
    
    $
    806Work in process
    
    
    875
    
    
    
    1,722Raw materials
    
    
    3,031
    
    
    
    2,672Total
    
    $
    5,452
    
    
    $
    5,200
 6. EMPLOYEE STOCK PLANS: In accordance with the provisions of Statement of Financial Accounting
Standards No. 123, Accounting for Stock-Based Compensation (SFAS 123),
as amended by Statement of Financial Accounting Standards No. 148,
Accounting for Stock-Based Compensation -Transition and Disclosure (SFAS
148), Noven may elect to continue to apply the provisions of the Accounting
Principles Boards Opinion No. 25, Accounting for Stock Issued to
Employees (APB 25), and related interpretations in accounting for its
employee stock option plans, or adopt the fair value method of accounting
prescribed by SFAS 123. Noven has elected to continue to account for its
stock plans using APB 25, and therefore no stock-based employee compensation
cost is reflected in net income, as all options granted under those plans
had an exercise price equal to the market value of the underlying common
stock on the date of grant. 7




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The following table illustrates the effect on net income and earnings
per share for the three and six months ended June 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
    
    Six Months2004
    
    2003
    
    2004
    
    2003Net income:As reported
    
    $
    5,678
    
    
    $
    3,050
    
    
    $
    5,836
    
    
    $
    3,523Total stock-based employee
compensation expense determined
under fair value based method for all
awards, net of related tax effects
    
    
    (984
    )
    
    
    (933
    )
    
    
    (1,724
    )
    
    
    (2,109
    )Pro forma
    
    $
    4,694
    
    
    $
    2,117
    
    
    $
    4,112
    
    
    $
    1,414Basic earnings per share:As reported
    
    $
    0.24
    
    
    $
    0.14
    
    
    $
    0.25
    
    
    $
    0.16Pro forma
    
    $
    0.20
    
    
    $
    0.09
    
    
    $
    0.18
    
    
    $
    0.06Diluted earnings per share:As reported
    
    $
    0.23
    
    
    $
    0.13
    
    
    $
    0.24
    
    
    $
    0.15Pro forma
    
    $
    0.19
    
    
    $
    0.09
    
    
    $
    0.17
    
    
    $
    0.06
 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 six
months ended June 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 $3.2 million for each of the six
months ended June 30, 2004 and 2003, respectively. Cash payments for
interest were not material for the six months ended June 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. Non-cash Investing Activities During the six months ended June 30, 2004, Noven entered into a capital
lease obligation of $0.3 million for new equipment. 8




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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, Noven believes that the earliest its generic
fentanyl patch could be launched is January 2005, assuming Food and Drug
Administration (FDA) approval is received by that time, but Noven cannot
give any assurance that it will receive FDA approval by that time or at all.
Noven and Endo may elect to manufacture launch supplies prior to receipt of
FDA approval. If launch supplies are manufactured and approval is
not ultimately received or is delayed, the agreement provides that Noven and
Endo will share the cost of manufacturing product that cannot be sold by
Endo in accordance with an agreed-upon formula. In that case,
Noven would not be able to offset all of its up-front production costs with
sales of the product. If the product has not been approved or Noven has not
supplied Endos launch requirements by May 2005, Endo may have the right to
terminate the license, depending on the number of generic competitors in the
market. In addition to the fentanyl license, Noven has established a
collaboration with Endo to identify and develop new transdermal therapies.
Of the $8.0 million up-front payment, $1.5 million has been allocated to
fund feasibility studies to determine whether certain compounds identified
by the parties can be delivered using Novens transdermal technology. Noven
believes the $1.5 million represents the fair value of such services. Endo
is expected to fund and manage clinical development of those compounds
proceeding into clinical trials. Of the $8.0 million received at signing, $6.5 million will be
recognized as revenues 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 three and six months ended June 30, 2004, Noven recognized as contract
revenues $0.8 million and $1.2 million, respectively, 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 collaboration were recognized for the same periods in 2003.
Potential development milestones totaling $3.6 million remain to be earned
under the collaboration. 9




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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 intend to
proceed 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 estimates that
the additional studies will cost up to $13.0 million, and Noven expects to
incur additional costs, which may include clinical supply costs, consulting
costs and other costs associated with our pursuit of marketing approval for
MethyPatch. 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 June
30, 2004, the amount of deferred revenues was $17.7 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 in April 2003. 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 us of up
to $5.0 million if certain development milestones are achieved. The product
is in pre-clinical development. 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 six months ended June 30, 2004 and 2003, Noven had
the following transactions with Novogyne (in thousands): Three Months
    
    Six Months2004
    
    2003
    
    2004
    
    2003Revenues:Product sales
    
    $
    4,886
    
    
    $
    6,086
    
    
    $
    10,694
    
    
    $
    9,016Royalties
    
    
    1,608
    
    
    
    968
    
    
    
    2,498
    
    
    
    2,199$
    6,494
    
    
    $
    7,054
    
    
    $
    13,192
    
    
    $
    11,215Reimbursed expenses
    
    $
    5,973
    
    
    $
    6,358
    
    
    $
    12,262
    
    
    $
    12,541
 As of June 30, 2004 and December 31, 2003, Noven had amounts due from
Novogyne of $3.5 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 six months ended June 30, 2004 and 2003 are as follows (in
thousands): Three Months
    
    Six Months2004
    
    2003
    
    2004
    
    2003Gross revenues
    
    $
    35,015
    
    
    $
    22,146
    
    
    $
    60,149
    
    
    $
    52,738Sales allowances
    
    
    3,517
    
    
    
    2,332
    
    
    
    6,289
    
    
    
    5,796Sales return allowances (reductions)
    
    
    (717
    )
    
    
    (1,995
    )
    
    
    292
    
    
    
    669Sales allowances and returns
    
    
    2,800
    
    
    
    337
    
    
    
    6,581
    
    
    
