**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

 

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**FORM 10-Q**

 

**(Mark One)**

 

|                                               | **ý** | ** ** | **QUARTERLY  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE  ACT OF 1934**  |
|----------------------------------------------------|------------|------------|----------------------------------------------------------------------------------------------------------|
|                                               |
| **For the  Quarter Ended September 30, 2004** |
| ** **                                         |
| **or**                                             |
| ** **                                         | ** ** | ** ** | ** **                                                                                               |
|                                               | **o**      | ** ** | **TRANSITION  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE  ACT OF 1934** |

 

**Commission file****number 333-12570**

 

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**STRESSGEN BIOTECHNOLOGIES CORPORATION**

(Exact name of registrant as specified in its charter)

 
| **Yukon  Territory, Canada**                                                                                                                            | ** ** | **N/A**                            |
|---------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------------------|
| (State of incorporation)                                                                                                                                | ** ** | (IRS Employer  Identification No.) |
|                                                                                                                                                    | ** ** | ** **                         |
| **350-4243 Glanford Avenue  Victoria, British Columbia V8Z 4B9****Parent  of Stressgen Biotechnologies, Inc.  6055 Lusk Boulevard  San Diego, CA** | ** ** | **92121**                          |
|  (Address of principal executive  offices)                                                                                                         | ** ** | (zip code)                         |
| ** **                                                                                                                                              |
| **(250) 744-2811****(858) 202-4900**                                                                                                                    |
| (Registrant’s telephone  number, including area code)                                                                                              |

 

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Indicate by check mark whether the registrant (1) hasfiled all reports required to be filed by Section 13 or 15(d) of theSecurities Exchange Act of 1934 during the preceding 12 months (or forsuch shorter period that the registrant was required to file such reports) and(2) has been subject to such filing requirements for the past90 days. Yes ý  No o

 

Indicate bycheck mark whether the registrant is an accelerated filer (as defined in Rule12b-2 of the Exchange Act).  Yes ý  No o

 

As of October 22, 2004 the registrant had approximately72,506,000 shares of Common Stock, no par value, outstanding. 

 

 

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**Stressgen Biotechnologies Corporationand Subsidiaries**

 

**INDEX**

 
| ** **                              | **Page**     |
|-----------------------------------------|--------------|
| **Part I — Financial Information** |         |
|                                    |         |
|                                    | Item 1. | Financial Statements (Unaudited) |   |
|                                    |         | Consolidated Balance Sheet  September 30, 2004 and December 31, 2003 |  

1 |
|                                    |         | Consolidated  Statement of Operations and Accumulated Deficit  Three and Nine Months Ended September 30, 2004 and 2003 |  

2 |
|                                    |         | Consolidated  Statement of Cash Flows  Three and Nine Months Ended September 30, 2004 and 2003 |  

3 |
|                                    |         | Notes to  Consolidated Financial Statements | 4 |
|                                    | Item 2.      | Management’s Discussion and  Analysis of Financial Condition and Results of Operations | 16 |
|                                    |         | Updated  Description of the Business of the Corporation | 16 |
|                                    |         | Liquidity and Capital  Resources | 27 |
|                                    |         | Results of Operations | 29 |
|                                    |         | Critical Accounting  Policies | 33 |
|                                    |         | Factors  That Could Affect Future Performance | 34 |
|                                    | Item  3.     | Quantitative  and Qualitative Disclosures About Market Risk | 40 |
|                                    | Item 4.      | Controls  and Procedures | 42 |
|                                    |         |   |   |
| **Part II — Other Information**    | 42           |
| ** **                              |         |
| Items 1 through 6                       |         |
|                                    |         |
| SIGNATURES AND CERTIFICATIONS           | 42           |

 

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**CONSOLIDATED BALANCE SHEET**

(Unaudited)

*Stressgen BiotechnologiesCorporation*

*(Canadian dollars) (In thousands,except share information)*

 
| ** **                                                                                                                                                                                                      | ** ** | **September 30,  2004** | ** ** | **December 31,  2003** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------------|------------|-----------------------------|------------|
| **Assets**                                                                                                                                                                                                      |       |                         |       |                        |       |
| Current  assets:                                                                                                                                                                                                |       |                         |       |                        |       |
| Cash and  cash equivalents                                                                                                                                                                                      |       | $                            | 483        |                        | $          | 19,996 |   |
| Short-term  investments                                                                                                                                                                                         |       | 31,233                       |       | 32,094                      |       |
| Accounts  receivable, net                                                                                                                                                                                       |       | 646                          |       | 733                         |       |
| Inventories                                                                                                                                                                                                     |       | 635                          |       | 639                         |       |
| Other  current assets                                                                                                                                                                                           |       | 1,058                        |       | 512                         |       |
| Total  current assets                                                                                                                                                                                           |       | 34,055                       |       | 53,974                      |       |
|                                                                                                                                                                                                            |       |                         |       |                        |       |
| Plant and  equipment                                                                                                                                                                                            |       | 1,809                        |       | 2,196                       |       |
| Deferred  expenses, net of current portion                                                                                                                                                                      |       | 191                          |       | 260                         |       |
|                                                                                                                                                                                                            |       | $                            | 36,055     |                        | $          | 56,430 |   |
|                                                                                                                                                                                                            |       |                         |       |                        |       |
| **Liabilities  and Stockholders’ Equity**                                                                                                                                                                  |       |                         |       |                        |       |
| Current  liabilities:                                                                                                                                                                                           |       |                         |       |                        |       |
| Accounts  payable and accrued liabilities                                                                                                                                                                       |       | $                            | 4,012      |                        | $          | 3,975 |   |
| Current  portion of deferred revenue                                                                                                                                                                            |       | 673                          |       | 688                         |       |
| Current  portion of notes payable and leases                                                                                                                                                                    |       | 471                          |       | 518                         |       |
| Total  current liabilities                                                                                                                                                                                      |       | 5,156                        |       | 5,181                       |       |
|                                                                                                                                                                                                            |       |                         |       |                        |       |
| Long-term  liabilities:                                                                                                                                                                                         |       |                         |       |                        |       |
| Deferred  revenue, net of current portion                                                                                                                                                                       |       | 1,515                        |       | 2,065                       |       |
| Notes  payable and leases, net of current portion                                                                                                                                                               |       | 253                          |       | 607                         |       |
| Total  long-term liabilities                                                                                                                                                                                    |       | 1,768                        |       | 2,672                       |       |
|                                                                                                                                                                                                            |       |                         |       |                        |       |
| Total  liabilities                                                                                                                                                                                              |       | 6,924                        |       | 7,853                       |       |
|                                                                                                                                                                                                            |       |                         |       |                        |       |
| Stockholders’  equity:                                                                                                                                                                                     |       |                         |       |                        |       |
| Common  shares and other equity – no par value; unlimited shares authorized,  72,506,403 and 72,491,403 shares issued and outstanding at September 30,  2004 and December 31, 2003, respectively |       | 216,412                      |       | 196,849                     |       |
| Contributed  surplus                                                                                                                                                                                            |       | 16,570                       |       | 2,207                       |       |
| Deferred  stock compensation (Note 2)                                                                                                                                                                           |       | —                       |       | (185                        | )          |
| Accumulated  deficit (Note 2)                                                                                                                                                                                   |       | (203,851                     | )          | (150,294                    | )          |
| Total  stockholders’ equity                                                                                                                                                                                |       | 29,131                       |       | 48,577                      |       |
|                                                                                                                                                                                                            |       | $                            | 36,055     |                        | $          | 56,430 |   |

 

*See accompanying notes to consolidated financial statements*.

 

1

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**CONSOLIDATED STATEMENT OF OPERATIONS ANDACCUMULATED DEFICIT**

(Unaudited)

*Stressgen BiotechnologiesCorporation*

*(Canadian dollars) (In thousands,except per share amounts)*

** **
| ** **                                                                                       | ** ** | **Three months ended  September 30,** | ** ** | **Nine months ended  September 30,** | ** ** |
|--------------------------------------------------------------------------------------------------|------------|--------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                                                                       | ** ** | **2004**                                   | ** ** | **2003**                                  | ** ** | **2004** | ** ** | **2003** | ** ** |
| Revenue:                                                                                         |       |                                       |       |                                      |       |   |   |   |   |
| Bioreagent  sales                                                                                |       | $                                          | 1,547      |                                      | $          | 1,316 |   | $ | 4,445 |   | $ | 4,108 |   |
| Collaborative  R&D revenue                                                                   |       | 174                                        |       | 855                                       |       | 537 |   | 7,584 |   |
| Total  revenue                                                                                   |       | 1,721                                      |       | 2,171                                     |       | 4,982 |   | 11,692 |   |
|                                                                                             |       |                                       |       |                                      |       |   |   |   |   |
| Operating  expenses:                                                                             |       |                                       |       |                                      |       |   |   |   |   |
| Research and  development                                                                        |       | 6,796                                      |       | 6,009                                     |       | 18,338 |   | 17,293 |   |
| Selling, general  and administrative                                                             |       | 1,724                                      |       | 1,510                                     |       | 5,969 |   | 5,666 |   |
| Cost of  bioreagent sales                                                                        |       | 383                                        |       | 296                                       |       | 1,045 |   | 1,049 |   |
|                                                                                             |       | 8,903                                      |       | 7,815                                     |       | 25,352 |   | 24,008 |   |
|                                                                                             |       |                                       |       |                                      |       |   |   |   |   |
| Operating  loss                                                                                  |       | (7,182                                     | )          | (5,644                                    | )          | (20,370 | ) | (12,316 | ) |
|                                                                                             |       |                                       |       |                                      |       |   |   |   |   |
| Other income  (expenses):                                                                        |       |                                       |       |                                      |       |   |   |   |   |
| Interest and  other income, net                                                                  |       | 262                                        |       | 41                                        |       | 564 |   | 499 |   |
| Net foreign  exchange loss                                                                       |       | (1,014                                     | )          | (12                                       | )          | (723 | ) | (638 | ) |
| Interest  expense                                                                                |       | (23                                        | )          | (8                                        | )          | (78 | ) | (28 | ) |
|                                                                                             |       | (775                                       | )          | 21                                        |       | (237 | ) | (167 | ) |
|                                                                                             |       |                                       |       |                                      |       |   |   |   |   |
| Net loss                                                                                         |       | (7,957                                     | )          | (5,623                                    | )          | (20,607 | ) | (12,483 | ) |
|                                                                                             |       |                                       |       |                                      |       |   |   |   |   |
| Accumulated  deficit, beginning of period                                                        |       | (195,894                                   | )          | (140,909                                  | )          | (150,294 | ) | (134,049 | ) |
| Cumulative  effect of change in accounting policy (Note 2)                             |       | —                                     |       | —                                    |       | (32,950 | ) | — |   |
| Accumulated  deficit, end of period                                                              |       | $                                          | (203,851   | )                                         | $          | (146,532 | ) | $ | (203,851 | ) | $ | (146,532 | ) |
|                                                                                             |       |                                       |       |                                      |       |   |   |   |   |
| Basic and  diluted net loss per common share                                                     |       | $                                          | (0.11      | )                                         | $          | (0.09 | ) | $ | (0.28 | ) | $ | (0.20 | ) |
|                                                                                             |       |                                       |       |                                      |       |   |   |   |   |
| Weighted  average shares used to compute basic and diluted loss per common share (in  thousands) |       | 72,506                                     |       | 61,692                                    |       | 72,504 |   | 61,048 |   |

 

*See accompanying notes to consolidated financial statements.*

 

2

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**CONSOLIDATED STATEMENT OF CASH FLOWS**

(Unaudited)

*Stressgen BiotechnologiesCorporation*

*(Canadian dollars in thousands)*

 
| ** **                                                                   | ** ** | **Three months ended  September 30,** | ** ** | **Nine months ended  September 30,** | ** ** |
|------------------------------------------------------------------------------|------------|--------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                                                   | ** ** | **2004**                                   | ** ** | **2003**                                  | ** ** | **2004** | ** ** | **2003** | ** ** |
| Cash flows  from operating activities:                                       |       |                                       |       |                                      |       |   |   |   |   |
| Net loss                                                                     |       | $                                          | (7,957     | )                                         | $          | (5,623 | ) | $ | (20,607 | ) | $ | (12,483 | ) |
| Adjustments  to reconcile net loss to net cash used in operating activities: |       |                                       |       |                                      |       |   |   |   |   |
| Depreciation  of plant and equipment                                         |       | 164                                        |       | 206                                       |       | 506 |   | 550 |   |
| Loss on  disposal of plant and equipment                                     |       | 60                                         |       | —                                    |       | 119 |   | — |   |
| Amortization  of stock compensation expense                                  |       | 242                                        |       | 50                                        |       | 1,206 |   | 157 |   |
| Unrealized  foreign exchange loss (gain)                                     |       | 1,299                                      |       | (15                                       | )          | 1,077 |   | 493 |   |
| Loss (gain)  on market value of investments                                  |       | (38                                        | )          | 284                                       |       | 272 |   | 336 |   |
| Changes in  operating assets and liabilities                                 |       | (464                                       | )          | 1,243                                     |       | (914 | ) | (974 | ) |
| Net cash  used in operating activities                                       |       | (6,694                                     | )          | (3,855                                    | )          | (18,341 | ) | (11,921 | ) |
|                                                                         |       |                                       |       |                                      |       |   |   |   |   |
| Cash flows  from investing activities:                                       |       |                                       |       |                                      |       |   |   |   |   |
| Purchase of  short-term investments                                          |       | (29,290                                    | )          | —                                    |       | (52,209 | ) | (31,191 | ) |
| Sales and  maturities of short-term investments                              |       | 28,850                                     |       | 3,715                                     |       | 51,793 |   | 8,577 |   |
| Purchase of  plant and equipment                                             |       | (50                                        | )          | (100                                      | )          | (238 | ) | (154 | ) |
| Net cash  (used in) provided by investing activities                         |       | (490                                       | )          | 3,615                                     |       | (654 | ) | (22,768 | ) |
|                                                                         |       |                                       |       |                                      |       |   |   |   |   |
| Cash flows  from financing activities:                                       |       |                                       |       |                                      |       |   |   |   |   |
| Proceeds on  issuance of common shares                                       |       | —                                     |       | 22                                        |       | 36 |   | 4,720 |   |
| Proceeds  from term loan                                                     |       | —                                     |       | 1,004                                     |       | — |   | 1,004 |   |
| Stock  subscription receivable                                               |       | —                                     |       | (12                                       | )          | — |   | (12 | ) |
| Share issue  costs                                                           |       | —                                     |       | —                                    |       | (81 | ) | — |   |
| Repayment of  borrowings                                                     |       | (170                                       | )          | (78                                       | )          | (401 | ) | (240 | ) |
| Net cash  (used in) provided by financing activities                         |       | (170                                       | )          | 936                                       |       | (446 | ) | 5,472 |   |
|                                                                         |       |                                       |       |                                      |       |   |   |   |   |
| Effect of  exchange rate changes on cash and cash equivalents                |       | (51                                        | )          | (109                                      | )          | (72 | ) | (279 | ) |
|                                                                         |       |                                       |       |                                      |       |   |   |   |   |
| (Decrease)  increase in cash and cash equivalents                            |       | (7,405                                     | )          | 587                                       |       | (19,513 | ) | (29,496 | ) |
| Cash and  cash equivalents, beginning of period                              |       | 7,888                                      |       | 1,119                                     |       | 19,996 |   | 31,202 |   |
| Cash and  cash equivalents, end of period                                    |       | $                                          | 483        |                                      | $          | 1,706 |   | $ | 483 |   | $ | 1,706 |   |

 

*See accompanying notes to consolidated financial statements.*

 

3

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***StressgenBiotechnologies Corporation***

**Notes to Consolidated Financial Statements**

***(Canadiandollars)***

(Unaudited)

 

**1.****                                     ****ORGANIZATION AND SUMMARY OFSIGNIFICANT ACCOUNTING POLICIES**

 

*TheCompany*

 

StressgenBiotechnologies Corporation (with its subsidiaries, “Stressgen” or the “Company”)is a biopharmaceutical company focused on the discovery, development andcommercialization of innovative stress protein-based immunotherapeutics, alsoknown as therapeutic vaccines. These therapeutic vaccines are created using theCompany’s proprietary CoValTM fusion product technology, whichcovalently link stress proteins (also known as heat shock proteins) to diseasespecific antigens.  The Company’s leadcandidate, HspE7, targets a broad spectrum of human papillomavirus (HPV)related diseases.  The Company has alsoinitiated research studies or is evaluating other CoValTM fusionproduct candidates for the treatment of hepatitis B, herpes simplex andhepatitis C.  Further, Stressgen has aninternationally recognized bioreagents business which sells reagents and otherresearch products to scientists studying cellular stress, apoptosis, oxidativestress and neurobiology.