    6,465Net revenues
    
    
    32,215
    
    
    
    21,809
    
    
    
    53,568
    
    
    
    46,273Cost of sales
    
    
    6,697
    
    
    
    4,460
    
    
    
    11,532
    
    
    
    10,225Selling, general and
administrative expenses
    
    
    6,937
    
    
    
    7,621
    
    
    
    14,562
    
    
    
    15,504Amortization of intangible assets
    
    
    1,545
    
    
    
    1,545
    
    
    
    3,090
    
    
    
    3,090Income from operations
    
    
    17,036
    
    
    
    8,183
    
    
    
    24,384
    
    
    
    17,454Interest income
    
    
    13
    
    
    
    17
    
    
    
    53
    
    
    
    102Net income
    
    $
    17,049
    
    
    $
    8,200
    
    
    $
    24,437
    
    
    $
    17,556Novens equity in earnings of Novogyne
    
    $
    8,228
    
    
    $
    3,795
    
    
    $
    8,865
    
    
    $
    5,320
 The activity in the Investment in Novogyne account for the six months
ended June 30, 2004 is as follows (in thousands): Investment in Novogyne, beginning of period
    
    $
    28,368Equity in earnings of Novogyne
    
    
    8,865Cash distributions from Novogyne
    
    
    (12,263
    )Non-cash distribution from Novogyne (Note 7)
    
    
    (1,692
    )Investment in Novogyne, end of period
    
    $
    23,278
 Subject to the approval of Novogynes management committee, Novogyne
may, from time to time, distribute cash to Novartis and Noven based upon a
contractual formula. For the three and six months ended June 30, 2004,
Noven received cash distributions of $6.3 million and 11




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$12.3 million, respectively, from Novogyne. For the three and six
months ended June 30, 2003, Noven received cash distributions of $1.3
million and $12.0 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 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 six months ended June 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 publication in 2002 and 2003 of the results of a number of other
studies that found that the overall health risks from the use of certain HT
products exceed the benefits from the use of those products. In the first
quarter of 2004, the NIH discontinued the estrogen-only arm of the WHI study
because of an increased risk of stroke and because, after nearly seven years
of follow-up, the NIH determined that it had sufficient data to assess the
risks and benefits of estrogen use in the trial. This arm of the WHI study
also found that the use of an estrogen-only oral formulation appeared to
decrease the risk of hip fracture, and did not appear to affect heart
disease or to increase the risk of breast cancer. Researchers continue to
analyze data from both arms of the WHI study and other studies, and other
publications may be forthcoming. These studies and others have caused the HT market, and the market for
Novens products, to significantly decline. Prescriptions for CombiPatch,
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 of the product recall, in 2003, Noven and Novogyne
established allowances for the return of recalled product, which had the
effect of reducing Noven and Novogynes net revenues by approximately $1.4
million and $6.5 million, respectively, for the year ended December 31,
2003. Based on their review of currently available information, including
actual product returns and future expected returns, Noven and 12




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Novogyne reduced these allowances during the six months ended June 30,
2004, which had the effect of increasing net revenues for the three months
ended June 30, 2004 by $0.6 million and $2.4 million for Noven and Novogyne,
respectively, and by $0.6 million and $3.1 million for the six months ended
June 30, 2004 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 $1.7 million and $2.0 million for the three and six
months ended June 30, 2004, respectively. The effect on Novogyne of
Novogynes adjustment was to increase Novogynes income before income taxes
by $1.9 million and $2.6 million for the three and six months ended June 30,
2004, respectively. At June 30, 2004, allowances for recall related returns were $0.1
million and $0.3 million at Noven and Novogyne, respectively. In addition,
Noven had $0.1 million remaining in reserves for expected costs related to
the product recall. The CombiPatch stability failures resulted from a production issue
related to a problematic raw material supplied by one vendor. After
addressing the issues with the specific raw material, Noven continues to
manufacture and ship CombiPatch to Novogyne and there was no interruption of
trade supplies. The Vivelle-Dot production issue resulted from the use of certain rolls
of patch backing material provided by a raw material supplier. Noven
believes that the Vivelle-Dot product currently in distribution and in its
inventory will maintain required stability. If Novens estimate concerning
the scope of, or amount of, expected product returns is incorrect or if
Novartis should initiate further unexpected recalls, then Novens results of
operations could be materially and adversely impacted. 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 defendants violated the
Securities Exchange Act of 1934 by making false and misleading statements in
its public disclosures regarding Novens MethyPatch product. Following the
filing of Plaintiffs complaint, five other substantially similar complaints
were filed against Noven and its officers named as defendants in the above
referenced action. In response to a joint motion, on or about January 6,
2004, the Court entered an order consolidating the six related actions.
Pursuant to this order, plaintiffs must file a consolidated class action
complaint not later than 60 days after the entry of an order appointing lead
plaintiff and lead counsel. An order appointing lead plaintiff and lead
counsel has not yet been entered. This development did not have a material
effect on the action or on Novens financial position or results of
operations. Noven believes the lawsuit is without merit, and intends to vigorously
defend the lawsuit, but its outcome cannot be predicted. The lawsuit, if
determined adversely to Noven, could have a material adverse effect on
Novens financial position and results of operations. Novens ultimate
liability, if any, with respect to the lawsuit is presently not
determinable. 13




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On July 30, 2004, Noven became aware that an individual plaintiff
and her husband filed a complaint in Superior Court of New Jersey Law
Division, Atlantic County as of July 8, 2004, 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 it has been named as a defendant in several 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. 14




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Item 2. Managements Discussion and Analysis of Financial Condition and Results of Operations The following section addresses material aspects of Novens financial
condition at June 30, 2004, and the results of operations for the three and six
months ended June 30, 2004 and 2003. The contents of this section include:  
    
    An overview of Noven and recent developments related to:  
    
    its menopausal hormone therapy business;  
    
    MethyPatch® and our collaboration with Shire;  
    
    our collaboration with P&G Pharmaceuticals; and  
    
    production issues and the allowances that we
established for recall-related returns;  
    
    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 six months ended June 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 second quarter of 2004, total
prescriptions dispensed in the HT market in the United States declined by 47%.
For the same period, aggregate prescriptions for Novens United States products
decreased 14%. The estrogen segment of the HT market in the United States
declined 42%, while our Vivelle product family decreased 7%. Vivelle-Dot,
which represented 78% of our total United States prescriptions in the second
quarter of 2004, increased 12% from the second quarter of 2002 to the second
quarter of 2004. We believe Vivelle-Dot patch prescriptions have benefited
from patient conversions from original Vivelle. At the end of the second
quarter of 2004, the Vivelle family held a 42% share of total estrogen patch
prescriptions in the United States, compared to a 35% share at the end of the
second quarter of 2002. Our Vivelle-Dot estrogen patch is currently the most
frequently dispensed estrogen patch in the United States. We believe this is
due in part to the beneficial wear characteristics made possible by our
technology. 15




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United States prescriptions for our CombiPatch product (which represented
approximately 14% of our total United States prescriptions in the second
quarter of 2004) declined 43% 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 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. Shire We are developing a transdermal methylphenidate patch for Attention
Deficit Hyperactivity Disorder. Global rights to the developmental product are
licensed to Shire. In April 2003, we received a not approvable letter from the
FDA relating to our 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 intend to proceed 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 we have committed to fund them. We estimate that the
additional studies will cost up to $13.0 million, and we expect to incur
additional costs, which may include clinical supply costs, consulting costs and
other costs associated with our pursuit of marketing approval for MethyPatch.
Our 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 our research and
development expenses in 2004, although the direct expenses incurred in pursuit
of MethyPatch approval will reduce our cash position and will have the effect
of reducing the amount of deferred revenues that we may recognize in future
periods. As of June 30, 2004, the amount of deferred revenues was $17.7
million (which excludes the $5.0 million of deferred revenues related to the
repurchase right described below) and we do not expect our costs 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 our 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 us,
and we would retain the $25.0 million previously paid by Shire in April 2003.
Shire continues to have the right to require us to repurchase the product
rights to MethyPatch for $5.0 million under certain circumstances. In June 2004, we entered into an agreement with Shire for the development
of a transdermal amphetamine patch for Attention Deficit Hyperactivity
Disorder. The agreement provides for the 16




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payment to us of up to $5.0 million if certain development milestones are
achieved. The product is in pre-clinical development. P&G Pharmaceuticals In April 2003, we established a collaboration with 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 three and six months ended June 30, 2004, we
recognized as contract revenues $0.8 million and $1.2 million, respectively, in
development milestones under this collaboration based on P&G Pharmaceuticals
determination that we had met the applicable performance criteria. No
development milestones under this collaboration were recognized for the same periods in 2003. Potential
development milestones totaling $3.6 million remain to be earned under the
collaboration. 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 of the product recall, in 2003, Noven and Novogyne established
allowances for the return of recalled product, which had the effect of reducing
Noven and Novogynes net revenues by $1.4 million and $6.5 million,
respectively, for the year ended December 31, 2003. Based on their review of
currently available information, including actual product returns and future
expected returns, Noven and Novogyne reduced these allowances during the six
months ended June 30, 2004, which had the effect of increasing net revenues for
the three months ended June 30, 2004 by $0.6 million and $2.4 million for Noven
and Novogyne, respectively, and by $0.6 million and $3.1 million for the six
months ended June 30, 2004 for Noven and Novogyne, respectively. The effect on
Noven of these adjustments by Noven and Novogyne was to increase our income
before income taxes by $1.7 million and $2.0 million for the three and six
months ended June 30, 2004, respectively. The effect on Novogyne of Novogynes
adjustment was to increase Novogynes income before income taxes by $1.9
million and $2.6 million for the three and six months ended June 30, 2004,
respectively. At June 30, 2004, allowances for recall related returns were $0.1 million
and $0.3 million at Noven and Novogyne, respectively. In addition, we had $0.1
million remaining in reserves for expected costs related to the product recall. 17




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Results of Operations Three and six months ended June 30, 2004 compared to the three and six months ended June 30, 2003 Revenues Total revenues for the three and six months ended June 30, 2004 and 2003
are summarized as
follows (dollar amounts in thousands): Three Months
    
    Six Months2004
    
    2003
    
    % Change
    
    2004
    
    2003
    
    
    % ChangeProduct revenues  Novogyne:Product sales
    
    $
    4,886
    
    
    $
    6,086
    
    
    
    (20
    %)
    
    $
    10,694
    
    
    $
    9,016
    
    
    
    19
    %Royalties
    
    
    1,608
    
    
    
    968
    
    
    
    66
    %
    
    
    2,498
    
    
    
    2,199
    
    
    
    14
    %6,494
    
    
    
    7,054
    
    
    
    (8
    %)
    
    
    13,192
    
    
    
    11,215
    
    
    
    18
    %Product revenues  third parties:Product sales
    
    
    3,489
    
    
    
    3,753
    
    
    
    (7
    %)
    
    
    6,327
    
    
    
    8,713
    
    
    
    (27
    %)Royalties
    
    
    75
    
    
    
    33
    
    
    
    N/M
    
    
    214
    
    
    
    30
    
    
    
    N/M3,564
    
    
    
    3,786
    
    
    
    (6
    %)
    
    
    6,541
    
    
    
    8,743
    
    
    
    (25
    %)Total product revenues
    
    
    10,058
    
    
    
    10,840
    
    
    
    (7
    %)
    
    
    19,733
    
    
    
    19,958
    
    
    
    (1
    %)License and contract revenues:Contract
    
    
    853
    
    
    
    39
    
    
    
    N/M
    
    
    1,372
    
    
    
    65
    
    
    