 

*Basisof presentation*

 

The consolidatedfinancial statements include the assets, liabilities and operating results ofthe Company and its wholly-owned subsidiaries. Intercompany accounts and transactions have been eliminated inconsolidation.

 

*Financialstatements and estimates*

 

The information at September 30, 2004 and for the three and ninemonth periods ended September 30, 2004 and 2003 has been prepared by theCompany and has not been audited.  Thefinancial statements, in the opinion of management, include all adjustmentsnecessary for their fair presentation in conformity with Canadian generallyaccepted accounting principles (“Canadian GAAP”), and conform in materialrespects with accounting principles generally accepted in the United States ofAmerica (“U.S. GAAP”), except as discussed in Note 7.  All such adjustments are of a normal andrecurring nature.  These financial statementsshould be read in conjunction with the financial statements and notes theretoin the Company’s December 31, 2003 Annual Report on Form 10-K and the June 30,2004 and March 31, 2004 Quarterly Reports on Form 10-Q.  Certain information and footnote disclosuresnormally included in financial statements prepared in accordance with CanadianGAAP and U.S. GAAP have been condensed or omitted pursuant to the applicableCanadian regulatory and U.S. Securities and Exchange Commission rules andregulations.  Interim results are notnecessarily indicative of results for the full year.

 

The preparation of financial statements in conformity with CanadianGAAP and U.S. GAAP requires management to make estimates and assumptions thataffect the reported amounts of assets, liabilities, revenue and expenses andrelated disclosures as of the date of the financial statements.  Significant estimates are used for, but notlimited to, revenue recognition, accrual of clinical trial costs, measurementof stock-based compensation, and the allocation of indirect costs betweenresearch and development (R&D), selling, general and administrative(SG&A) and cost of bioreagent sales. Actual results could differ from such estimates.

 

*Foreigncurrency translation*

 

The Company uses the Canadian dollar as its consolidated functionalcurrency.  Monetary assets andliabilities that are denominated in U.S. dollars or British pounds aretranslated into Canadian dollars at the rates of exchange prevailing at thebalance sheet date.  Non-monetary assetsand liabilities are translated at historical exchange rates.  Revenue and expenses are translated at theaverage rate of exchange for the period of such transactions.

 

4

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*Revenue recognition*

 

Revenue from productsales of the Company’s bioreagent business is recognized upon delivery tocustomers when persuasive evidence of an arrangement exists, the price is fixedor determinable and collection is reasonably assured.  Revenue also includes amounts charged forshipping and handling costs.

 

Revenue fromcollaborative research and development arrangements may include multipleelements within a single contract.  TheCompany’s accounting policy complies with the revenue determinationrequirements set forth in EITF 00-21, *Accountingfor Revenue Arrangements with Multiple Deliverables*, and EIC 142, *Revenue Arrangements with Multiple Deliverables,*relating to the separation of multiple deliverables into individual accountingunits with determinable fair values. Payments received under collaborative arrangements may include thefollowing:  non-refundable fees atinception of contract for technology rights; funding for services performed;milestone payments for specific achievements; and payments based upon resultingsales of products.

 

The Company recognizes collaborative research anddevelopment revenues as services are rendered consistent with the performancerequirements of the contract.  Revenuefrom non-refundable contract fees where the Company has continuing involvementthrough research and development collaborations or other contractualobligations, less the fair market value of any related warrants, is recognizedratably over the development period or the period for which Stressgen continuesto have a performance obligation.  Theperiod of development is evaluated on a regular basis.  In December 2003, the Company increasedthe development period by one year to reflect management’s research anddevelopment plan.  Revenue fromperformance milestones is recognized upon the achievement of the milestones asspecified in the agreement, provided payment is proportionate to the effortexpended.  Payments are recorded asdeferred revenue if they are received in advance of performance or delivery.

 

*Clinical trial accruals*

 

The Company recognizes expenses related to its ongoing clinical trialsusing a methodology designed to accrue estimated costs in the appropriateaccounting periods when the expenses are incurred.  The Company recognizes clinical trial costs inthree distinct phases that correspond with the period during which the servicesare performed:  the start-up phase, thepatient accrual phase, and the close-out phase. The start up portion of thetrial contract is accrued during the trial planning and protocol writingperiod.  The perpatient accrual cost is recognized as each patient enters the trial.  The close-out portion of the trial isrecognized as the final analyses of patient data are prepared.  Based on the design of the trial includingnumber of patients, number of clinical sites, method of treatment, andfollow-up, the proportion of the cost of each phase could vary from trial totrial.   As each trial continues, theCompany evaluates the total contract costs and makes adjustments accordingly. Changesto the cost estimates are charged to expense in the appropriate period based onthe facts and timing of the adjustment.

 

*Stock-based compensation plan*

 

In September 2003,the CICA Accounting Standards Board released revised transitional provisions for*Stock-Based Compensation and OtherStock-Based Payments*, Section 3870 (CICA 3870), to provide thesame alternative methods of transition as is provided in the U.S. for voluntaryadoption of the fair value based method of accounting.   In January 2004, the Company adoptedthe recommendations of the CICA 3870. This standard requires that all stock-based awards made to non-employeesbe measured and recognized using a fair value based method.  The standard encourages the use of a fairvalue based method for all awards granted to employees, but only requires theuse of a fair value based method for direct awards of stock, stock appreciationrights, and awards that call for settlement in cash or other assets.

 

5

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Awards that acompany has the ability to settle in stock are recorded as equity, whereasawards that the entity is required to or has a practice of settling in cash arerecorded as liabilities.

 

The Company has twostock-based compensation plans, which are described in Note 5.  The Company typically grants options with anexercise price equal to the fair market value of the underlying commonstock.  Under the principles of CICA 3870,compensation expense is recognized over the vesting period of the grant basedon the estimated fair value at the time of grant using the Black-Scholesmethod.  Any consideration paid bydirectors, employees and others on exercise of stock options is credited tocommon shares.  See further discussion ofthe change in accounting policy in Note 2.

 

**2.****                                     ****CHANGE IN ACCOUNTING POLICY**

 

In January 2004the Company changed its accounting policy relating to stock based compensationawards, retroactive to January 1, 1995, in accordance with therecommendation of CICA 3870*.*  As permitted by the September 30, 2003transitional provisions issued by the CICA Accounting Standards Board relatedto CICA 3870, the Company has applied this change using the retroactive methodwithout restatement.  Expense related tostock-based compensation awards is calculated using the Black-Scholes optionpricing model and recognized over the vesting period of the grant.  Previously, the Company used the intrinsicvalue method for valuing stock-based compensation awards granted to employeesand directors where compensation expense was recognized for the excess, if any,of the quoted market price of Company’s common shares over the compensationaward exercise price on the day that options were granted.

 

The following proforma information presents the net loss and the basic loss per common share hadCICA 3870 been retroactively applied:

 
| **(in thousands, except per share amounts)**                           | ** ** | **Three months ended  September 30, 2003** | ** ** | **Nine months ended  September 30, 2003** | ** ** |
|------------------------------------------------------------------------|------------|-------------------------------------------------|------------|------------------------------------------------|------------|
| Net loss  under Canadian GAAP                                          |       | $                                               | (5,623     | )                                              | $          | (12,483 | ) |
|                                                                   |       |                                            |       |                                           |       |
| Stock-based  compensation expense under intrinsic value method         |       | 50                                              |       | 157                                            |       |
| Stock-based  employee compensation expense under the fair value method |       | (736                                            | )          | (2,295                                         | )          |
| Pro forma  net loss under Canadian GAAP                                |       | $                                               | (6,309     | )                                              | $          | (14,621 | ) |
| Pro forma  basic and diluted loss per common share under Canadian GAAP |       | $                                               | (0.10      | )                                              | $          | (0.24 | ) |

 

To implement the fair value method for stock-basedcompensation beginning January 1, 2004, the Company recorded an adjustmentto beginning accumulated deficit of $32,950,000, comprised of $17,105,000related to the fair value expense calculated on options granted on or after January 1,1995, $16,434,000 related to compensation expense on the release ofcontingently issuable shares completed in 1999, offset by a $589,000 reversalof previously recorded expense under the principles of APB Opinion No. 25, *Accounting for Stock Issued to Employees*.  Under the principles of CICA 3870, theCompany reclassified $3,174,000 from contributed surplus to common stockrelated to the historical exercise of employee stock options.  The Company recorded expense of $242,000 and$1,206,000 for the three and nine month periods ended September 30, 2004,representing the amortization of the fair value of

 

6

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compensation based on the vesting period of stock optionsgranted to employees and directors.  Theweighted-average per-share fair values of the individual options granted duringthe three month periods ended September 30, 2004 and 2003 were $0.37 and$1.00, respectively.   Theweighted-average per-share fair values of the individual options granted duringthe nine month periods ended September 30, 2004 and 2003 were $0.51 and$1.06.   The fair value of the optionswas determined using a Black-Scholes option-pricing model with the followingassumptions:

 
| ** **               | ** ** | **For the three months  ended September 30,** | ** ** | **For the nine months  ended September 30,** | ** ** |
|--------------------------|------------|----------------------------------------------------|------------|---------------------------------------------------|------------|
| ** **               | ** ** | **2004**                                           | ** ** | **2003**                                          | ** ** | **2004** | ** ** | **2003** | ** ** |
| Dividend  yield          |       | 0                                                  | %          | 0                                                 | %          | 0 | % | 0 | % |
| Volatility               |       | 66                                                 | %          | 78                                                | %          | 66 | % | 80 | % |
| Risk-free  interest rate |       | 4.0                                                | %          | 2.7                                               | %          | 3.7 | % | 2.5 | % |
| Expected  life           |       | 4 years                                            |       | 4 years                                           |       | 4 years |   | 4 years |   |

 

**3.****                                     ****COLLABORATIVE AGREEMENT**

 

On December 2, 2003, the Company announced ithad restructured its June 24, 2002 collaboration agreement with F.Hoffmann-La Roche Ltd and Hoffmann-La Roche Inc. (together, “Roche”), providingfor the development and commercialization of the pharmaceutical fusion productcandidate, HspE7.  Under the restructuredterms Roche was granted an option to develop the first generation HspE7product, a license to develop a second generation HspE7 product, and an optionto negotiate rights to the Company’s CoValTM fusion productcandidates for the treatment of cancer and hepatitis C.

 

In connection with the first generation HspE7product, the restructured agreement gives the Company the right to develop andcommercialize the product for indications other than genital warts, includingcontrol of regulatory matters such as U.S. Investigational New Drugapplications (IND).  The Company may conductdose-ranging studies in patients with genital warts.  In the original agreement the Company wasresponsible for clinical development expenses related to the recurrentrespiratory papillomatosis (RRP)indication.  In the new agreement theCompany is responsible for the manufacturing and other costs of all indicationsit develops.

 

The Companyrecorded collaborative R&D revenue of $174,000 and $855,000 during thethree month periods ended September 30, 2004 and 2003, respectively.Collaborative R&D revenue for the nine month periods ended September 30,2004 and 2003 was $537,000 and $7,584,000, respectively.  Collaborative R&D revenue during thethree and nine month periods in 2004 relates principally to the amortization ofupfront license fees in accordance with CICA Accounting Standards Boardrecommendations, section 3400, *Revenue,* andStaff Accounting Bulletin (SAB) No. 101 *Revenue Recognition inFinancial Statements*. Collaborative R&D revenue for the nine month period ended September 30,2003 includes $4,615,000 for development activities, a time-based developmentpayment of $2,214,000 and $755,000 from the amortization of upfront licensefees.

 

**4.****                                     ****COMMITMENTS**

 

On January 28, 2004, the Company entered into abiological services agreement with Avecia Limited for manufacturing and processdevelopment of HspE7.  Under the terms ofthe contract, payments are due in British pounds.  The contract is a multi-year agreement forprocess development and manufacturing of clinical supplies, and may alsoinclude the manufacturing of commercial drug substance.  The Company purchased British pounds inanticipation of making payments in that currency.  The services agreement

 

7

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contains cancellation fees based on a slidingpercentage of certain future program milestones.  The cancellation fee as of September 30,2004 would have been $4,493,000.

 

**5.****                                      BALANCESHEET****DETAILS**

 

At September 30,2004 the Company had outstanding principal balances of $724,000 in the form offixed rate capital leases and term loans including the September 2003 termloan with Oxford Finance Corporation (Oxford). At September 30, 2004 the outstanding principal balance was$630,000 on the Oxford loan.  Under theterms of the Oxford loan, the Company must issue a letter of credit for the outstandingloan balance if our combined cash, cash equivalents, and short-term investmentsfall below $6,000,000**.**

 

The followingtables provide details of selected balance sheet items:

 

 
| **(In thousands)**                     | ** ** | **September 30,  2004** | ** ** | **December 31,  2003** | ** ** |
|----------------------------------------|------------|------------------------------|------------|-----------------------------|------------|
| Accounts  receivable:                  |       |                         |       |                        |       |
| Trade  accounts receivable             |       | $                            | 677        |                        | $          | 492 |   |
| Collaborative  receivable              |       | —                       |       | 277                         |       |
| Less:  allowance for doubtful accounts |       | (31                          | )          | (36                         | )          |
|                                   |       | $                            | 646        |                        | $          | 733 |   |
|                                   |       |                         |       |                        |       |
| Inventories:                           |       |                         |       |                        |       |
| Raw materials (1)                      |       | $                            | 233        |                        | $          | 202 |   |
| Work in progress (2)                   |       | 106                          |       | 146                         |       |
| Finished goods (3)                     |       | 296                          |       | 291                         |       |
|                                   |       | $                            | 635        |                        | $          | 639 |   |

 

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(1)   Net of $16 and $31 provision for obsolescenceas of September 30, 2004 and December 31, 2003, respectively.

(2)   Net of $229 and $166 provision forobsolescence as of September 30, 2004 and December December 31,2003, respectively.

(3)   Net of $112 and $182 provision forobsolescence as of September 30, 2004 and December 31, 2003,respectively.

 
| **(In thousands)**                         | ** ** | **September 30,  2004** | ** ** | **December 31,  2003** | ** ** |
|--------------------------------------------|------------|------------------------------|------------|-----------------------------|------------|
|                                       |       |                         |       |                        |       |
| Accounts  payable and accrued liabilities: |       |                         |       |                        |       |
| Trade  accounts payable                    |       | $                            | 2,048      |                        | $          | 1,461 |   |
| Accrued  compensation and benefits         |       | 1,287                        |       | 1,009                       |       |
| Clinical  trial accruals                   |       | 593                          |       | 1,409                       |       |
| Other  accrued liabilities                 |       | 84                           |       | 96                          |       |
|                                       |       | $                            | 4,012      |                        | $          | 3,975 |   |

 

8

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| ** **              | ** ** | **September 30, 2004** | ** ** |
|-------------------------|------------|-----------------------------|------------|
| **(In thousands)**      | ** ** | **Cost**                    | ** ** | **Accumulated  Depreciation** | ** ** | **Net Book  Value** | ** ** |
| Plant and  equipment:   |       |                        |       |   |   |   |   |
| Laboratory  equipment   |       | $                           | 4,170      |   | $ | 2,766 |   | $ | 1,404 |   |
| Computer  equipment     |       | 910                         |       | 710 |   | 200 |   |
| Furniture  and fixtures |       | 395                         |       | 273 |   | 122 |   |
| Leasehold  improvements |       | 749                         |       | 666 |   | 83 |   |
|                    |       | $                           | 6,224      |   | $ | 4,415 |   | $ | 1,809 |   |

 
| ** **              | ** ** | **December, 31 2003** | ** ** |
|-------------------------|------------|-----------------------|------------|
| **(In thousands)**      | ** ** | **Cost**              | ** ** | **Accumulated  Depreciation** | ** ** | **Net Book  Value** | ** ** |
| Plant and  equipment:   |       |                  |       |   |   |   |   |
| Laboratory  equipment   |       | $                     | 4,397      |   | $ | 2,771 |   | $ | 1,626 |   |
| Computer  equipment     |       | 1,025                 |       | 733 |   | 292 |   |
| Furniture  and fixtures |       | 563                   |       | 391 |   | 172 |   |
| Leasehold  improvements |       | 716                   |       | 610 |   | 106 |   |
|                    |       | $                     | 6,701      |   | $ | 4,505 |   | $ | 2,196 |   |

 

*Stockholders’ equity*

 

In June 2002 theCompany issued 2,036,436 common shares for $7,657,000 pursuant to thecollaboration agreement with Roche (see Note 3).  The equity was issued at a per share pricedetermined by the weighted average price of common shares of the Company duringthe ten business days prior to the Roche transaction.