    N/MLicense
    
    
    1,044
    
    
    
    1,382
    
    
    
    (24
    %)
    
    
    1,980
    
    
    
    2,263
    
    
    
    (13
    %)1,897
    
    
    
    1,421
    
    
    
    33
    %
    
    
    3,352
    
    
    
    2,328
    
    
    
    44
    %Net revenues
    
    $
    11,955
    
    
    $
    12,261
    
    
    
    (2
    %)
    
    $
    23,085
    
    
    $
    22,286
    
    
    
    4
    %
 N/M  not meaningful Net Revenues As described in more detail below, the decrease in net revenues for the
three months ended June 30, 2004 as compared to the same period in 2003 was
primarily attributable to lower unit sales of our products and a decrease in
license revenue. These decreases were partially offset by an increase in our
royalties and contract revenue due to the attainment of certain product
development milestones. Net revenues also benefited from a reduction in the
allowances for returns related to product recalls. As described in more detail below, the increase in net revenues for the
six months ended June 30, 2004 as compared to the same period in 2003 was
primarily attributable to higher unit sales of our U.S. products and an
increase in contract revenue due to the attainment of certain product
development milestones. Net revenues also benefited from a reduction in the
allowances for returns related to product recalls. This increase was partially
offset by a decline in unit sales of our international products and a decrease
in our license revenue. 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. 18




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The $0.6 million decrease in product revenues from Novogyne for the three
months ended June 30, 2004 as compared to the same period in the prior year
primarily related to lower unit sales of all products, of which the most
significant was a $1.1 million decline in CombiPatch unit sales. CombiPatch
unit sales increased in the second quarter of 2003 after we temporarily
suspended shipment of this product to Novogyne in the first quarter of 2003 as
a result of a production issue. The decrease in our product sales was
partially offset by higher royalties of $0.6 million due to higher Novogyne
sales of Vivelle family products. Product revenues also benefited from a $0.6
million reduction in allowances for returns established in the prior year
related to product recalls. The $2.0 million increase in product revenues from Novogyne for the six
months ended June 30, 2004 as compared to the same period in the prior year
primarily relates to $2.5 million in higher unit sales for Vivelle-Dot. This
increase also included the $0.6 million reduction in allowances for returns
discussed above. This increase was primarily due to lower sales in the prior
period resulting from inventory reduction initiatives intended to align
inventories with post-WHI demand. 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 $0.2 million decrease in product revenues from third parties for the
three months ended June 30, 2004 as compared to the same period in the prior
year primarily related to $1.7 million in lower unit sales of Estalis, our
combination estrogen/progestin patch. The decline in Estalis reflected lower
prescription trends following the publication of the combination therapy arm of
the WHI study and other studies. This decrease in product revenues  third
parties was partially offset by $1.1 million in higher unit sales of Estradot.
We believe this increase was primarily attributable to Novartis Pharma
restocking inventory in certain countries. The $2.2 million decrease in product revenues from third parties for the
six months ended June 30, 2004 as compared to the same period in the prior year
primarily related to $3.4 million in lower unit sales of Estalis, partially
offset by $1.3 million in higher unit sales of Estradot, each of which was
attributable to the same factors noted above for the three months ended June
30, 2004. License and Contract Revenues The increase in contract revenues for the three and six months ended June
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 three and six months ended June 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. Beginning in the third quarter of 2003, we ceased amortization of
the unamortized balance of license revenue received in the Shire transaction
due to the planned initiation of an additional clinical trial and the
significant costs expected to be incurred in pursuing MethyPatch® approval. As
described above under Overview  Shire our direct costs incurred in pursuit
of approval are expected to be deferred and offset against a portion of the $25
million deferred revenue previously received from Shire. 19




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Gross Margin Gross margin for the three and six months ended June 30, 2004 and 2003 are
summarized as follows (dollar amounts in thousands): Three Months
    
    Six Months2004
    
    2003
    
    % Change
    
    2004
    
    2003
    % ChangeTotal product revenues
    
    $
    10,058
    
    
    $
    10,840
    
    
    
    (7
    %)
    
    $
    19,733
    
    
    $
    19,958
    
    
    
    (1
    %)Gross profit (product revenues
less cost of products sold)
    
    
    5,083
    
    
    
    4,800
    
    
    
    6
    %
    
    
    9,240
    
    
    
    9,633
    
    
    
    (4
    %)Gross margin (gross profit as a
percentage of product revenues)
    
    
    51
    %
    
    
    44
    %
    
    
    
    
    
    
    47
    %
    
    
    48
    %
 The increase in gross margin for the three months ended June 30, 2004 as
compared to the same period in the prior year was primarily due to a decrease
of $0.6 million in the deferred profit related to sales of product to Novogyne.
We defer 49% of the profit on product we sell to Novogyne until that product
is sold by Novogyne to trade customers. As a result, if Novogyne sells more
product than we provide it in a given period (i.e., if Novogynes inventories
decline), we will defer less profit from Novogyne, which increases our gross
margin for that period. The decrease in the deferred profit on sales to
Novogyne for the three months ended June 30, 2004 as compared to the prior
period reflected the combined impact of Novogynes increased sales to trade
customers and our reduced sales to Novogyne in the current period in comparison
to the same period in the prior year. The increase in gross margin for the
three months ended June 30, 2004 was also due to a $0.6 million reduction in
the reserve we established for the 2003 product recall. Additionally, an
increase in product royalties had a favorable impact on gross margin when
compared to prior year. Gross margin was consistent for the six months ended
June 30, 2004 and 2003. Operating Expenses Operating expenses for the three and six months ended June 30, 2004 and 2003
are summarized as follows (dollar amounts in thousands): Three Months
    
    Six Months2004
    
    2003
    
    % Change
    
    2004
    
    2003
    
    % ChangeResearch and development
    
    $
    2,734
    
    
    $
    2,154
    
    
    