 

At the time of the original collaboration agreement,Roche received two warrants to purchase the common stock of Stressgen.  The Company allocated $1,264,000 as the fairvalue of the warrants, determined by independent valuation.  In April 2003, Roche exercised the firstwarrant to acquire 1,413,600common shares at $3.25, resulting in net proceeds of $4,594,000 to theCompany.  Under the originalcollaboration agreement, the Company had the right to call the second warrantresulting in an issuance of a range of shares and exercise price depending uponthe price of the Company’s common stock. In connection with the restructuredcollaboration agreement, Roche has a continued right to exercise the secondwarrant for 814,574 shares at a purchase price of $3.76 per share at any timeuntil June 28, 2007.  TheCompany no longer has the right to call the second warrant.

 

*Employeeshare option plan*

 

The followingtable summarizes information related to all stock options outstanding andexercisable granted to employees, directors and non-employees under the Company’s1996 and 2001 stock-based compensation plans as of September 30, 2004.

 

9

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| ** **                    | ** ** | **Options Outstanding** | ** ** | **Options Exercisable**                            | ** ** |
|-------------------------------|------------|-------------------------|------------|----------------------------------------------------|------------|
| **Range of  Exercise Prices** | ** ** | **Number  Outstanding** | ** ** | **Weighted  Average  Remaining  Contractual Life** | ** ** | **Weighted  Average  Exercise  Price** | ** ** | **Number  Exercisable** | ** ** | **Weighted  Average  Exercise  Price** | ** ** |
|                          |       |                    |       | **(in years)**                                     |       |   |   |   |   |   |   |
|                          |       |                    |       |                                               |       |   |   |   |   |   |   |
| $0.67 -  $1.99                |       | 1,412,659               |       | 7.5                                                |       | $ | 1.65 |   | 930,848 |   | $ | 1.73 |   |
| $2.00 -  $3.99                |       | 608,500                 |       | 7.9                                                |       | $ | 3.23 |   | 397,326 |   | $ | 3.36 |   |
| $4.00 -  $5.99                |       | 1,197,514               |       | 6.8                                                |       | $ | 4.91 |   | 1,097,888 |   | $ | 4.90 |   |
| $6.00 -  $8.00                |       | 1,467,100               |       | 5.7                                                |       | $ | 6.20 |   | 1,466,599 |   | $ | 6.20 |   |
|                          |       | 4,685,773               |       |                                               |       |   |   | 3,892,661 |   |   |   |

 

At September 30,2004, there were 632,831options available for future grant under the 2001Plan.  At October 22, 2004 therewere approximately 4,680,000 options outstanding.

 

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**6.****                                      SEGMENTINFORMATION**

 

The Company manages itsoperations in two reportable segments, Biotechnology and Bioreagents.  Revenues are allocated to countries based oncustomer locations.

 
| ** **                           | ** ** | **Three months ended  September 30,** | ** ** | **Nine months ended  September 30,** | ** ** |
|--------------------------------------|------------|--------------------------------------------|------------|-------------------------------------------|------------|
| **(In thousands)**                   | ** ** | **2004**                                   | ** ** | **2003**                                  | ** ** | **2004** | ** ** | **2003** | ** ** |
| **Bioreagents**                      |       |                                       |       |                                      |       |   |   |   |   |
| Revenue:                             |       |                                       |       |                                      |       |   |   |   |   |
| U.S.                                 |       | $                                          | 1,068      |                                      | $          | 908 |   | $ | 3,024 |   | $ | 2,763 |   |
| Canada                               |       | 62                                         |       | 66                                        |       | 193 |   | 192 |   |
| Other                                |       | 417                                        |       | 342                                       |       | 1,228 |   | 1,153 |   |
|                                 |       | 1,547                                      |       | 1,316                                     |       | 4,445 |   | 4,108 |   |
| Operating  expenses:                 |       |                                       |       |                                      |       |   |   |   |   |
| Research and  development            |       | 503                                        |       | 440                                       |       | 1,436 |   | 1,194 |   |
| Selling,  general and administrative |       | 407                                        |       | 359                                       |       | 984 |   | 1,272 |   |
| Cost of  bioreagent sales            |       | 383                                        |       | 296                                       |       | 1,045 |   | 1,049 |   |
|                                 |       | 1,293                                      |       | 1,095                                     |       | 3,465 |   | 3,515 |   |
| Operating  income                    |       | $                                          | 254        |                                      | $          | 221 |   | $ | 980 |   | $ | 593 |   |
|                                 |       |                                       |       |                                      |       |   |   |   |   |
| **Biotechnology**                    |       |                                       |       |                                      |       |   |   |   |   |
| Collaborative  R&D revenue       |       | $                                          | 174        |                                      | $          | 855 |   | $ | 537 |   | $ | 7,584 |   |
|                                 |       |                                       |       |                                      |       |   |   |   |   |
| Operating  expenses:                 |       |                                       |       |                                      |       |   |   |   |   |
| Research and  development            |       | 6,293                                      |       | 5,569                                     |       | 16,902 |   | 16,099 |   |
| Selling,  general and administrative |       | 1,317                                      |       | 1,151                                     |       | 4,985 |   | 4,394 |   |
|                                 |       | 7,610                                      |       | 6,720                                     |       | 21,887 |   | 20,493 |   |
| Operating  loss                      |       | $                                          | (7,436     | )                                         | $          | (5,865 | ) | $ | (21,350 | ) | $ | (12,909 | ) |
|                                 |       |                                       |       |                                      |       |   |   |   |   |
| **Totals**                           |       |                                       |       |                                      |       |   |   |   |   |
| Revenue:                             |       |                                       |       |                                      |       |   |   |   |   |
| Bioreagent  sales                    |       | $                                          | 1,547      |                                      | $          | 1,316 |   | $ | 4,445 |   | $ | 4,108 |   |
| Collaborative  R&D revenue       |       | 174                                        |       | 855                                       |       | 537 |   | 7,584 |   |
| Total  revenue                       |       | 1,721                                      |       | 2,171                                     |       | 4,982 |   | 11,692 |   |
|                                 |       |                                       |       |                                      |       |   |   |   |   |
| Expenses:                            |       |                                       |       |                                      |       |   |   |   |   |
| Research and  development            |       | 6,796                                      |       | 6,009                                     |       | 18,338 |   | 17,293 |   |
| Selling,  general and administrative |       | 1,724                                      |       | 1,510                                     |       | 5,969 |   | 5,666 |   |
| Cost of  bioreagent sales            |       | 383                                        |       | 296                                       |       | 1,045 |   | 1,049 |   |
|                                 |       | 8,903                                      |       | 7,815                                     |       | 25,352 |   | 24,008 |   |
| Operating  loss                      |       | $                                          | (7,182     | )                                         | $          | (5,644 | ) | $ | (20,370 | ) | $ | (12,316 | ) |

 

The Company does notallocate interest and other income, or interest on capital lease obligations toeach segment.

 

At September 30,2004 and December 31, 2003, respectively, $1,637,000 and $2,006,000 ofplant and equipment supported the Biotechnology operating segment while theremaining $172,000 and $190,000 supported the Bioreagent operating segment.

 

11

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**7.****                                     ****THE EFFECT OF APPLYING ACCOUNTING PRINCIPLES GENERALLY ACCEPTED IN THEU.S.**

 

These financialstatements have been prepared in accordance with Canadian GAAP which, except asset out below, conform in all material respects to U.S. GAAP.  Effect on the consolidated financialstatements:

 

*Balance Sheet*

 

| **(In thousands)**                             | ** ** | **September 30,  2004** | ** ** | **December 31,  2003** | ** ** |
|------------------------------------------------|------------|------------------------------|------------|-----------------------------|------------|
| Current assets under  Canadian GAAP            |       | $                            | 34,055     |                        | $          | 53,974 |   |
| Adjustments to Canadian  GAAP                  |       | —                       |       | —                      |       |
| Current assets under U.S.  GAAP                |       | $                            | 34,055     |                        | $          | 53,974 |   |
|                                           |       |                         |       |                        |       |
| Stockholders’ equity under  Canadian GAAP |       | $                            | 29,131     |                        | $          | 48,577 |   |
| Adjustment to common stock  (a)                |       | (17,537                      | )          | —                      |       |
| Adjustment to deferred  stock compensation (a) |       | (119                         | )          | —                      |       |
| Adjustment to accumulated  deficit (a)         |       | 17,656                       |       | —                      |       |
|                                           |       | —                       |       | —                      |       |
| Stockholders’  equity under U.S. GAAP     |       | $                            | 29,131     |                        | $          | 48,577 |   |

 

*Statement of Operations*

 
| ** **                                                                                   | ** ** | **Three months ended  September 30,** | ** ** | **Nine months ended  September 30,** | ** ** |
|----------------------------------------------------------------------------------------------|------------|--------------------------------------------|------------|-------------------------------------------|------------|
| **(In thousands except per share amounts)**                                                  | ** ** | **2004**                                   | ** ** | **2003**                                  | ** ** | **2004** | ** ** | **2003** | ** ** |
| Net loss under Canadian  GAAP                                                                |       | $                                          | (7,957     | )                                         | $          | (5,623 | ) | $ | (20,607 | ) | $ | (12,483 | ) |
| Reversal of unrealized  foreign exchange loss (gain) on investments (b)                      |       | 1,248                                      |       | (124                                      | )          | 1,005 |   | 214 |   |
| (Gain) loss on market  value of investments (b)                                              |       | (38                                        | )          | 284                                       |       | 272 |   | 336 |   |
| Reversal of stock  compensation expense (a)                                                  |       | 242                                        |       | —                                    |       | 1,206 |   | — |   |
| Stock compensation expense  under APB No. 25 (a)                                             |       | (14                                        | )          | —                                    |       | (66 | ) | — |   |
|                                                                                         |       | 1,438                                      |       | 160                                       |       | 2,417 |   | 550 |   |
| Net loss under U.S. GAAP                                                                     |       | $                                          | (6,519     | )                                         | $          | (5,463 | ) | $ | (18,190 | ) | $ | (11,933 | ) |
| Basic and diluted loss per  common share under Canadian GAAP                                 |       | $                                          | (0.11      | )                                         | $          | (0.09 | ) | $ | (0.28 | ) | $ | (0.20 | ) |
| Basic and diluted loss per  common share under U.S. GAAP                                     |       | $                                          | (0.09      | )                                         | $          | (0.09 | ) | $ | (0.25 | ) | $ | (0.20 | ) |
| Common shares used to  compute basic and diluted loss per share under Canadian and U.S. GAAP |       | 72,506                                     |       | 61,692                                    |       | 72,504 |   | 61,048 |   |

 

12

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*Statement of Cash Flows*

 

For all periodspresented there are no significant differences under Canadian and U.S. GAAP innet cash (used in) provided by operating, investing and financing activities.

 

*Differences*

 

As disclosed inNote 11 to the financial statements in the Company’s December 31, 2003Annual Report on Form 10-K, differences exist for the Company between Canadianand U.S. GAAP.

 

The followingnotes outline the differences that affect the Company for the three and ninemonth periods ended September 30, 2004 and 2003.

 

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(a)                                  Asdiscussed in Note 2, on January 1, 2004, the Company adopted fair valueaccounting for all stock options as required by CICA 3870.  The Company is required to record the expenseof the fair value of all stock options over their respective vesting term.  The Company used the “Retrospective methodwithout Restatement.”  This methodrequires the Company to record the cumulative expense as an adjustment toaccumulated deficit for the period beginning January 1, 1995 through December 31,2003 and begin recording the expense to retained earnings in 2004.

 

The FASB issued SFAS No. 148, *Accounting for Stock-Based Compensation, Transitionand Disclosure*(SFAS 148)**inDecember 2002.  SFAS 148 providesalternative transition methods for entities that voluntarily elect to adopt the fairvalue recognition provisions of FASB Statement No. 123, *Accounting for Stock-Based Compensation*(SFAS123)*,*to stock-based employeecompensation.  Under the provisions ofSFAS 123, fair value accounting is required for all grants made on or after January 1,1995.  The Company has not elected toadopt the provisions of SFAS 123 for U.S. reporting purposes, which would require fair value based accountingfor grants made on or after January 1, 1995.

 

Under the principles of SFAS 123, the Company wouldhave recorded $19,295,000 of deferred compensation related to the total fairvalue for stock options granted between January 1, 1995 and September 30,2004.  The following table illustratesthe effect on net loss and loss per share under U.S. GAAP if the Company hadapplied the fair value accounting provisions of SFAS 123 to employee stockbased compensation:

 
| ** **                                                          | ** ** | **Three months ended  September 30,** | ** ** | **Nine months ended  September 30,** | ** ** |
|---------------------------------------------------------------------|------------|--------------------------------------------|------------|-------------------------------------------|------------|
| **(In thousands except per share amounts)**                         | ** ** | **2004**                                   | ** ** | **2003**                                  | ** ** | **2004** | ** ** | **2003** | ** ** |
| Net loss  under U.S. GAAP                                           |       | $                                          | (6,519     | )                                         | $          | (5,463 | ) | $ | (18,190 | ) | $ | (11,933 | ) |
|                                                                |       |                                       |       |                                      |       |   |   |   |   |
| Stock-based  compensation under APB No. 25                |       | 14                                         |       | 50                                        |       | 66 |   | 157 |   |
| Stock-based  compensation expense recorded under SFAS 123 |       | (242                                       | )          | (736                                      | )          | (1,206 | ) | (2,295 | ) |
| Pro forma  net loss under U.S. GAAP                                 |       | $                                          | (6,747     | )                                         | $          | (6,149 | ) | $ | (19,330 | ) | $ | (14,071 | ) |
| Pro forma  loss per common share                                    |       | $                                          | (0.09      | )                                         | $          | (0.10 | ) | $ | (0.27 | ) | $ | (0.23 | ) |

 

13

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(b)                                 UnderU.S. GAAP Statement of Financial Accounting Standards (SFAS) No. 115, *Accounting for Certain Investments in Debt and EquitySecurities*, the Company would have classified certain of itsshort-term securities as available-for-sale and, accordingly, would haveincluded the changes in net unrealized holding gains or losses on thesesecurities as a component of stockholders’ equity rather than in operations.

 

The Emerging IssuesTask Force (EITF) recently deliberated regarding Issue 03-01, “The Meaning ofOther-Than-Temporary Impairment and Its Application to Certain Investments.”  The Issue is intended to address the meaningof other-than-temporary impairment and its application to certain investmentsheld at cost.  The EITF reached aconsensus regarding disclosure requirements concerning unrealized losses onavailable-for-sale debt and equity securities accounted for under SFAS No.115.  The guidance for evaluating whetheran investment is other-than-temporarily impaired has been deferred.  The disclosure requirements apply to annualfinancial statements for fiscal years ending after December 15, 2003 forinvestments accounted for under SFAS No. 115. For all other investments within the scope of this Issue, the disclosurerequirements have been deferred.  Additional disclosure requirements for costmethod investments apply to fiscal years ending after June 15, 2004.  The Company continues to evaluate the effectof this pronouncement on its financial statements.