    27
    %
    
    $
    4,989
    
    
    $
    4,647
    
    
    
    7
    %Marketing, general and
administrative
    
    
    3,762
    
    
    
    3,293
    
    
    
    14
    %
    
    
    7,666
    
    
    
    7,474
    
    
    
    3
    %
 Research and Development The $0.6 million and $0.3 million increase in research and development
expenses for the three and six months ended June 30, 2004, respectively, as
compared to the same period in 2003 was primarily attributable to an increase
in non-clinical development expenses related to our fentanyl transdermal system
and other projects. 20




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Marketing, General and Administrative The $0.5 million increase in marketing, general and administrative
expenses for the three months ended June 30, 2004 as compared to the same
period in 2003 was primarily attributable to $0.3 million of increased
consulting and professional fees primarily related to new requirements
resulting from Sarbanes-Oxley. The $0.2 million increase in marketing, general and administrative
expenses for the six months ended June 30, 2004 as compared to the same period
in 2003 was primarily attributable to $0.6 million of increased compensation
costs, $0.5 million of increased consulting and professional fees primarily
related to new requirements resulting from Sarbanes-Oxley, and $0.3 million of
increased insurance costs. This increase was partially offset by a $1.3
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. Income Taxes Our effective tax rate was approximately 36% for each of the three and six
months ended June 30, 2004 and 2003. The provision for income taxes is based on
the Federal statutory and state income tax rates. Net deferred income tax
assets are measured using the average graduated tax rate for the estimated
amount of annual taxable income in the years that the liability is expected to
be settled or the asset recovered. The effect of adjusting the expected tax
rate related to the net deferred income tax assets is included in the provision
for income taxes. As of June 30, 2004, we had a net deferred tax asset of
$21.8 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 six months ended June
30, 2004 and 2003 are summarized as follows (dollar amounts in thousands): Three Months
    
    Six Months2004
    
    2003
    
    % Change
    
    2004
    
    2003
    
    % ChangeGross revenues1
    
    $
    35,015
    
    
    $
    22,146
    
    
    
    58
    %
    
    $
    60,149
    
    
    $
    52,738
    
    
    
    14
    %Sales allowances
    
    
    3,517
    
    
    
    2,332
    
    
    
    51
    %
    
    
    6,289
    
    
    
    5,796
    
    
    
    9
    %Sales returns allowances (reductions)
    
    
    (717
    )
    
    
    (1,995
    )
    
    
    (64
    %)
    
    
    292
    
    
    
    669
    
    
    
    (56
    %)Sales allowances and returns
    
    
    2,800
    
    
    
    337
    
    
    
    731
    %
    
    
    6,581
    
    
    
    6,465
    
    
    
    2
    %Net revenues
    
    
    32,215
    
    
    
    21,809
    
    
    
    48
    %
    
    
    53,568
    
    
    
    46,273
    
    
    
    16
    %Cost of sales
    
    
    6,697
    
    
    
    4,460
    
    
    
    50
    %
    
    
    11,532
    
    
    
    10,225
    
    
    
    13
    %Gross profit
    
    
    25,518
    
    
    
    17,349
    
    
    
    47
    %
    
    
    42,036
    
    
    
    36,048
    
    
    
    17
    %Gross margin percentage
    
    
    79
    %
    
    
    80
    %
    
    
    
    
    
    
    78
    %
    
    
    78
    %Selling, general and
administrative expenses
    
    
    6,937
    
    
    
    7,621
    
    
    
    (9
    %)
    
    
    14,562
    
    
    
    15,504
    
    
    
    (6
    %)Amortization of intangible asset
    
    
    1,545
    
    
    
    1,545
    
    
    
    
    
    
    
    3,090
    
    
    
    3,090
    
    
    
    Income from operations
    
    
    17,036
    
    
    
    8,183
    
    
    
    108
    %
    
    
    24,384
    
    
    
    17,454
    
    
    
    40
    %Interest income
    
    
    13
    
    
    
    17
    
    
    
    (24
    %)
    
    
    53
    
    
    
    102
    
    
    
    (48
    %)Net income
    
    $
    17,049
    
    
    $
    8,200
    
    
    
    108
    %
    
    $
    24,437
    
    
    $
    17,556
    
    
    
    39
    %Novens equity in earnings of Novogyne
    
    $
    8,228
    
    
    $
    3,795
    
    
    
    117
    %
    
    $
    8,865
    
    
    $
    5,320
    
    
    
    67
    %
   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 $12.9 million for the three months ended June 30,
2004 compared to the prior year, primarily due to $12.0 million in increased
sales of Vivelle-Dot. The Vivelle-Dot increase was primarily due to increased
unit sales. Because underlying prescriptions for Vivelle-Dot increased only
slightly from period to period, we believe the increase in Vivelle-Dot sales
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. We
believe Novogynes revenues in the second quarter of 2004 may have benefited as
trade customers replenished inventories depleted during the first quarter of
2004. Gross revenues increased $7.4 million for the six months ended June 30,
2004 compared to the prior year, primarily due to $6.6 million in increased
sales of Vivelle-Dot and $2.7 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 $4.4 million of the Vivelle-Dot increase
was due to price, while the remaining $2.2 million increase related to
increased unit sales. This increase in sales was partially offset by a $1.0
million decrease in sales of Vivelle, our first generation estrogen patch, and
$0.8 million decrease in sales of CombiPatch due to a continuing decline in the
market for combination therapies after the publication of the combination arm
of the WHI study. 22