 

SFAS No. 130, *ReportingComprehensive Income,* establishes standards for the reporting anddisplay of comprehensive loss and its components in a full set ofgeneral-purpose financial statements. Comprehensive loss is as follows:

 
| ** **                                                            | ** ** | **Three months ended  September 30,** | ** ** | **Nine months ended  September 30,** | ** ** |
|-----------------------------------------------------------------------|------------|--------------------------------------------|------------|-------------------------------------------|------------|
| **(In thousands)**                                                    | ** ** | **2004**                                   | ** ** | **2003**                                  | ** ** | **2004** | ** ** | **2003** | ** ** |
|                                                                  |       |                                       |       |                                      |       |   |   |   |   |
| Net loss  under U.S. GAAP                                             |       | $                                          | (6,519     | )                                         | $          | (5,463 | ) | $ | (18,190 | ) | $ | (11,933 | ) |
| Other  comprehensive income                                           |       |                                       |       |                                      |       |   |   |   |   |
| Adjustment  of unrealized foreign exchange (loss) gain on investments |       | (1,248                                     | )          | 124                                       |       | (1,005 | ) | (214 | ) |
| Market value  adjustments on investments                              |       | 38                                         |       | (284                                      | )          | (272 | ) | (336 | ) |
| Comprehensive  net loss under U.S. GAAP                               |       | $                                          | (7,729     | )                                         | $          | (5,623 | ) | $ | (19,467 | ) | $ | (12,483 | ) |

 

14

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**8.****                                      SUPPLEMENTALCASH FLOW INFORMATION**

 

The changes in operating assets and liabilities are as follows:

 
| ** **                                                                           | ** ** | **Three months ended  September 30,** | ** ** | **Nine months ended  September 30,** | ** ** |
|--------------------------------------------------------------------------------------|------------|--------------------------------------------|------------|-------------------------------------------|------------|
| **(In thousands)**                                                                   | ** ** | **2004**                                   | ** ** | **2003**                                  | ** ** | **2004** | ** ** | **2003** | ** ** |
| Collaborative  receivable                                                            |       | $                                          | —     |                                      | $          | 645 |   | $ | 277 |   | $ | 3,355 |   |
| Trade  receivables                                                                   |       | (71                                        | )          | 71                                        |       | (190 | ) | (87 | ) |
| Inventories                                                                          |       | 24                                         |       | 65                                        |       | 4 |   | 206 |   |
| Other  current assets                                                                |       | (566                                       | )          | (269                                      | )          | (546 | ) | (85 | ) |
| Deferred  expenses, net of current portion                                           |       | 34                                         |       | 31                                        |       | 69 |   | 151 |   |
| Accounts  payable and accrued liabilities                                            |       | 426                                        |       | 950                                       |       | 37 |   | (3,151 | ) |
| Deferred  revenue                                                                    |       | (311                                       | )          | (250                                      | )          | (565 | ) | (1,363 | ) |
|                                                                                 |       | $                                          | (464       | )                                         | $          | 1,243 |   | $ | (914 | ) | $ | (974 | ) |
| Supplemental  disclosures of cash flows:                                             |       |                                       |       |                                      |       |   |   |   |   |
| Interest  paid                                                                       |       | $                                          | 23         |                                      | $          | 8 |   | $ | 79 |   | $ | 28 |   |
|                                                                                 |       |                                       |       |                                      |       |   |   |   |   |
| Supplemental  disclosures of non-cash transactions Reversal of deferred compensation |       | $                                          | —     |                                      | $          | 4 |   | $ | 185 |   | $ | 4 |   |

 

**9.****                                      SUBSEQUENTEVENT**

 

On October 4,2004, the Company filed a Canadian preliminary prospectus pursuant to which itintends to raise US $50,000,000 through the sale of common shares of theCompany.  The offering price per shareand the number of shares to be placed will be determined prior to the filing ofthe final prospectus.  The Company plansto use the proceeds of the offering to fund development and commercializationof HspE7, its lead product candidate.

 

15

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

 

This “Management’s Discussion and Analysis ofFinancial Condition and Results of Operations” is datedas of October 22, 2004.  It  should be read in conjunction with our September 30, 2004consolidated financial statements and related notes therein, which are preparedin accordance with Canadian GAAP and with our December 31, 2003 AnnualReport on Form 10-K.  The differences from U.S. GAAP,as they affect our consolidated financial statements, are described in Note 7to our consolidated quarterly financial statements and in Note 11 to our Form10-K.  All amounts following areexpressed in Canadian dollars unless otherwise indicated.

 

The discussion contains forward-looking statementsthat involve risk and uncertainties.  Thepredictions described in these statements may not materialize if management’scurrent expectations regarding our future performance prove incorrect. Ourresults could also be affected by factors including, but not limited to, ourreliance on collaborative partners and other risks described below under “FactorsThat May Affect Future Performance.”  Theforward-looking statements are based on currently available information; wedisclaim any obligation to update them.

 

**UpdatedDescription of the Business of the Corporation**

 

**CompanyOverview**

 

Weare a biopharmaceutical company that discovers, develops and seeks tocommercialize therapeutic vaccines for the treatment of infectious diseases andcancers.  Unlike traditional preventativevaccines that need to be administered before an individual becomes infected,therapeutic vaccines are designed to stimulate the human immune system to fightexisting infectious diseases and cancers.

 

Our lead therapeutic vaccine candidate is HspE7.  HspE7 is a broad-spectrum therapeutic vaccinecandidate in development for diseases caused by the human papilloma virus (“HPV”),a virus which has over 100 types.  HPV infection can result in diseasesincluding internal and external genital warts and precancerous conditions, suchas cervical and anal dysplasia. Precancerous HPV-related conditions can progress into life-threateningdiseases, including cervical, anal and head and neck cancers.  HPV is the most common sexually transmitteddisease in the U.S.  Approximately 5.5million new sexually transmitted HPV infections are reported in the U.S. eachyear.  At least 20 million people in theU.S. are already infected.  Existing estimates of annual U.S. healthcarecosts associated with HPV include US$1.6 billion in direct costs and up to US$6billion in screening for cervical cancer, making it the second most costlysexually transmitted disease after HIV infection.

 

Weinitially plan to seek approval of HspE7 for the treatment of patientssuffering from an HPV-related disease called recurrent respiratorypapillomatosis (“RRP”). In RRP the papillomas, commonly known as warts, grow inthe upper airways of patients.  They caninterfere with the breathing of pediatric patients and occasionally befatal.  Over 2,300 new cases of pediatricRRP and over 3,600 new cases of adult RRP were diagnosed in a 12-month periodaccording to the most recent reported survey of U.S. otolaryngologists andbronchoesophagologists; the survey estimated that there were over 5,970 casesof active pediatric RRP in which surgery was required in the previous threeyears, and over 9,000 cases of active adult RRP in the U.S.

 

InFebruary 2004 we announced the resultsof an open-label, single arm, multicenter RRP phase II trial in 27patients ranging in age from two to 18 years who required frequent surgicalprocedures to reduce the obstruction caused by the warts. The median intervalof all surgeries reported following treatment suggests that the 27-childpatient population experienced an aggregate of 87 fewer surgeries during thefirst year after treatment.  The time between post-treatment surgeries, measured as the medianpost-treatment interval, increased by a mean of 95%. The mean of thefirst post-treatment interval after surgery increased to 106 days from anaverage of 55 days between surgeries before treatment with HspE7.  We planto commence a pivotal phase III clinical trial in RRP beginning in the secondquarter of 2005.  The U.S. Foodand Drug Administration (“FDA”) has agreed to review the protocol for the trialunder a Special Protocol

 

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Assessment(“SPA”), has granted HspE7 orphan drug status for thetreatment of RRP and has designated HspE7 for the treatment of RRP as a fasttrack product development program.

 

Weplan to expand the application for HspE7 to other HPV indications, so that itcan be indicated for a broad range of HPV-related diseases.  In addition to RRP, we are initiallytargeting niche patient populations for which there are serious unmet medicalneeds, including HIV-positive patients with HPV-associated diseases andpatients with high-grade cervical dysplasia for whom the standard treatment,LEEP (loop electrosurgical excision procedure), has been unsuccessful. We have a strategic collaboration with Roche thatcould lead to further development of HspE7 for genital warts.

 

HspE7is derived from our proprietary platform technology that enables us tocovalently fuse stress proteins to antigens that invoke immune systemresponses.  Stress proteins, also knownas heat shock proteins (“Hsp”), naturally occur in the human body.  Hsp play important roles in the immunesystem, including transporting substances within cells and activating cells ofthe immune system.  By covalently fusingHsp and disease-associated antigens, we believe that we can create a proprietaryportfolio of CoValTM fusion products designed to stimulate the immune system toidentify, target and eliminate virus-infected and cancerous cells.

 

Inaddition to our drug development efforts, we produce and sell Hsp, antibodies,bioreagents and other products for research use.

 

We have incurred significant losses since our inception and expect toincur substantial losses for the foreseeable future as we invest in ourresearch and product development programs, including manufacturing,pre-clinical studies and clinical trials, and regulatory activities.  At September 30, 2004 our accumulateddeficit was $203,851,000.  Historically,we have depended principally on equity financings, cash flows from ourbioreagent business and funding from research collaborations to fund ourbusiness activities.  We intend to pursueadditional equity financings, markets permitting, and to seek additionalresearch collaborations to fund our business activities.

 

Our success will depend upon the safety and efficacy of our immunotherapeuticproducts in pre-clinical studies and clinical trials, and upon obtaining thenecessary regulatory approvals to market our products.  The marketability of our products will beinfluenced by competition from alternative therapies and the degree ofprotection our intellectual property provides. We believe there will besignificant markets for our therapeutic products should these products prove tobe effective in human clinical trials.

 

**Business Strategy**

 

Ourgoal is to develop and commercialize a variety of therapeutic vaccines for thetreatment of virally-induced human diseases and cancers.  Key elements to our strategy include:

 

•                  *Completethe development and obtain regulatory approval for HspE7 to treat RRP*.  Weintend to bring HspE7 to market as rapidly as possible by seeking U.S.regulatory approval to market it for RRP. The FDA has granted fast track andorphan drug status to HspE7 for RRP patients and has agreed to review aprotocol for this trial under a SPA.  Weplan to commence a phase III trial for this indication in second quarter of2005.

 

•                  *Expandthe label for HspE7 to other indications*.  We plan to expand the list ofconditions for which HspE7 is indicated by initially targeting other patientpopulations with high risk forms of HPV disease, including HIV-positivepatients and patients with cervical intraepithelial neoplasia (“CIN”) for whomLEEP has not been successful.  In thelonger term, we plan to target larger market opportunities for HPV-relateddiseases such as genital warts and high-risk dysplasias.

 

•                  *Builda U*.*S*.*sales force*.  We plan to establish our own U.S.commercialization team to help us generate sales for HspE7 and subsequentproducts. We believe that this initiative will require a relatively smallcommercial sales and marketing team for the indications that we are currentlytargeting.

 

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•                  *Builda broad portfolio of product candidates*.  Using our proprietary platformtechnology, we plan to develop additional CoValTM fusion productcandidates to treat other viral infections and cancers.  We also plan to strengthen our pipeline byin-licensing complementary product candidates.

 

•                  *Collaboratewith established pharmaceutical and biotechnology companies*.   Weintend to partner and collaborate with established pharmaceutical andbiotechnology companies, including Roche, to speed development of our productcandidates and to provide us access to global regulatory, sales and marketinginfrastructures.

 

**Background of HPV**

 

HPVinfection is extremely common, with an estimated 80% of sexually active peoplecontracting it at some point in their lives. At least 20 million people in the U.S. are already infected withsexually transmitted HPV infections. Although HPV can remain latent or regress spontaneously in some people,it can also manifest itself physically as warts, dysplasias and cancers.  More than 30 of the over 100 different typesof HPV infect genital tissue.  Some typesalso infect head, neck and anal epithelial cells.  Relatively benign types of HPV cause plantarand common warts.

 

Warts,dysplasias and cancers result from excessive cell growth.  In HPV infections, uncontrolled cell growthcan be caused by proteins expressed by HPV, such as E7, which interfere withnormal cell functions that usually limit cell growth.  HPV infects epithelial cells, which do notpresent antigens efficiently for detection by the immune system.  The immune system does not always recognizeor eradicate HPV-infected cells which allows for warts, dysplasias and cancersto develop.

 

SeriousHPV-related diseases include:

 

*Recurrent Respiratory Papillomatosis*

 

RRPis usually caused by HPV types 6 and 11 that also cause the better knowncondition of genital warts.  Rather thaninfecting genital tissue, the papillomas in RRP occur in the epithelial tissuelocated in the larynx and airways.  Theycan interfere with the breathing of pediatric patients and occasionally befatal.  Death can occur from airwayobstruction, cancerous transformation, the overwhelming spread of the diseaseor complications from surgical treatments. There are two groups of RRPpatients.  Juvenile-onset RRP can occurin children born to mothers infected with HPV. Adult-onset RRP may arise from birth or oral sexual activity.  Over 2,300 new cases of pediatric RRP andover 3,600 new cases of adult RRP were diagnosed in a 12 month period accordingto the most recent reported survey of U.S. otolaryngologists andbronchoesophagologists.  The survey estimatedthat there were over 5,970 cases of active pediatric RRP in which surgery wasrequired in the previous three years, and over 9,000 cases of active adult RRPin the U.S.  Approximately 75% ofdiagnosed juvenile-onset cases become evident before the age of five years. Nodrugs are approved for RRP in the U.S. Instead, patients are typically treated with surgery using amicrodebrider or a laser.  Surgery is nota cure and recurrence is frequent.  Theaverage pediatric patient has approximately five surgeries per year, with somepatients undergoing more than 20 procedures annually.  Each surgery can cost thousands of dollarsand result in complications, including the formation of scar tissue, decreasedfunctioning of the larynx and hoarseness.

 

*Genital Warts*

 

Genitalwarts are soft, fleshy raised growths that can appear in internal and externalgenital areas.  They are also usuallycaused by HPV types 6 and 11.  Theincidence of genital warts is an estimated one million new cases in the U.S.each year.  Despite a commonmisperception, genital warts can be spread even when condoms are used.  Although warts are generally benign, they cancause psychological distress by making patients feel ashamed and lessattractive.  There is no approved curefor genital warts; however, a variety of therapies are available.  The choice of treatment depends on the extentand location of disease and the preferences of the physician and patient.  External genital warts can be treated withtopical medications.  Published sustainedclearance rate estimates for topical treatments range from 20% to 44%; however,the duration of follow-up in most studies is very brief.  We believe that the rate of long termclearance is much

 

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lower.  When topical medications arenot appropriate or effective, ablative therapies are typically used.  These therapies, which require office visits,include the application of trichloroacetic acid, cryotherapy (freezing withliquid nitrogen), laser surgery, electrosurgery (burning) and, particularly forinternal warts, surgical excision. Recurrence is common even after treatment.

 

*Cervical Intraepithelial Neoplasia**and Failures of LEEP*

 

CIN,also known as cervical dysplasia, is characterized by the presence in thecervix of abnormal cells that can precede and develop into cervicalcancer.  The primary cause of suchabnormalities is infection with HPV types 16 and 18.  Experts recommend screening all sexuallyactive women for HPV.  In the U.S. Papscreens, which are used to help detect HPV, are estimated to cost up to US$6billion per year.  An estimated 1.2million women each year are diagnosed with low-grade cervical dysplasia in theU.S.  Another estimated 200,000 to 300,000women are diagnosed with high-grade cervical dysplasia in the U.S. eachyear.  There are no FDA-approved drugtherapies for CIN.  Typically, high-gradeCIN is treated with a type of surgery called LEEP, estimated to cost fromUS$400 to US$1,450 per treatment.  Theincidence of residual disease after LEEP varies from 20% to 30%. Potentialcomplications include bleeding and the excessive removal of healthytissue.  LEEP is not recommended forlesions that are too deep to view with medical instruments.  In those cases, widely used treatmentsinclude surgery, the cost of which varies depending upon the site of thelesion, or cold-knife cone biopsy, estimated to cost US$3,700 per treatment.None of the treatments are always effective in removing all abnormalcells.  The recurrence rates of CIN havebeen estimated at 19% of patients treated with cryotherapy and 13% of patientstreated with laser surgery or LEEP.  Inaddition, the available treatments do not treat the underlying HPV infection.

 

*HPV Infection in Immunocompromised Patients*

 

Patientsdevelop compromised immune systems for reasons including HIV infection,chemotherapy and the use of immunosuppressants following an organtransplant.  Patients with compromisedimmune systems are particularly prone to HPV infection, including the manifestationsdescribed above and anal intraepithelial neoplasia (“AIN”), a condition similarto CIN but occurring in the anal epithelial tissue. Most treatments for HPVused in the general patient population are also used in immunocompromisedpatients.  Recurrence of HPV-associateddiseases after treatment is especially common in HIV-infected HPV patients. Forexample, 39% to 62% of HIV-positive women have recurrences of CIN, comparedwith 9% to 18% of HIV-negative women. Patients that receive highly active antiretroviral therapy (“HAART”) forHIV have better response rates than HIV patients that do not receiveHAART.  However, they still experiencemore frequent and persistent HPV infections than people without compromisedimmune systems.

 

*Cervical Cancer*

 

Almostall cervical cancers can be attributed to four HPV types: 16, 18, 45 and31.  American Cancer Society estimatesfor 2003 predicted that approximately 12,200 women in the U.S. would bediagnosed with invasive cervical cancer and that about 4,100 patients would diefrom the disease.  Globally, an estimated400,000 new cases of cervical cancer are identified each year. Although deathrates from cervical cancer have declined in developed countries, invasivecervical cancer continues to be associated with extreme morbidity.  Because of the mortality rates, the WorldHealth Organization has called cervical cancer the second most important cancerthreat in women after breast cancer. There are no FDA-approved drug therapies.Patients with cancer are typically treated with surgery and radiation.  If the cancer spreads, chemotherapy can beused to treat the cancer in other areas of the body.