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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 10%
and 11% of gross revenues for the three months ended June 30, 2004 and 2003,
respectively, and 10% and 11% of gross revenues for the six months ended June
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 June 30, 2004, there was a net reduction in sales return
allowances of $0.7 million, consisting of an increase in allowances for
expiring product of $1.7 million, offset by a $2.4 million decrease in the
allowances for returns for product recalls. Novogyne increased its allowances
for returns of expiring product primarily due to higher unit sales of
Vivelle-Dot. Unit sales are one of the significant factors considered in
assessing the adequacy of allowances for returns of expiring product. Novogyne
decreased its allowances for returns for product recalls in the quarter
ended June 30, 2004 based on an analysis of currently available information relating to the product
recalls initiated in 2003, including actual returns received in the recalls to
date and an estimate of remaining returns expected to be received in the
recalls. At June 30, 2004, Novogynes remaining product recall allowances were
$0.3 million. For the three months ended June 30, 2003, there was a net
reduction in sales return allowances of $2.0 million, all of which was related
to allowances for returns of expiring product due to the
analysis of actual returns and other factors at the time. For
the six months ended June 30, 2004, there was a net increase in sales
return allowances of $0.3 million, consisting of an increase in allowances for
expiring product of $3.4 million 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 sales of Vivelle-Dot. Novogyne
decreased its allowances for returns for product recalls in the six months ended June 30, 2004
based on its on-going analysis of available information relating to the product
recalls initiated in 2003. For the six months ended June 30,
2003, there was a net increase in sales
return allowances of $0.7 million, all of which was related to allowances for expiring product
due to the analysis of actual returns and other factors at the
time. Novogyne Gross Margin The decline in gross margin for the three months ended June 30, 2004 as
compared to the same period in 2003 was primarily due to higher sales
allowances and returns, which decreased net revenues without affecting cost of
goods sold. Gross margin was consistent for the six months ended June 30, 2004
and 2003, respectively. Novogyne Selling, General and Administrative Expenses Selling, general and administrative expenses for the three and six months
ended June 30, 2004 decreased $0.7 million and $0.9 million, respectively,
which was primarily attributable to lower samples expense due to timing of
orders. 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 June 30, 2004 and
2003 and $3.1 million for each of the six month periods ended June 30, 2004 and 2003.
Our CombiPatch product was licensed by Novogyne in March 2001. 23




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Liquidity and Capital Resources As of June 30, 2004 and December 31, 2003, we had $106.8 million and $83.4
million in cash and cash equivalents, and working capital of $94.6 million and
$76.7 million, respectively. Cash provided by (used in) operating, investing and financing activities
for the six months ended June 30, 2004 and 2003 is summarized as follows
(amounts in thousands): 2004
    
    2003Cash flows:Operating activities
    
    $
    20,732
    
    
    $
    29,528Investing activities
    
    
    (2,575
    )
    
    
    (3,277
    )Financing activities
    
    
    5,272
    
    
    
    (1,146
    )
 Operating Activities Net cash provided by operating activities for the six months ended June
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. Net cash provided by operating activities for the six months ended June
30, 2003 primarily resulted from the receipt of a $25.0 million license payment
from Shire and a $12.0 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 six months ended June 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 six months ended June
30, 2004 was primarily attributable to $5.3 million received in connection with
the issuance of common stock from the exercise of stock options. Net cash used in financing activities for the six months ended June 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
six months ended June 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. 24




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Our short-term cash flow is dependent on sales, royalties and license fees
associated with transdermal HT products. Any decrease in sales of those
products by us or our licensees or any increase in returns of products to
Novogyne (including any such changes resulting from the recent or ongoing HT
studies), the further decline of the HT market, or the inability or failure of
Novogyne to pay distributions would have a material adverse effect on our
short-term liquidity and require us to rely on our existing cash balances or on
borrowings to support our operations and business. We also expect our funding of any additional studies for our MethyPatch
product will have a negative impact on our short-term liquidity. We cannot
assure that MethyPatch will be approved by the FDA, particularly in light of
the not approvable letter we received from the FDA in April 2003, and there is
no assurance that the additional studies that Noven and Shire propose to
conduct 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 up to $5.2 million in
capital expenditures during the remainder of 2004 primarily in preparation for
the expected launch of new products, including our fentanyl patch.
Such amount includes purchase obligations at June 30, 2004 for
fentanyl of $3.7 million. In
addition, in the remainder 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
launch supplies are manufactured prior to receipt of FDA approval of our
fentanyl patch and approval is delayed or not ultimately received, our
agreement with Endo provides that we will share with Endo the cost of
manufacturing product that cannot be sold by Endo, in accordance with an
agreed-upon formula. In that case, we cannot assure that Endo would be able to
sell any of the product that had been produced. Accordingly, we cannot assure
that we would be able to offset all of our up-front production costs of launch
inventories with sales of the product. 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 a new
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
June 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 for 2004 is
provided below. This information is based on our current assumptions and
expectations, many of which are beyond our control to achieve. This
information is also premised on our current assumption that during 2004 there
will not be any unforeseen material:  
    
    transactions;  
    
    changes in Novens or Novogynes accounting or accounting principles;  
    
    regulatory, technological or clinical study developments;  
    
    changes in the supply of, demand for, or distribution
of our HT products (including any changes resulting from the
impact of competitive HT products that have been launched in
2004);  
    
    changes in our business relationships/collaborations; or  
    
    changes in the economy or the health care sector generally. 26




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##### Table of Contents



If our assumptions or expectations concerning these matters prove to be
incorrect, our actual financial results could differ materially from the
expected results discussed below. Accordingly, we cannot assure that we will
achieve results consistent with this guidance. For a discussion of these and
other factors that may impact our actual financial results for 2004, we refer
you to the risks, uncertainties and cautionary factors discussed below under
the caption Cautionary Factors that May Impact Future Results as well as
those discussed in our Form 10-K for the year ended December 31, 2003. For full-year 2004, we currently expect:  
    
    Novens net revenues to approximate 2003 results;  
    
    Novens research and development spending in 2004 to
increase compared to 2003;  
    
    Novens fully diluted earnings per share to be in the $0.40 to $0.45 range; and  
    
    Novogynes 2004 net revenues and net income to approximate 2003 results. As has historically been the case, Novogynes operating results are
expected to continue to fluctuate by quarter, in part due to the timing of
orders placed by trade customers, which we believe is driven by the inventory
needs of each customer and other factors, and does 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 will be approximately offset by an increase in Novens other
revenue sources. We expect capital expenditures in 2004 to increase by up to
$3.1 million 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 MethyPatch and products under our P&G Pharmaceuticals
collaboration. In the second quarter of 2004, we recognized as contract revenues a $0.8
million development milestone under our collaboration with P&G Pharmaceuticals.
Potential development milestones totaling $3.6 million remain to be earned
under the P&G Pharmaceuticals collaboration. In May 2004, Noven and Shire met with the FDA to review a jointly prepared
development plan intended to address issues raised in the MethyPatch not
approvable letter. Based on feedback resulting from the meeting,
Noven and Shire intend to proceed with the development of MethyPatch.
Development efforts are expected to include additional clinical studies,
including another Phase 3 study. We estimate that the additional studies will
cost up to $13.0 million, and we expect to incur additional costs which may
include clinical supply costs, consulting costs and other costs associated with
our pursuit of MethyPatch approval. Under our agreements with Shire, we have
committed to fund any additional studies, and we expect to defer and offset our
direct costs incurred in any additional studies against a portion of the $25.0
million deferred revenue that we previously received from Shire. Such expenses
are not expected to impact our research and development expenses in 2004,
although the direct expenses incurred in pursuit of MethyPatch approval will
reduce our cash position and will have the effect of reducing the amount of
deferred revenues that we may recognize in future periods. As of June 30,
2004, the amount of deferred revenues was $17.7 million (which excludes the $5
million of deferred revenues related to Shires right to require us to
repurchase product rights under certain circumstances) and we do not expect our
costs 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. If development is not successfully completed,
or if MethyPatch is not approved or launched, we will not receive additional
milestone payments or manufacturing revenues from Shire. 27




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In June 2004, we signed an agreement with Shire for the development of a
transdermal amphetamine patch for ADHD. The agreement provides for payments to
us of up to $5.0 million if certain development milestones are achieved. The
product is in pre-clinical development. Based on the current patent and exclusivity status of Johnson & Johnsons
Duragesic fentanyl patch, we believe that the earliest our generic fentanyl
patch (licensed to Endo) could be launched in the United States is January
2005, assuming FDA approval is received by that time, but we cannot give any
assurance that we will receive FDA approval by that time or at all. In
addition to the fentanyl license, we have established a collaboration with Endo
to seek to identify and develop new transdermal therapies and we expect to
undertake feasibility studies for selected compounds in 2004. Cautionary Factors that May Impact Future Results Except for historical information contained herein, the matters discussed
in this report are forward-looking statements made pursuant to the safe
harbor provisions of the Private Securities Litigation Reform Act of 1995.
These forward-looking statements include, but are not limited to, statements
about our and our licensees respective plans, objectives, expectations,
estimates, strategies, prospects, product approvals and development plans, and
anticipated financial results. These statements are typically identified by
the use of terms such as anticipates, believes, estimates, hopes,
expects, intends, may, plans, could, should, will, would and
similar words. These statements are based on our current expectations and
beliefs concerning future events and are subject to risks and uncertainties
that could cause actual results to differ materially from those expressed
herein. We do not undertake to update any of these forward-looking statements
or to announce the results of any revisions to these forward-looking statements
except as required by law. In addition to the factors described elsewhere in
this report and in our Form 10-K for the year ended December 31, 2003, the
risks and uncertainties in the following categories, among others, as well as
our success at managing those risks, could cause our actual results to differ
materially from those expressed in any forward-looking statements: HT Market,risks associated with increased competition in the HT market,
including as a result of the 2004 launches of estrogen cream and gel products,
each of which is a new dosage form in this category; any further impact on our
HT business due to the announcement of additional negative clinical results or
otherwise, which could reduce or eliminate any profit contribution by Novogyne
to us and/or sales of HT products from us to Novartis Pharma; uncertainties
regarding any future regulatory developments resulting from those studies; the
risk that Novogyne may not be able to realize the full value of the marketing
rights for our CombiPatch product; 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 DEA regulations related to our purchase, storage
and usage of controlled substances in products we may manufacture, including
MethyPatch and our 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 28




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materials and compounds used in our products; uncertainties regarding the
timing and magnitude of any product recalls; the impact of the recalls or
related issues on Novartis or other partners strategy for the
commercialization of our products; the possibility that our estimates of the
impact of future returns and charges may prove inaccurate, incomplete or
otherwise incorrect; the impact of detected or undetected product stability
failures or other product defects on our ability to estimate our reserves for
sales returns and other associated accounting consequences. Our Partners,the risk that our development partners may have different or
conflicting priorities than ours which may adversely impact their ability or
willingness to assist in the development and commercialization of our products
or to continue the development programs in which they and we have partnered;
uncertainties regarding our ability to attract additional development partners;
the possibility that our technologies may not be approvable or suitable for use
in additional therapeutic categories, including those categories addressed
through products developed with our development partners; the possibility that
we may be unsuccessful in achieving milestone objectives under our development
programs and may not receive any further payments; the possibility that our
development programs may not proceed on schedule or as expected, which could,
among other things, prevent us from achieving milestone objectives under our
development programs and/or cause delays or cancellations of programs; the
possibility that our current development priorities could render us unable to
advance our other development projects or increase the cost of advancing those
projects; risks related to our dependence on Novartis to perform Novogynes
financial, accounting, inventory, distribution, revenues and sales deductions
functions (including any asset impairment decisions for Novogyne), including
the risk that Novartis may perform these functions differently than we would
have, inadequately or incorrectly; 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 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 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 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 million
received from Shire could change under certain circumstances, including if the
parties MethyPatch product strategy changes or if our MethyPatch product
development is discontinued; and the likelihood that our development strategy
would change if Shire were to terminate the agreement under certain
circumstances, or if our MethyPatch product were not ultimately approved or
were abandoned. Fentanyl Patch,the risks and uncertainties associated with the FDAs
review of Novens fentanyl Abbreviated New Drug Application; the possibility
that milestone payments may be reduced and/or that Endo may exercise its
contractual right to terminate the license agreement if the product launch is
delayed for any reason, including delay in obtaining FDA approval; patent or
other 29