 

*Head and Neck Cancer*

 

Cancersof the oral cavity, pharynx and larynx constitute a serious and increasingpublic health problem worldwide.  In theU.S an estimated 40,000 new head and neck squamous cell carcinomas occurannually. Worldwide, there are an estimated 600,000 head and neck cancers inmen and 270,000 cases in women annually. In studies HPV DNA has been found in an average of 35% of head and necktumors.   The specific percentages ofcancers attributable to HPV can increase depending upon the location of thecancer.  Fifty percent to 70% oforopharyngeal cancers and 60% of tonsillar carcinomas are estimated to beHPV-associated in developed Western countries. No FDA approved therapies or cures exist for HPV-related

 

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head and neck cancers.  Instead,these cancers are treated with surgery and with primary radiation therapy.  However, most oropharyngeal cancers aredetected at a late stage, where the five-year survival rate is 50% or less,despite expensive treatments.  Othercomplications include infections, pain, loss of taste and eating problems.

 

**The Stressgen Solution**

 

Weare developing HspE7 as a broad-spectrum therapeutic vaccine for HPV-relatedconditions.  HspE7 is one of ourproprietary CoValTM fusion proteins. It is made using recombinant DNA technologyto covalently fuse an Hsp to a HPV E7 viral protein to form one therapeuticprotein.  The E7 viral protein is oftenpoorly recognized by the immune system. By combining Hsp with E7, strong E7-specific immune responses can beachieved.  HspE7 works by efficientlytargeting the E7 antigen to dendritic cells, which have a natural affinity forHsp. Dendritic cells are known to be the most potent cells in the body fortriggering immune responses.

 

Dendriticcells are a type of white blood cell that educate other white blood cells,called T cells, to seek out and destroy diseased cells in the body infected byviruses or that are cancerous. Dendritic cells work by binding, engulfing andprocessing proteins called antigens that are expressed by viruses and cancercells into small fragments. The dendritic cells then present these fragments ontheir surface to program T cells to recognize these fragments as foreign andharmful. Once T cells identify the fragments as foreign, they rapidly multiplyand roam the body to target and kill infected cells that express the antigens.These types of T cells are called killer T cells.

 

CouplingE7 to Hsp takes advantage of the Hsp receptors that dendritic cells express ontheir surface to introduce E7, as part of a larger fusion protein, into thedendritic cells.   The introduction ofthe fusion protein appears to allow the dendritic cells to process E7 andproduce specific antigens to promote a killer T cell response against infectedcells that express the E7 protein.  Inpreclinical studies conducted using an animal model, administration of HspE7has been shown to prevent the growth of, and cause the destruction of, tumorsthat express the HPV E7 protein. Only the fusion protein induces significanttumor regression and long-term survival in these studies.  According to our research, neither the E7antigen nor the Hsp alone, nor a mixture of the two, is effective.

 

Webelieve our HspE7 product candidate offers a number of advantages as a therapyfor HPV because, based on our research to date, it:

 

•                  treats a broadspectrum of HPV-diseases;

 

•                  utilizesthe body’s own immune system;

 

•                  actssystemically to reach HPV infections throughout the body;

 

•                  iswell tolerated (based on 400 patients to date);

 

•                  ismuch less invasive than surgery; and

 

•                  isadministered by a short series of injections, assuring patient compliance.

 

**Our Clinical Development Programs**

 

Weplan to build a portfolio of CoValTM fusion candidates. Our leadcandidate is HspE7, which we are currently developing to treat RRP.  We and our collaborators are also developingHspE7 as a treatment for HPV-related conditions in HIV-positive patients, LEEPfailures in CIN patients and genital warts.

 

Intrials involving over 400 patients to date, HspE7 has been well tolerated.  The predominant adverse experience noted fromHspE7 treatment at various doses and schedules has been injection sitereaction, mild to moderate in severity, clearing in hours to days withouttreatment.  Mild to moderate flu-likesymptoms also have been observed in some patients.

 

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*Recurrent Respiratory Papillomatosis*

 

InFebruary 2004 we reported results from an open-label, single arm,multicenter RRP phase II trial in 27 patients ages two to 18 years oldrequiring frequent surgical debulking. The dosing regimen was 500 mg HspE7 subcutaneously every four weeks forthree doses.  Patients were followed forup to 48 weeks from the first dose to assess the frequency of requiredsurgeries and the safety and tolerance of HspE7.  The trial met its targeted primary endpointof lengthening the time between surgeries following treatment with HspE7.  The time betweenpost-treatment surgeries, measured as the median post-treatment interval,increased by a mean of 95%.  Themean of the first post-treatment interval after surgery increased to 106 daysfrom an average of 55 days between surgeries before treatment with HspE7(p<0.02).  The average annual surgeryrate after treatment with HspE7 decreased from approximately 8.7 to 6.5(p<0.003).  Of the 27 patients in thestudy, two patients required no surgery in the 48 week follow-period comparedto a pre-treatment median of 63 days and 101 days respectively. The medianinterval of all surgeries reported following treatment suggests that the27-child patient population experienced an aggregate of 87 fewer surgeriesduring the first year after treatment. Overall, these results were internally consistent and statisticallysignificant.

 

Weheld an end-of-phase II meeting with the FDA in June 2004 to discuss thedesign of our planned pivotal phase III clinical trial.  The FDA plans to review a pivotal clinicaltrial protocol under a Special Protocol Assessment, an agreement with the FDAthat is typically binding regarding the protocol design for a clinical trial tosupport a biologics license application (“BLA”).  We intend to initiate our pivotal phase IIItrial during the second quarter of 2005. Depending on the results, we anticipate being able to submit a BLA forHspE7 to treat RRP in mid-2007.  The FDAhas granted us fast track and orphan drug status for HspE7 in RRP.

 

*Dysplasiasin HIV+ Patients*

 

TheU.S. National Cancer Institute (“NCI”) is sponsoring a phase I/II trial withHspE7 to treat AIN in 15 HIV-positive patients. The trial will evaluate clinical and immunological response ofescalating doses of HspE7 and viral load at six months.  The NCI plans to sponsor a phase II CIN trialin HIV-positive patients.  We haveconducted preclinical studies that demonstrate Hsp fusions induce killer T cellresponses in animals that are deficient in CD4+ T helper cells, which are regulatorycells in the immune system that are best known for their ability to promoteantibody production.  In HIV-positivepatients the number and function of T helper cells is substantially impaired.Because HspE7 activity appears to be independent of T helper cells, we believeit has the potential to treat patients immunocompromised by HIV infection.

 

*Cervical Intraepithelial Neoplasia / LEEP Failures*

 

Twoinvestigators sponsored by the NCI and a university-sponsored collaborator arerunning separate phase II CIN trials targeting the accrual of 249 patients inthe aggregate.  These investigators aresponsoring:

 

•                  two single arm trials in 21 and 12 HIV-negative females with high-gradeCIN to assess pathological and clinical response, HPV status and immunologicalmarkers;

 

•                  a single arm, open-label trial in 66 HIV-negative females withhigh-grade CIN; and

 

•                  a randomized, double-blind placebo controlled trial in 150 HIV-negativefemales with low-grade CIN to assess pathological and clinical response, HPVstatus and immunological markers.

 

Thesetrials use different dosing regimens. If we obtain positive data from one ormore of these phase II trials, we intend to initiate a phase III trial in CINpatients for whom LEEP has not been effective.

 

*Genital Warts*

 

Wehave completed a six month phase II, multicenter, randomized, double-blind,parallel-group, placebo-controlled study in 53 male and female patients withanogenital (external genital or perianal) warts.  The dosing regimen was 500 mg HspE7 administered subcutaneously everyfour weeks for three doses. The

 

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primary objective of the study was to determine whether this regimen was moreeffective than placebo in reducing the total area of anogenital warts. A secondaryobjective of the study was to compare the safety of HspE7 to placebo in thesepatients.  Results from this trial showedthat, at six months, genital warts decreased in size by a median of 53%compared to a median of 16% in patients treated with placebo.  At six months, 35% of patients treated withHspE7 had complete clearance of warts compared with 25% of patients treatedwith placebo.  The complete response ratefor patients with genital warts varied depending on the gender of the patientand location of the warts.  The treatmentmet expectations, but the variance in size reduction was much greater thanexpected. As a result, we concluded that the study did not include sufficientpatients for the trial results to be statistically significant.

 

Duringa study of AIN patients who received 500 mg of HspE7 administered subcutaneously everyfour weeks for three doses, one of our investigators identified an improvementin genital warts.  In a retrospectivereview of the data, 23 patients were identified for continuing follow-up for upto 24 months.  Within the cohort, 11 of23 patients reaching the 12 month evaluation point, 11 of 17 patients reachingthe 18 month evaluation point and eight of ten patients reaching the 24 monthevaluation point had complete clearance of internal and external warts.

 

*Anal Intraepithelial Neoplasia*

 

InFebruary 2004 we reported the results of a randomized, double-blind,placebo-controlled, multicenter phase III trial in AIN in 133 patients, 110 ofwhom continued into a blinded cross-over study. The original HspE7 dosing regimen was 500 mg HspE7 administered subcutaneously everyfour weeks for three doses.  In thecross-over study, patients that had received placebo were given HspE7.  Patients that had received HspE7 were givenone booster from six to 12 months after the initial dose.  The phase III trial did not meet its primaryendpoint of demonstrating that the patients’ dysplasia downgraded from highgrade to low grade or no dysplasia at six months.  The results are difficult to interpret due inpart to a high level of disagreement among the pathologists as to whether thesamples should be classified as high-grade, low-grade or no dysplasia.  In addition, the placebo effect that we had anticipatedbased on a previous phase II trial and studies of the natural history of thedisease doubled from the estimate used to power the study.  Certain secondary endpoints, such asdowngrades assessed through the physician’s observations of manifestations ofthe disease, did achieve statistical significance at certain observational timepoints.

 

Inan earlier open-label phase II trial in 82 patients using three 500 mg subcutaneous doses of HspE7, 82.9% ofpreviously untreated patients with high-grade AIN demonstrated a partialresponse 24 weeks after receiving HspE7, compared with a placebo response rateestimated from an earlier trial to be 18.6%. That trial supported the possibility that HspE7 is effective.  Based on the data in AIN in the aggregate andtaking into account the normal variability in the reading of biopsies, webelieve that HspE7 may be active in AIN. We will assess the appropriate timing for another AIN trial as we obtainadditional information from the NCI dysplasia trials.

 

*HPV-Related Cancers*

 

In2001 we suspended a study in Brazil in patients with advanced cancer after onlyseven of 23 projected patients received the planned five doses of HspE7, basedon investigator feedback that the patients’ carcinoma was so advanced that ameaningful clinical response could not reasonably be expected in a populationof the targeted size.  The treatmentregimen itself was judged to be well tolerated in the dosed patients.  However, preclinical studies conducted inanimal models have provided some evidence to suggest that HspE7 may stimulatecell-mediated immunity to fight cervical cancer.  In vivo studies of tumor implantation andrejection in a murine model of cervical cancer (TC-1 tumor cells) showed:

 

•                  treatment with HspE7 promotes regression ofestablished TC-1 tumors;

 

•                  treatment with HspE7 that leads to tumor regressionalso provides protection against a subsequent challenge with TC-1 tumor cells;and

 

•                  treatment with E7 alone or an admixture of Hsp and E7does not cause regression of TC-1 tumors.

 

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TheNCI plans to sponsor a clinical trial with HspE7 in cervical cancer pending theavailability of clinical supplies.

 

**Follow-on CoValTM Fusion Products**

 

Weare researching other fusion proteins which, like HspE7, are made using ourproprietary technology based on the covalently bonding Hsp to antigensexpressed by viruses or cancers.  As inHspE7 the heat shock protein portion of the fusion may stimulate dendriticcells to process disease-specific antigens to enable the immune system torecognize and destroy cells presenting the antigen.

 

*Hepatitis B*

 

We have begun compiling preclinical data to support an InvestigativeNew Drug (“IND”) application for a fusion of an Hsp and a selected hepatitis Bvirus (“HBV”) antigen.  In mice our HBVfusions have been shown to elicit killer T cells that recognize the HBVantigen, suggesting such killer T cells would be capable of eliminatingHBV-infected cells.  The killer T cellshave also been shown to produce the cytokine interferon gamma, which is knownto have anti-viral activity.  We expectthat the results of these preclinical studies would support a filing for an INDfor the Hsp-HBV antigen fusion protein in 12 to 18 months after initiation ofdevelopment activities.

 

*Herpes Simplex*

 

Weare collaborating with a university to perform preclinical studies on heatshock fusion proteins to treat genital herpes caused by herpes simplex virustype 2 (HSV-2). The university is testing a number of HSV-2 proteins in Hspfusions as therapeutic vaccines in animal models of human genital herpes. Weintend to dedicate additional effort to this project when resources permit.

 

**Strategic Relationships**

 

*Roche Collaboration Agreement*

 

InDecember 2003, we announced a restructuring of our June 2002collaboration agreement with Roche providing for the development andcommercialization of HspE7.  Under therestructured terms we granted Roche an option to develop the first generationHspE7 product, a license to develop a second generation HspE7 product, andnon-exclusive options to negotiate rights to CoValTM fusion productcandidates for the treatment of cancers related to or stemming from HPV andhepatitis C.   Roche can pay fees to makethese options exclusive until January 1, 2007.

 

Inconnection with the first generation of HspE7, the restructured agreement givesus the right to develop and commercialize the product for indications otherthan genital warts, including control of regulatory matters such as INDapplications.  In the original agreementwe were responsible for clinical expenses only for the development of RRP.  In the new agreement we are responsible forthe manufacturing and other costs of all indications that we develop.  If Roche exercises its rights to the firstgeneration product, it will fund all prospective development costs.  Roche can exercise its rights to the firstgeneration of HspE7 by paying a fee, in which case it would also becomeresponsible for event-driven milestones that could result in aggregate paymentsto us of up to US$138,000,000. Under that scenario, we would receive therevenue from all first generation HspE7 product sales in the U.S. and Canadafor three years following approval of a BLA with the FDA and would receivesales-based payments (similar to royalties) of approximately 35% of net salesin the U.S. and Canada thereafter.  Wewould receive sales-based payments of 20% of net sales in countries other thanthe U.S. and Canada.

 

Bypaying additional fees, Roche can exclusively develop the second generationHspE7 product.  In such case Roche would be required to pay the costsof development, manufacturing and commercialization of the product and to makepayments to us upon the achievement of defined milestones. We would alsoreceive tiered, progressive sales-based payments that we believe are competitivewith other agreements of this stage and type.  Commercial success paymentsof up to approximately US$85,000,000 become payable depending upon theaggregate net sales of either or both generations of the HspE7 products. The

 

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restructuredcollaboration agreement gives us the right to discuss, negotiate and execute analternative agreement with a third-party for the development andcommercialization of HspE7 through a license, partnership, joint venture orsimilar transaction.  After March 31,2005 Roche can terminate this right by paying us a fee, which we expect wouldbe either US$10,000,000 or US$15,000,000 depending on the stage of developmentof the product.

 

*Other Research and Development Collaborations*

 

In1999 we entered into a collaboration and signed a clinical trials agreementwith the NCI’s Division of Cancer Treatment and Diagnosis to sponsor trials ofHspE7 for the treatment of cancers caused by HPV.  In June 2002 we signed a second agreementwith the NCI’s Division of Cancer Prevention to sponsor additional clinicaltrials for the prevention of cancers caused by HPV.

 

Ourclinical trials agreements allow the NCI to develop a general plan for clinicaldevelopment of HspE7 for cancer-related indications, solicit clinical researchprotocols from independent investigators and cooperative research groups, andsponsor and fund their studies.  We areexpected to provide clinical grade HspE7 for the investigators to use in theirstudies but not to provide funding.  Wewill receive access to data from the trials in return for providing HspE7.

 

Wehave a number of other collaborative or sponsored research agreements thatcould provide us with important sources of research data and lead to technologydevelopment opportunities.  We haveentered into an agreement with the U.S. National Institute of Allergy andInfectious Diseases to test our hepatitis B product candidate in preclinicalmodels.  We are also sponsoring academicinstitutions to evaluate our hepatitis B product candidate in animal models andto perform research with our CoValTM fusion protein candidates madewith herpes simplex antigens.