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strategies by third parties could delay or prevent the launch of our
fentanyl patch or other products; the possibility that we may be unable to
recover significant costs to manufacture fentanyl patches prior to product
launch if FDA approval is not obtained on a timely basis or at all; and the
possibility that, even if approved, our fentanyl patch or other products may
not be successfully commercialized due to competitive market conditions or
other factors, including physician/patient preferences for other therapies. Other Matters,expected fluctuations in quarterly revenues and research
and development expenses; and uncertainties associated with our beliefs
regarding the timing of trade customer orders. 
 Item 3. Quantitative and Qualitative Disclosure About Market Risk Not Applicable. 
 Item 4. Controls and Procedures Pursuant to Exchange Act Rule 13a-15, as of the end of the quarterly
period covered by this report, we carried out an evaluation, under the
supervision and with the participation of our management, including our Chief
Executive Officer and Chief Financial Officer, of the effectiveness of our
disclosure controls and procedures. In addition, we reviewed our internal
controls, and there have been no significant changes in our internal controls
or in other factors that could significantly affect those controls subsequent
to the date of the last evaluation. Based upon that evaluation, the Chief
Executive Officer and Chief Financial Officer concluded that our disclosure
controls and procedures are effective in timely alerting them to material
information relating to Noven required to be included in our periodic
Securities and Exchange Commission filings. However, that conclusion should be
considered in light of the various limitations described below on the
effectiveness of those 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 1. Legal
Proceedings On July 30, 2004, we became aware that an individual plaintiff and
her husband filed a complaint in Superior Court of New Jersey Law
Division, Atlantic County as of July 8, 2004, 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 us and
distributed by Novogyne. The plaintiffs claim compensatory, punitive and
other damages in an unspecified amount. In addition, Novartis has advised us that it has been named as a
defendant in several 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 our products,
Vivelle, Vivelle-Dot and CombiPatch. To date neither Noven, nor Novogyne
has, to our 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 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. 
 Item 2. Changes in Securities and Use of Proceeds The following table provides information with respect to our stock
repurchases during the second quarter of 2004: Total Number of
    
    ApproximateShares
    
    Dollar ValueAverage Price
    
    Purchased as
    
    That May Yet beTotal Number of
    
    Paid
    
    Part of Publicly
    
    Purchased underShares Purchased
    
    Per Share
    
    Announced Program
    
    the Program(1)April 1, 2004 to
April 30, 2004
    
    
    
    
    
    
    
    
    
    
    
    
    
    $
    23,711,040May 1, 2004 to
May 31, 2004
    
    
    
    
    
    
    
    
    
    
    
    
    
    $
    23,711,040June 1, 2004 to
June 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 million of our Common Stock. There is no expiration
date specified for this program. 
 Item 4. Submission of Matters to a Vote of Security Holders The
following proposals were approved at our Annual Meeting of Stockholders
held on May 18, 2004: 1. Election of Directors For
    
    WithheldSidney Braginsky
    
    
    20,927,342
    
    
    
    179,859John G. Clarkson, M.D.
    
    
    20,932,502
    
    
    
    174,699Donald A. Denkhaus
    
    
    20,932,402
    
    
    
    174,799Robert G. Savage
    
    
    20,932,502
    
    
    
    174,699Robert C. Strauss
    
    
    20,912,582
    
    
    
    194,619Wayne P. Yetter
    
    
    20,917,002
    
    
    
    190,199
 2. Amendments to the Noven Pharmaceuticals, Inc. 1999 Long-Term Incentive Plan For
    
    Against
    
    Abstained
    
    Broker Non-Votesa13,922,492
    
    3,416,912
    
    31,565
    
    3,736,232
  a.
    
    Brokers lacked discretionary voting power for the proposal to amend
the 1999 Long-Term Incentive Plan. Broker Non-Votes represent those
shares that brokers did not receive voting instructions from the
beneficial owner and for which such brokers did not vote because they
lacked discretionary voting power. 31




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3. Ratification of the Appointment of Deloitte & Touche LLP as our Independent Accountant for 2004 For
    
    Against
    
    Abstained20,860,805
    
    231,936
    
    14,460
 
 Item 6. Exhibits and Reports on Form 8-K  (a)
    
    Exhibits 10.1
    
    Agreement between Shire U.S. Inc. and Noven, dated June
15, 2004 (with certain provisions omitted pursuant to Rule 24b-2)31.1
    
    Certification of Robert C. Strauss, President, Chief
Executive Officer and Chairman of the Board pursuant to 18 U.S.C.
Section 1350, as Adopted Pursuant to Section 302 of the
Sarbanes-Oxley Act of 200231.2
    
    Certification of Diane M. Barrett, Vice President and
Chief Financial Officer, pursuant to 18 U.S.C. Section 1350, as
Adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of 200232.1
    
    Certification of Robert C. Strauss, President, Chief
Executive Officer and Chairman of the Board, pursuant to 18 U.S.C.
Section 1350, as Adopted Pursuant to Section 906 of the
Sarbanes-Oxley Act of 200232.2
    
    Certification of Diane M. Barrett, Vice President and
Chief Financial Officer, pursuant to 18 U.S.C. Section 1350, as
Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
  (b)
    
    Reports on Form 8-K We did not file any reports on Form 8-K during the three months ended
June 30, 2004. 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: August 3, 2004
    By:
    /s/ Diane M. BarrettDiane M. BarrettVice President and
Chief Financial Officer 33