 

**Bioreagent Business**

 

ThroughStressgen Bioreagents Limited Partnership, we also produce and sell bioreagentsto build a market awareness of the value of Hsp and to strengthen strategicrelationships with other companies, academic institutions and stress responseresearchers.  Our bioreagent businesssupplies biomedical research reagents to researchers and research organizationsworldwide.  The products that we sellinclude antibodies, proteins, DNA products, ELISA kits and extracts for use instudying cellular stress response pathways, including oxidative stress, apoptosis,neurobiology and more.

 

**Manufacturing**

 

Weare currently working with a contract manufacturer, Avecia Limited (“Avecia”),to develop a quality controlled and quality assured process for producingHspE7.  Avecia has experience usingstandard operating procedures, analytical methods and specifications that allowbiologics such as HspE7 to be manufactured in commercial quantities inaccordance with current GMP and other regulations.  Under the agreement Avecia will performprocess development, scale-up and manufacturing of bulk active ingredient forthe production of commercial-grade clinical supplies needed for our clinicaltrials with HspE7. We anticipate that clinical-grade supplies will be availablein the second quarter of 2005.  We expectthe scope of services covered by the existing agreement to extend through theBLA process.  If we terminate our currentservices agreement with Avecia, we may be required to pay a cancellation fee,which would have been $4,493,000 as of September 30, 2004.  We may also have Avecia manufacturecommercial drug substance under a separate agreement.  A separate contractor will perform the filland finish operations to produce the vialed product.  We expect that our dependence on contractorssuch as Avecia for the process development and manufacture of heat shock proteinfusions will continue for the foreseeable future.

 

**Intellectual Property**

 

Ourintellectual property protection policy involves filing and prosecuting patentapplications relevant to the inventions that we consider meaningful to ourbusiness.  We also rely upon unpatentedtrade secrets, know-how and continuing technological innovation to develop andmaintain a competitive position.  We

 

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havedevoted substantial management attention and resources to maintaining patentsand licenses and conducting an assertive patent prosecution strategy.

 

We have a worldwideexclusive license agreement with the Whitehead Institute for our core fusiontechnology, giving us rights to various patents, pending applications,continuation-in-part applications and their foreign counterparts.  Pursuant to the license agreement we fund theprosecution of the patent applications, which currently include applications inthe U.S., Canada, Europe and Japan.  TwoU.S. patents, which will expire in 2019, and a European patent, which willexpire in 2014, have been granted based on these Whitehead applications.  We are vigorously defending challenges tothese patents, which cover Hsp fusions with viral or cancer-associated antigensand their use as immunotherapeutics, and to our European patent directed to Hspfusions with HPV viral antigens, including HPV E6 and E7, and their use asimmunotherapeutics.  See “Risk Factors —The profitability of our products will depend in part on our ability to protectproprietary rights and operate without infringing the proprietary rights ofothers”.  We also hold issued U.S.patents related to Hsp fusions with HPV viral antigens, including HPV E6 and E7and to the detection of elevated levels of Hsp expression.  Some of our U.S. patent applications receivedpre-GATT filing status, meaning that their terms extend for 17 years after thedate of grant, rather than 20 years from the earliest date of filing.

 

Interpretationand evaluation of biopharmaceutical or biotechnology patent claims presentcomplex and often novel legal and factual questions.  We cannot be sure that:

 

•                  ourpending applications will result in issued patents;

 

•                  theissued patents will be held valid and enforceable if challenged; or

 

•                  acompetitor will not be able to circumvent an issued patent by the developmentor adoption of a competitive non-infringing product or process.

 

Ourbioreagents business requires intellectual property licenses to sell many ofour products.  However, because ourbioreagents sales are spread over more than 400 products, we do not believethat any individual patent or license is material to the bioreagent business.

 

**Competition**

 

Thediseases we are targeting are currently managed through a variety of therapeuticand surgical approaches.  For example,genital warts can be treated by topical creams and ointments, cryosurgery,freezing, electro-surgery and laser treatment. Some papillomas and cancers caused by HPV can be treated surgically.

 

Weare subject to competition from products that use different approaches or meansof accomplishing a similar therapeutic effect as our CoValTM fusionproducts.  Many pharmaceutical andbiotechnology companies also focus their research and product developmentprograms on the treatment of the same therapeutic indications as ours,including HPV-related diseases, HBV and cancer. For example, Merck & Co., Inc. is currently conducting a large phaseIII trial for a preventative vaccine against HPV.

 

Potentialcompetitors that are developing products to treat HPV indications useapproaches including therapeutic vaccines, immunotherapies, immunomodulators,topical therapies and small molecule drugs. As examples, Transgene S.A. andZycos Inc., recently acquired by MGI Pharma, Inc., are conducting clinicaltrials with different formulations of HPV antigens as therapeutic vaccines;Medigene AG is developing a topical immunomodulator.

 

Otherpotential competitors are performing research and developing therapeuticproducts based on the intrinsic nature of stress proteins to assist the body infighting infection and related cancers. Our technology focuses on Hsp covalently fused to antigens; however,there are other ways to potentially use Hsp to modulate immune responses.  Companies including Antigenics Inc. are usingstress protein-related approaches to stimulate or modulate the body’s immunesystem in therapeutic applications. Other

 

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companiessuch as Conforma Therapeutics and Vernalis plc are developing small moleculedrugs to modulate Hsp expression in cells as another approach for cancertherapy.

 

Competitionin our industry may increase over time due to rapid and substantial changes intechnology and other critical inputs required for product development andcommercialization.  Many of ourcompetitors have greater human and financial resources dedicated to productdevelopment and human clinical testing than we do.  Our competitors may have more substantialmarketing and financial resources. Acquisitions of, or investments in, competing pharmaceutical andbiotechnology companies by other firms could increase their financial,marketing and other resources.  Technologicaldevelopments could render our proposed products or technologies non-competitive.

 

Inthe bioreagent market there are numerous suppliers.  Direct competition is more limited in thestress protein area in which we specialize. A few companies have a broad line of competing products, such asAffinity Bioreagents Inc.  Several largercompanies have introduced a limited range of products similar to ours.  Many of our bioreagent product licenses arenon-exclusive.  As a result competitionfrom other suppliers could increase in the future.

 

**Government Regulation**

 

Wemust navigate a complex regulatory process to obtain approval to market ourproducts.  In the U.S. the FDA regulatesdrugs and biological products.  TheHealth Products and Food Branch (“HPFB”) Inspectorate enforces the Canadianrules and regulations governing the production and manufacturing of ourproducts and research and development activities.  In these and other jurisdictions, applicabledrug licensing laws require:

 

•                  carefullycontrolled research and testing of products;

 

•                  governmentalreview and approval of results prior to marketing therapeutic products;

 

•                  licensureof manufacturing facilities; and

 

•                  adherenceto GMP during production.

 

Pre-clinicalstudies must be conducted to test chemistry, pharmacology and efficacy.  Successful pre-clinical results, which entailachieving potentially valuable pharmacological activity combined with anacceptably low level of toxicity, enable the manufacturer of the new drug tofile an IND application to begin clinical trials involving humans.  An IND application must be filed with andaccepted by the FDA or HPFB, as applicable, before human clinical trials maybegin.

 

Clinicaltrials typically include at least three phases. Phase I clinical trials consist of testing a product in a small numberof humans for its safety (toxicity), dose tolerance and pharmacokineticproperties including absorption, distribution, metabolism and elimination.  Phase II clinical trials usually involve alarger patient population than is required for phase I trials.  The phase II trials are conducted to evaluatethe effectiveness of a product in patients having the disease or medicalcondition for which the product is indicated. These trials also serve to identify possible common short-term sideeffects and risks in a larger group of patients.  Potential dosing regimens may also beevaluated during phase II trials. Phase III clinical trials involve conductingtests in an expanded patient population at geographically dispersed sites toestablish clinical safety and effectiveness. These trials usually involve comparison to a standard treatment or to notreatment.  They also generateinformation from which the overall benefit-risk relationship relating to thedrug can be determined to provide a basis for drug labeling.

 

Twokey factors influencing the rate of progression of clinical trials are the rateat which patients can be accrued to participate in the research program andwhether effective treatments are currently available for the disease the drugis intended to treat.  Patient accrualcan depend upon the incidence and severity of the disease and the alternativetreatments available.

 

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Uponcompletion of all clinical studies, the results of these studies are submittedto the U.S. FDA as part of a biologics license application or to Canada’s HPFBas part of a new drug submission, to obtain approval to commence marketing theproduct.  The entity that willmanufacture the product must submit an establishment license application forapproval by the FDA or HPFB.

 

Beforea product can receive approval for marketing in the U.S. or Canada theapplicant must show:

 

•                  developmentof a well-controlled process of manufacturing;

 

•                  preclinicalstudies of safety and pharmacology; and

 

•                  studiesof safety and efficacy in humans.

 

Evenafter a marketing approval is obtained, further studies, including phase IVpost-market studies, may be required to provide additional data on safety andefficacy necessary to gain approval for the use of a product as a treatment forclinical indications other than those for which the product was initiallytested.  The FDA or HPFB may requirepost-market surveillance programs to monitor a product’s side effects.

 

Inaddition to obtaining pre-licensing approval, manufacturing facilities mustconform on an ongoing basis with GMP. After the establishment is licensed for the manufacture of any product,manufacturers are subject to periodic inspections by regulatory authorities.

 

Whetheror not FDA or HPFB approval has been obtained, approval of a product bycomparable regulatory authorities in Europe and other jurisdictions will benecessary prior to commencement of marketing the product in suchcountries.  Each country may impose itsown requirements and may refuse to grant, or may require additional data beforegranting, an approval even though the relevant product has been approved byanother authority.

 

Inaddition to the need to meet regulatory requirements before our products can besold, the nature of our business requires compliance with numerous federal,provincial, state, local and international laws, regulations andrecommendations.  For example, we aresubject to regulations covering:

 

•                  themaintenance of safe working conditions;

 

•                  laboratorymanufacturing practices; and

 

•                  theuse and disposal of hazardous or potentially hazardous substances, includingradioactive compounds and infectious disease agents used in connection with ourresearch work.

 

## **Liquidity and Capital Resources**

 

Since inception we haverelied principally on equity financings, research collaborations and cash flowsgenerated from our bioreagents business to fund our research and developmentprograms, operations and capital expenditures. Through September 30, 2004 we have raised net proceeds of$198,238,000 through equity transactions.

 

In early October 2004, we filed a Canadianpreliminary prospectus pursuant to which we intends to raise US $50,000,000through the sale of common shares of the Company.  The offering price per share and the numberof shares to be placed will be determined prior to the filing of the finalprospectus.  We plan to use the proceedsof the offering to fund development and commercialization of HspE7, our leadproduct candidate.

 

We need to obtainsignificant additional funds through financings or strategic transactions tocontinue product development, manufacturing and commercialization.  If adequate funds are not available fromthose sources, we will be required to delay or reduce the scope of the developmentof HspE7, and divest certain operations for cash.   Based on these considerations, we believeour current capital resources are sufficient to fund operations for twelvemonths.

 

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We employ a financialperformance measurement system designed to ensure our revenues and expenses areconsistent with management’s operational objectives and budgetaryconstraints.  Our cash utilization in 2004 is dependent upon severalfactors, including the timing and progress of clinical development of HspE7 andthe cost of manufacturing clinical supplies.

 

At September 30,2004, we had $31,716,000 of cash, cash equivalents and short-term investments.The $20,374,000 decrease since December 31, 2003 is due principally tospending related to the development of HspE7. At September 30, 2004 and December 31, 2003, approximately 45%and 24%, respectively, of cash, cash equivalents and short-term investmentswere held in U.S. dollars.  During thenine months of 2004, we purchased British pounds to fund payments made toAvecia.  At September 30, 2004approximately 30% of our cash, cash equivalents and short-term investments wereheld in British pounds.  Periodically wemay purchase additional British pounds based on future anticipated payments inthat currency.

 

Forthe three month periods ended September 30, 2004 and 2003, we spent net$6,694,000 and $3,855,000, respectively on operating activities.  During the nine month periods ended September 30,2004 and 2003, we reported $18,341,000 and $11,921,000, respectively net cashused in operating activities.  Theincrease in 2004 over 2003 is due to an increase in net losses recorded offsetby stock compensation expense recorded in 2004 that was not recorded in 2003and higher unrealized foreign exchange losses in 2004 over 2003.

 

Ourcapital expenditures totaled $50,000 and $100,000 during the three monthperiods ended September 30, 2004 and 2003, respectively.  For the nine month periods ended September 30,2004 and 2003 capital expenditures were $238,000 and $154,000, respectively*. *Spendingduring the nine months of 2004 consisted of tenant improvements on ourfacilities, laboratory equipment, and computer related hardware.  Capital expenditures in the fourth quarterare expected to be consistent with third quarter levels.

 

At September 30,2004 and December 31, 2003 we had outstanding principal balances of$724,000 and $1,125,000, respectively, in the form of fixed rate capital leasesand term loans including our September 2003 term loan with Oxford FinanceCorporation (Oxford).  At September 30,2004 and December 31, 2003 the outstanding principal balances were$630,000 and $906,000 on the Oxford loan. Under the terms of the Oxford loan, we must issue a letter of credit forthe outstanding loan balance if our combined cash, cash equivalents, andshort-term investments fall below $6,000,000.

 

*Contractual Obligations*

 

Ourcontractual obligations consist of operating leases for facilities, capitalleases to finance equipment and a term loan to increase working capital cashflows.  Details of these commitments aredescribed in our 2003 Annual Report on Form 10-K under the section “Liquidityand Capital Resources.”  In January 2004we entered into a biological services agreement with Avecia that is cancellable subjectto specified termination conditions. The services agreement, which is furtherdiscussed below, specifies cancellation fees based on a sliding percentage ofcertain future program milestones.  Thecancellation fee as of September 30, 2004 would have been $4,493,000.  During the three and nine month periods endedSeptember 30, 2004 there were no material changes to our contractualobligations.

 

Wehave entered into various contracts for research, process development andlimited product manufacturing to further the development of HspE7.  Due to our goal to retain a flexibledevelopment program, we typically negotiate termination provisions so that ourfinancial obligations are limited to paying for work performed up to the terminationdate and if applicable, pre-established cancellation fees.  Except as disclosed above we currently do nothave other significant research and development contracts subject tocancellation fees.  We have not enteredinto any minimum supply agreements with any service vendors or contract manufacturers.

 

Weexpect to seek additional funds from various sources, including corporatepartners that enter into research and development collaborations with us, andpublic and private equity financings.  Ifwe raise

 

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additionalfunds by issuing equity securities, substantial dilution to our existingshareholders may result.  We may need toobtain funds through collaborative arrangements with others that are onunfavorable terms.  We may also have torelinquish rights to certain of our technologies, product candidates orproducts that we would otherwise seek to develop ourselves.

 

**Results ofOperations**

 

Forthe three month periods ended September 30, 2004 and 2003, our net losswas $7,957,000 and $5,623,000, respectively, or $0.11 and $0.09 per commonshare, respectively.  Our net losses forthe nine month periods ended September 30, 2004 and 2003 were $20,607,000and $12,483,000, respectively, or $0.28 and $0.20 per common share,respectively.  Our increased net lossduring the nine months of 2004 compared to the same period in 2003 is dueprincipally to spending on research and development (R&D) activitiesrelated to manufacturing development that was previously funded by Roche, atime based development payment earned in March 2003, and third partyspending to further the development of HspE7.

 

***Collaborative R&D revenue***

 

Werecorded collaborative R&D revenue of $174,000 and $855,000 during thethree month periods ended September 30, 2004 and 2003, respectively.Collaborative R&D revenue for the nine month periods ended September 30,2004 and 2003 was $537,000 and $7,584,000, respectively.  Collaborative R&D revenue during both thethree and nine month periods in 2004 relates principally to the amortization ofupfront license fees in accordance with CICA Accounting Standards Boardrecommendations, section 3400, *Revenue*and Staff AccountingBulletin (SAB) No. 101 “Revenue Recognition in Financial Statements.”  Collaborative R&D revenue for the ninemonth period ended September 30, 2003 includes $4,615,000 for developmentactivities, a time-based development payment of $2,214,000 and $755,000 fromthe amortization of upfront license fees. Under the terms of the restructured HspE7 collaboration agreement, we expectfuture collaborative R&D revenue to include amortization of the initialup-front license fee which reflects the anticipated development period of HspE7and recognition of future milestone revenues.

 

***Bioreagent sales***

 

Theproduction and sale of bioreagents supports our business strategy by buildingour market presence in stress proteins and strengthening our strategicrelationships with companies, academic institutions and government researchorganizations. Our products are sold directly to end-users and through thirdparty distributors.  For the three monthperiods ended September 30, 2004 and 2003, we reported an 18% increase inbioreagent sales to $1,547,000 from $1,316,000. Bioreagent sales increased by 8% to $4,445,000 during the nine monthperiod ended September 30, 2004 from $4,108,000 during the same period in2003. U.S. and Canadian dollar denominated sales in the nine months of 2004compared to the same period in 2003 increased by 17% and 5%, respectively,aided by the introduction of new products and several higher priced kit-basedresearch products.  The foreign exchangerate applied to U.S. denominated sales was lower in the nine months of 2004compared to the nine months of 2003, thereby diluting the reported improvementin U.S. dollar sales.

 

***Research and development***

 

Researchand development includes costs associated with therapeutic product development,clinical studies, ongoing exploratory research and bioreagent productdevelopment.  In order to optimize ourfinancial flexibility, we employ clinical research organizations to conduct ourclinical trials and engage contract manufacturers to assist us with productdevelopment and manufacturing.

 

OurR&D spending during the nine months of 2004 was devoted principally toactivities in support of developing HspE7, including in-house activitiessupporting the process development of HspE7, spending to close out our AINclinical trials and begin a new Phase II trial, and activities to further theprocess development and manufacturing of HspE7. During the nine months of 2004**approximately85% of our

 

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R&Dspending related to efforts developing HspE7, compared to approximately 65% forthe same period in 2003.  The remainingspending relates to research supporting our bioreagent business and exploratoryresearch involving our follow-on CoValTM fusion proteins.

 

Weheld an end-of-phase II meeting with the FDA in June 2004 to discuss thedesign of our planned pivotal phase III clinical trial.  The FDA plans to review a pivotal clinicaltrial protocol under a Special Protocol Assessment, an agreement with the FDAthat is typically binding regarding the protocol design for a clinical trial tosupport a biologics license application (“BLA”).  We intend to initiate our pivotal phase IIItrial during the second quarter of 2005. Depending on the results, we anticipate being able to submit a BLA forHspE7 to treat RRP in mid-2007.  The FDAhas granted us fast track and orphan drug status for HspE7 in RRP.

 

InSeptember 2004, we announced the initiation of a single arm pilot Phase IIclinical trial to investigate HspE7 in patients with internal genitalwards.  During the third quarter weenrolled approximately two-thirds of the patients and plan to enroll the remainingpatients during the fourth quarter of 2004. Patients will be evaluated up to one year.

 

Alsoin September 2004, we were issued a patent covering a method of treating apatient with RRP using a fusion protein comprised of a heat shock protein fromthe Hsp60 family and an HPV type 16 E7 antigen. This patent provides additional patent exclusivity for HspE7 to treatpatients with RRP through mid-2021.

 

InJanuary 2004, we entered into a biological services agreement withAvecia.  The contract is a multi-yearagreement for process development, scale-up and manufacturing of clinicalsupplies.  Although the timelines maychange for specific manufacturing events covered by the contract, such as GMPbulk release and fill/finish, we believe clinical-grade supplies will beavailable in the second quarter of 2005. We may also have Avecia manufacturecommercial drug substance.

 

R&Dspending increased by approximately 13% to $6,796,000 during the three monthsended September 30, 2004, compared with $6,009,000 for the same period in2003.  For the nine months ended September 30,2004, R&D spending increased by approximately 6% to $18,338,000 from$17,293,000 for the same period in 2003. This increase is due principally to increased spending at Avecia, whichbegan early in 2004; in contrast, in 2003 our third-party spending focused onRoche-requested manufacturing initiatives, which are complete.  Our spending at Avecia is expected tocontinue to be a major component of our R&D spending during the remainderof 2004 up to mid-2005 as we transition from process development activities toinitial production runs of bulk drug substance for our upcoming pivotal trial.

 

Duringthe remaining three months of 2004, we expect to continue to devote themajority of planned R&D spending to support HspE7 development and thestart-up activities relating to our RRP Pivotal trial and other relatedclinical initiatives.

 

***Selling, general and administrativeexpenses***

 

Selling,general and administrative expense, or SG&A, includes executive management,business development, investor relations, legal support and generaladministrative activities.

 

SG&Aspending increased by approximately 14% to $1,724,000 for the three monthperiods ended September, 2004 from $1,510,000 for the same period in 2003.  This increase is primarily due to the use ofexternal consultants and additional fees for attest services over internalcontrols over financial reporting to ensure compliance with requirements ofSarbanes-Oxley regulations.  For the ninemonth periods ended September 30, 2004 and 2003, SG&A spending was$5,969,000 and $5,666,000, respectively.

 

***Cost of bioreagent sales***

 

Theaggregate cost of bioreagent sales as a percentage of bioreagent sales wasapproximately 25% and 22% for the three month periods ended September 30,2004 and 2003, respectively, resulting in gross margins of

 

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75%and 78%, respectively.   For the ninemonth periods ended September 30, 2004 and 2003 the aggregate cost ofsales was approximately 24% and 26%, respectively, resulting in gross marginsof 76% and 74%, respectively.

 

***Interest and other income, net***

 

Interestand other income, net increased during the three month periods ended September 30,2004 by 539% to $262,000 compared with $41,000 during the same period in2003.  The increase is due principally toa write-down of our fixed income investment portfolio of $284,000 recorded inthe third quarter of 2003 that was not repeated in the third quarter of2004.  During the nine month periodsended September 30, 2004 and 2003 interest and other income increased by13% to $564,000 from $499,000, respectively.

 

***Net foreign exchange gain/loss***

 

Forthe three month period ended September 30, 2004 we recorded net foreignexchange losses of $1,014,000 compared with losses of $12,000 for the sameperiod in 2003.  During the third quarterof 2004, the Canadian dollar strengthened against the U.S. dollar and theBritish pound compared to recent levels. Since approximately 75% of our cash, cash equivalents and short terminvestments are held in currencies other than the Canadian dollar, weexperienced a foreign exchange loss. During the nine months of 2004, we recorded foreign exchange losses of$723,000 compared to $638,000 for the same period in 2003.

 

# ***Basicand diluted loss per share***

 

The42% increase in net loss to $7,957,000 for the three month periods ended September 30,2004 compared with $5,623,000 for the same period in 2003, was diluted by a 18%increase in the weighted average number of common shares outstanding, resultingin basic and diluted loss per share of $0.11 in 2004 and $0.09 in 2003.  The 65% increase innet loss to $20,607,000 for the nine month periods ended September 30,2004 compared with $12,483,000 for the same period in 2003, was diluted by a19% increase in the weighted average number of common shares outstanding,resulting in basic and diluted loss per share of $0.28 in 2004 and $0.20 in2003.

 

***Differences between Canadian and U.S.generally accepted accounting principles***

 

Ourconsolidated financial statements include adjustments necessary for their fairpresentation in accordance with Canadian GAAP. Certain adjustments would be required if these statements were to beprepared in all material respects in accordance with U.S. GAAP.

 

Toconform to U.S. GAAP, our net loss would decrease by $1,438,000 and $2,417,000for the three and nine month periods ended September 30, 2004.  The principal differences under U.S. GAAP asopposed to Canadian GAAP for the three and nine month periods ended September 30,2004 were the reversal of an unrealized foreign exchange loss on investments of$1,248,000 and $1,005,000, a reversal of a gain on market value of investmentsof $38,000 and a loss of $272,000 and the reversal of stock compensationexpense totaling $242,000 and $1,206,000 related to fair value stock optionaccounting adopted beginning January 1, 2004, offset by stock compensationexpense of $14,000 and $66,000 that would be recorded under APB Opinion No.25.  U.S. GAAP does not currently requirefair value accounting on stock based compensation.  Therefore, under the provisions of APBOpinion No. 25, no expense is recorded for options granted with an exerciseprice equal to the fair value of the stock on the day of grant.  Under APB Opinion No. 25 expense is incurredwhen stock options are granted at exercise prices less than the fair value ofthe underlying stock.  Further, underU.S. GAAP, adjustments to the market value of our investment portfolio would berecorded as a component of stockholders’ equity.  Under Canadian GAAP unfavorable market valueadjustments are recorded as a component of operations.

 

To conform to U.S. GAAP our net loss would decrease by $160,000 and$550,000 for the three and nine month periods ended September 30,2003.  The principal differences underU.S. GAAP as opposed to Canadian GAAP for the current quarter and nine monthperiods ended September 30, 2003, respectively,

 

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were the reversal of unrealized foreign exchange gain onavailable-for-sale securities of $124,000 and a loss of $214,000, coupled witha $284,000 and $336,000 reversal of a write-down of short term investments.

 

Basic netloss per common share under U.S. GAAP would have been $0.09 and $0.25 in thethree and nine month periods ended September 30, 2004, respectively.  Basic net loss per common share under U.S.GAAP would have been $0.09 and $0.20 in the three and nine month periods ended September 30,2003, respectively.   Our current assetsand stockholders’ equity at September 30, 2004 are the same under U.S.GAAP and Canadian GAAP.

 

**Summary of Quarterly Results**

 

The following is a summary of the unaudited quarterlyresults of operations for the previous eight quarters beginning with thequarter ended September 30, 2004.

 
| ** **                                  | ** ** | **Quarter ended**           | ** ** |
|---------------------------------------------|------------|-----------------------------|------------|
| **(In thousands except per share amounts)** | ** ** | **September 30, 2004** | ** ** | **June 30, 2004** | ** ** | **March 31, 2004** | ** ** | **December 31, 2003** | ** ** |
| Net revenues                                |       |                        |       |   |   |   |   |   |   |
| Canadian and U.S. GAAP                      |       | $                           | 1,721      |   | $ | 1,636 |   | $ | 1,625 |   | $ | 1,727 |   |
|                                        |       |                        |       |   |   |   |   |   |   |
| Research and development  expenses          |       |                        |       |   |   |   |   |   |   |
| Canadian and U.S. GAAP                      |       | 6,796                       |       | 5,973 |   | 5,569 |   | 3,572 |   |
|                                        |       |                        |       |   |   |   |   |   |   |
| Net loss (1)                                |       |                        |       |   |   |   |   |   |   |
| Canadian GAAP                               |       | (7,957                      | )          | (6,366 | ) | (6,284 | ) | (3,762 | ) |
| U.S. GAAP                                   |       | (6,519                      | )          | (6,014 | ) | (5,657 | ) | (3,365 | ) |
|                                        |       |                        |       |   |   |   |   |   |   |
| Basic and diluted loss per  common share    |       |                        |       |   |   |   |   |   |   |
| Canadian GAAP                               |       | $                           | (0.11      | ) | $ | (0.09 | ) | $ | (0.09 | ) | $ | (0.06 | ) |
| U.S. GAAP                                   |       | $                           | (0.09      | ) | $ | (0.08 | ) | $ | (0.08 | ) | $ | (0.05 | ) |

 
| ** **                               | ** ** | **Quarter ended**           | ** ** |
|------------------------------------------|------------|-----------------------------|------------|
| ** **                               | ** ** | **September 30, 2003** | ** ** | **June 30, 2003** | ** ** | **March 31, 2003** | ** ** | **December 31, 2002** | ** ** |
| Net revenues                             |       |                        |       |   |   |   |   |   |   |
| Canadian and U.S. GAAP                   |       | $                           | 2,171      |   | $ | 2,881 |   | $ | 6,640 |   | $ | 5,320 |   |
|                                     |       |                        |       |   |   |   |   |   |   |
| Research and development  expenses       |       |                        |       |   |   |   |   |   |   |
| Canadian and U.S. GAAP                   |       | 6,009                       |       | 4,791 |   | 6,493 |   | 7,167 |   |
|                                     |       |                        |       |   |   |   |   |   |   |
| Net loss (1)                             |       |                        |       |   |   |   |   |   |   |
| Canadian GAAP                            |       | (5,623                      | )          | (4,403 | ) | (2,457 | ) | (4,059 | ) |
| U.S. GAAP                                |       | (5,463                      | )          | (4,222 | ) | (2,248 | ) | (3,981 | ) |
|                                     |       |                        |       |   |   |   |   |   |   |
| Basic and diluted loss per  common share |       |                        |       |   |   |   |   |   |   |
| Canadian GAAP                            |       | $                           | (0.09      | ) | $ | (0.07 | ) | $ | (0.04 | ) | $ | (0.07 | ) |
| U.S. GAAP                                |       | $                           | (0.09      | ) | $ | (0.07 | ) | $ | (0.04 | ) | $ | (0.07 | ) |

 

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(1)                                  To conform these results to U.S. GAAP, certain adjustments would bemade.  The principal differences betweenU.S. GAAP and Canadian GAAP are described in detail in the notes to our 2003and 2002 financial statements and our March 31, 2004, June 30, 2004,and September 30, 2004 interim financial statements.

 

Our quarterlyfinancial results over the past eight quarters were principally affected byvariations in revenues from our Roche collaboration and variations in R&Dspending.  Our collaborative R&Drevenues have decreased over time due principally to our December 2003restructured Roche agreement under which

 

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we are notreimbursed for R&D spending related to HspE7.   Another variation in our revenues occurredin the first quarter of 2003 when we received a time based developmentmilestone.  There have not been anymilestone payments since that time.  Thefluctuation of R&D expense over the most recent eight quarters relates totiming of spending associated with our clinical trials, process development andmanufacturing of HspE7.   See thediscussion under the captions “Results of Operations—Collaborative R&DRevenue” and “Results of Operations—Research and Development” for additionalinformation.

 

**CriticalAccounting Policies**

 

Oursignificant accounting policies are disclosed in Note 1 to our consolidatedfinancial statements herein.  Certain ofour policies require the application of management judgment in making estimatesand assumptions that affect the amounts reported in the consolidated financialstatements and disclosures made in the accompanying notes.  Those estimates and assumptions are based onhistorical experience and various other factors deemed applicable andreasonable under the circumstances.  Theuse of judgment in determining such estimates and assumptions is, by nature,subject to a degree of uncertainty. Accordingly, actual results could differ from the estimates made.  Our critical accounting policies include:

 

***Revenue recognition***

 

Revenuefrom collaborative R&D arrangements may include multiple elements within asingle contract.  Our accounting policycomplies with the revenue determination requirements set forth in EITF 00-21 “Accountingfor Revenue Arrangements with Multiple Deliverables,” and EIC 142 “RevenueArrangements with Multiple Deliverable,” relating to the separation of multipledeliverables into individual accounting units with determinable fairvalues.  We estimate the fair value ofdeliverables in collaboration agreements using standard industrytechniques.  Changes in the determinationof fair values or performance periods relating to certain deliverables, andassociated milestones, could impact the timing of future revenue streams.

 

***Clinical trial accruals***

 

Clinicaltrial costs constitute a significant portion of R&D expense.  We recognize expenses related to our ongoingclinical trials using a methodology designed to accrue estimated costs in theappropriate accounting periods in which the expenses are incurred.    We recognize clinical trial costs in threedistinct phases that correspond with the period during which the services areperformed:  the start-up phase, thepatient accrual phase, and the close-out phase. Based on the design of thetrial, including the number of patients, number of clinical sites, method oftreatment, and follow-up, the allocation of trial costs to each phase couldvary from trial to trial.   Using our currenttrial accrual methodology, our liability for clinical trials as of September 30,2004 is $593,000, which includes the estimated effect of any work-in-processterminated at the end of the reporting period. Alternatively, if we utilized a percentage of completion approach andused an operational estimate of the actual work completed as of September 30,2004 compared to the total contract value, our clinical trial liability woulddecrease by approximately $434,000.

 

***Stock-based compensation***

 

In September 2003the CICA Accounting Standards Board released revised transitional provisionsfor *Stock-Based Compensation and OtherStock-Based Payments*, Section 3870, to provide the samealternative methods of transition as is provided in the U.S. for voluntaryadoption of the fair value based method of accounting.  The AcSB has also amended Section 3870to require that all transactions whereby goods and services are received inexchange for stock-based compensation and other payments result in expensesthat should be recognized in financial statements, and that this requirementwould be applicable for financial periods beginning on or after January 1,2004.  Section 3870 requires thatshare-based transactions should be measured on a fair value basis. Weretroactively adopted the provisions of CICA Section 3870 beginning January 1,1995.  See the detail at Note 2 in thefinancial statements included herein.

 

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**New U.S. GAAP Accounting Pronouncement**

 

The Emerging Issues TaskForce (EITF) recently deliberated regarding Issue 03-01, “The Meaning ofOther-Than-Temporary Impairment and Its Application to Certain Investments.”  The Issue is intended to address the meaningof other-than-temporary impairment and its application to certain investmentsheld at cost.  The EITF reached aconsensus regarding disclosure requirements concerning unrealised losses onavailable-for-sale debt and equity securities accounted for under SFAS No.115.  The guidance for evaluating whetheran investment is other-than-temporarily impaired has been deferred.  The disclosure requirements apply to annualfinancial statements for fiscal years ending after December 15, 2003 forinvestments accounted for under SFAS No. 115. For all other investments within the scope of this Issue, the disclosurerequirements have been deferred. Additional disclosure requirements for cost method investments apply tofiscal years ending after June 15, 2004. We continue to evaluate the effect of this pronouncement on ourfinancial statements.

 

**Factors That May Affect Future Performance**

 

*Investingin our securities involves a high degree of risk.  The risks and uncertainties described beloware not the only ones facing us. Additional risks and uncertainties that we are unaware of, or that wecurrently deem immaterial, also may become important factors that affectus.  If any of the following risks occur,our business, financial condition or results of operations could be materiallyand adversely affected.  In that case,the trading price of our stock could decline, and you may lose some or all ofyour investment.*

 

**Weare an early stage development company**

 

Ourbiotechnology business is still at an early stage of development.  Significant additional research anddevelopment and clinical trials must be completed before our technology can becommercialized.  We have not completedthe development of any therapeutic products and, therefore, have not begun tomarket or generate revenues from the commercialization of any therapeutic products.  We have undertaken only limited humanclinical trials for HspE7 and cannot assure you that subsequent trials willgenerate favourable results, that the results obtained from laboratory orresearch studies for our other products will be replicated in human studies,that our human studies will demonstrate efficacy or that our studies and trialswill not identify undesirable side effects of our products.  There are no assurances that any of ourtherapeutic products will:

 

•                  meet applicablehealth regulatory standards;

 

•                  obtain required regulatoryapprovals or clearances;

 

•                  be produced incommercial quantities at reasonable costs;

 

•                  be successfullymarketed; or

 

•                  be profitable enoughthat we will recoup the investment made in such product candidates.

 

Noneof our therapeutic product candidates are expected to be commercially availablefor several years.  It is possible thatwe will not successfully develop any therapeutic products.

 

**We have a history of operating losses and may never become profitable**

 

Wehave not recorded any revenues from the sale of therapeutic products and haveaccumulated substantial net losses.  Weexpect we will continue to incur losses for at least the next several yearswhile our primary activities are research, development and clinicaltrials.  To become profitable we, eitheralone or with one or more partners, must develop, manufacture and successfullymarket therapeutic product candidates.

 

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**We may require additional financing to execute our business plan**

 

Therevenues from our production and sale of bioreagents and our projected revenuesfrom collaborators are not adequate to support either the development of HspE7under our restructured Collaboration Agreement with F. Hoffmann-La Roche Ltd. andHoffmann-La Roche Inc. (together, “Roche”) or our other therapeutic product developmentprograms.  If we receive less thanUS$50,000,000 of gross proceeds in our proposed offering of common stock, theamount of proceeds allocated to the development and commercialization of HspE7will be reduced accordingly.  Even if theproposed offering is successfully completed, we may need additional funds to:

 

•                  pursue furtherresearch and development;

 

•                  conduct clinicaltrials;

 

•                  obtain regulatoryapprovals;

 

•                  file, prosecute, defendand enforce our intellectual property rights; and

 

•                  market our products.

 

Wemay seek additional funds through public or private equity or debt financing,strategic transactions and/or from other sources.  We could enter into collaborative arrangementsfor the development of particular products that would lead to our relinquishingsome or all rights to the related technology or products.

 

Thereare no assurances that future funding will be available on favorable terms orat all.  If adequate funding is notobtained, we will need to reduce, defer or cancel development programs, plannedinitiatives or overhead expenditures, to the extent necessary.  The failure to fund our capital requirementswould have a material adverse effect on our business, financial condition andresults of operations.

 

**Our success depends on collaborative partners, licensees and otherthird parties over whom we have limited control**

 

Dueto the complexity of the process of developing therapeutics, our core businessdepends on arrangements with pharmaceutical companies, corporate and academiccollaborators, licensors, licensees and others for the research, development,clinical testing, technology rights, manufacturing, marketing andcommercialization of our products. We have various research collaborations andoutsource many other business functions, including clinical trials andmanufacturing.  Our license agreementscould obligate us to diligently bring potential products to market, make milestonepayments and royalties that, in some instances, could be substantial, and incurthe costs of filing and prosecuting patent applications.  There are no assurances that we will be ableto establish or maintain collaborations that are important to our business onfavorable terms, or at all.

 

Anumber of risks arise from our dependence on collaborative agreements withthird parties.  Product development andcommercialization efforts could be adversely affected if key collaborativepartners:

 

•                  terminate or suspendtheir agreements with us;

 

•                  cause delays;

 

•                  fail to timelydevelop or manufacture in adequate quantities a substance needed in order toconduct clinical trials;

 

•                  fail to adequatelyperform clinical trials;

 

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•                  determine not todevelop, manufacture or commercialize a product to which they have rights; or

 

•                  otherwise fail tomeet their contractual obligations.

 

Also,our collaborative partners could pursue other technologies or developalternative products that could compete with the products we are developing.

 

**The profitability of our products will depend in part on our ability toprotect proprietary rights and operate without infringing the proprietaryrights of others**

 

Theprofitability of our products will depend in part on our ability to obtain andmaintain patents and licenses and preserve trade secrets, and the period ourintellectual property remains exclusive. We must also operate without infringing the proprietary rights of thirdparties and without third parties circumventing our rights. The patentpositions of pharmaceutical and biotechnology enterprises, including ours, areuncertain and involve complex legal and factual questions for which importantlegal principles are largely unresolved. For example, no consistent policy has emerged regarding the breadth ofbiotechnology patent claims that are granted by the U.S. Patent and TrademarkOffice or enforced by the U.S. federal courts. In addition, the scope of the originally claimed subject matter in apatent application can be significantly reduced before a patent is issued.  The biotechnology patent situation outsidethe U.S. is even more uncertain, is currently undergoing review and revision inmany countries, and may not protect our intellectual property rights to the sameextent as the laws of the U.S.  Becausepatent applications are maintained in secrecy in some cases, we cannot becertain that we or our licensors are the first creators of inventions describedin our pending patent applications or patents or the first to file patentapplications for such inventions.

 

Othercompanies may independently develop similar products and design around anypatented products we develop.  We cannotassure you that:

 

•                  any of our patentapplications will result in the issuance of patents;

 

•                  we will developadditional patentable products;

 

•                  the patents we havebeen issued will provide us with any competitive advantages;

 

•                  the patents of otherswill not impede our ability to do business; or

 

•                  third parties willnot be able to circumvent our patents.

 

On October 22,2002 Antigenics Inc. announced that it had filed an opposition in the EuropeanPatent Office to a European patent and requests for re-examination in the U.S.Patent and Trademark Office of two U.S. patents we licensed in connection withour platform technology.  In October 2003Antigenics filed an opposition in the European Patent Office to an additional,product specific, European patent.  Itcould take several years to obtain results from these proceedings.  Until we receive final results from theopposition and re-examination processes, we will not be able to assureinvestors of the success of our planned vigorous defense of the patents.

 

Anumber of pharmaceutical, biotechnology, research and academic companies andinstitutions have developed technologies, filed patent applications or receivedpatents on technologies that may relate to our business.  If these technologies, applications orpatents conflict with ours, the scope of our current or future patents could belimited or our patent applications could be denied.  Our business may be adversely affected ifcompetitors independently develop competing technologies, especially if we donot obtain, or obtain only narrow, patent protection.  If patents that cover our activities areissued to other companies, we may not be able to: obtain licenses at areasonable cost, or at all; develop our technology; or introduce, manufactureor sell the products we have planned.

 

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Patentlitigation is becoming widespread in the biotechnology industry.  Such litigation may affect our efforts toform collaborations, to conduct research or development, to conduct clinicaltesting or to manufacture or market any products under development.  There are no assurances that our patentswould be held valid or enforceable by a court or that a competitor’s technologyor product would be found to infringe our patents in the event of patentlitigation.  Our business could bematerially affected by an adverse outcome to such litigation.  Similarly, we may need to participate ininterference proceedings declared by the U.S. Patent and Trademark Office orequivalent international authorities to determine priority of invention.  We could incur substantial costs and devotesignificant management resources to defend our patent position or to seek adeclaration that another company’s patents are invalid.

 

Muchof our know-how and technology may not be patentable, though it may constitutetrade secrets. There are no assurances that we will be able to meaningfullyprotect our trade secrets.  We cannotassure you that any of our existing confidentiality agreements with employees,consultants, advisors or collaborators will provide meaningful protection forour trade secrets, know-how or other proprietary information in the event ofany unauthorized use or disclosure. Collaborators, advisors or consultants may dispute the ownership ofproprietary rights to our technology, for example by asserting that theydeveloped the technology independently.

 

**We may encounter difficulties in manufacturing our products**

 

Ourmanufacturing experience in bioreagents is not directly applicable to themanufacture of therapeutic products.  Wehave not yet introduced any therapeutic products and have no experiencemanufacturing therapeutic vaccines ourselves. Before our products can be profitable, they must be produced incommercial quantities in a cost-effective manufacturing process that complies withregulatory requirements, including good manufacturing practices (“GMP”),production and quality control regulations. Because we do not have facilities for the production of therapeuticproducts such as HspE7, we contract with third parties for process development,the scale-up of manufacturing our products from the laboratory bench tocommercial quantities, manufacturing of bulk materials, productcharacterization, filling the product into vials, packaging and relatedprocesses.  If there are delays ordifficulties in developing a commercial manufacturing process, performingmanufacturing or transferring HspE7 between contractors performing differentaspects of the manufacturing process, we may not be able to conduct clinicaltrials, obtain regulatory approval or meet demand for our products.

 

Productionof future products could require raw materials which are scarce or which can beobtained only from a limited number of sources. If our manufacturers were unable to obtain adequate supplies of such rawmaterials, the development, regulatory approval and marketing of our productscould be delayed.

 

**We could need more clinical trials or take more time to complete ourclinical trials than we have planned**

 

Clinicaltrials vary in design by factors including dosage, end points, length,controls, and numbers and types of patients enrolled.  We may need to conduct a series of trials todemonstrate the safety and efficacy of our products.  The results of these trials may not demonstratesafety or efficacy sufficiently for regulatory authorities to approve ourproducts.

 

Regulatoryauthorities may require us to determine whether our products delay or preventdisease recurrence.  Clinical trials toshow that a disease does not recur take longer to complete than clinical trialsthat end when patients stop having specific symptoms.  The actual schedules for our clinical trialscould vary dramatically from the forecasted schedules due to factors includingchanges in trial design, conflicts with the schedules of participatingclinicians and clinical institutions, delayed patient accrual and changesaffecting product supplies for clinical trials.

 

Werely on collaborators, including academic institutions, governmental agenciesand clinical research organizations, to conduct, supervise, monitor and designsome or all aspects of clinical trials involving our products.  The U.S. National Cancer Institute issponsoring some HspE7 clinical trials. Since these trials depend on governmental participation and funding, wehave less control over their timing and design than

 

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trialswe sponsor.  Delays in or failure tocommence or complete any planned clinical trials could delay the ultimatetimelines for product release.

 

**We may not be able to obtain the regulatory approvals or clearancesthat are necessary to commercialize our products**

 

TheU.S., Canada and other countries impose significant statutory and regulatoryobligations upon the manufacture and sale of human therapeutic products.  Each regulatory authority typically has alengthy approval process in which it examines pre-clinical and clinical dataand the facilities in which the product is manufactured.  Regulatory submissions must meet complexcriteria to demonstrate the safety and efficacy of the ultimate products.  Addressing these criteria requiresconsiderable data collection, verification and analysis.  We may spend time and money preparingregulatory submissions or applications without assurances as to whether theywill be approved on a timely basis or at all.

 

Ourproduct candidates, some of which are currently in the early stages ofdevelopment, will require significant additional development and pre-clinicaland clinical testing prior to their commercialization. These steps and theprocess of obtaining required approvals and clearances can be costly andtime-consuming.  If our potentialproducts are not successfully developed, cannot be proven to be safe andeffective through clinical trials, or do not receive applicable regulatoryapprovals and clearances, or if there are delays in the process:

 

•                  thecommercialization of our products could be adversely affected;

 

•                  anycompetitive advantages of the products could be diminished; and

 

•                  revenuesor collaborative milestones from the products could be reduced or delayed.

 

Governmentaland regulatory authorities may approve a product candidate for fewerindications or narrower circumstances than requested or may condition approvalon the performance of post-marketing studies for a product candidate.  Even if a product receives regulatoryapproval and clearance, it may later exhibit adverse side effects that limit orprevent its widespread use or that force us to withdraw the product from themarket.

 

Anymarketed product and its manufacturer will continue to be subject to strictregulation after approval.  Results ofpost-marketing programs may limit or expand the further marketing ofproducts.  Unforeseen problems with anapproved product or any violation of regulations could result in restrictionson the product, including its withdrawal from the market and possible civilactions.

 

Themanufacturers of our products will be required to comply with applicable GMPregulations, which include requirements relating to quality control and qualityassurance, as well as the maintenance of records and documentation.  If the manufacturers cannot comply withregulatory requirements, including applicable GMP requirements, we may not beallowed to develop or market the product candidates.  If we or our manufacturers fail to complywith applicable regulatory requirements at any stage during the regulatoryprocess, we may be subject to sanctions, including fines, product recalls,product seizures, injunctions, refusal of regulatory agencies to review pendingmarket approval applications or supplements to approve applications, total orpartial suspension of production, civil penalties, withdrawals of previouslyapproved marketing applications and criminal prosecution.

 

**Competitors may develop and market drugs that are less expensive, moreeffective or safer, making our products obsolete or uncompetitive**

 

Many competitors andpotential competitors have substantially greater product developmentcapabilities and financial, scientific, marketing and staffing resources thanwe do.  Technological competition frompharmaceutical companies and biotechnology companies is intense and is expectedto increase.  Other companies havedeveloped technologies that could be the basis for competitive products.  Some of these

 

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products have an entirelydifferent approach or means of accomplishing the desired therapeutic effectthan products we are developing. Alternative products may be developed that are more effective, workfaster and are less costly than our products. Competitors may succeed in developing products earlier than us,obtaining approvals and clearances for such products more rapidly than us, ordeveloping products that are more effective than ours.  In addition, other forms of medical treatment,such as surgery, are competitive with our products. Over time, our technologyor products may become obsolete or uncompetitive.  See “Business of the Corporation -Competition.”

 

**Our products may not gain market acceptance**

 

Productssuch as HspE7, our lead therapeutic vaccine candidate, may not gain marketacceptance among physicians, patients, healthcare payors and the medicalcommunity.  The degree of marketacceptance of any product depends on a number of factors, includingestablishment and demonstration of clinical efficacy and safety,cost-effectiveness, clinical advantages over alternative products, andmarketing and distribution support for the products.  Limited information regarding these factorsis available in connection with our products or products that may compete withours.

 

Our sales experience is limited to the sale of bioreagents.  We do not have experience sellingtherapeutics such as HspE7.  To directlymarket and distribute any pharmaceutical products, we or our collaborators willneed a marketing and sales force with appropriate technical expertise andsupporting distribution capabilities.  Wemay not be able to establish sales, marketing and distribution capabilities orenter into arrangements with third parties on acceptable terms.  If we or our partners cannot successfullymarket and sell our products, our ability to generate revenue will be limited.

 

**Our operations and the use of our products could subject us to damagesrelating to injuries or accidental contamination**

 

Thehuman clinical trials we conduct, including trials in children, may haveunforeseen long-term health implications. We have only limited amounts of product liability insurance for ourclinical trials.  We may not correctlyanticipate or be able to maintain on acceptable terms the level of insurancecoverage that would adequately cover potential liabilities from proposedclinical trials and eventual commercial sales. Product liability insurance is expensive, difficult to obtain and maynot be available in the future.  If wecannot obtain sufficient insurance coverage or other protection againstpotential product liability claims, the commercialization of our products maybecome financially infeasible.  If anyliabilities from a claim exceed the limit of insurance coverage, we may nothave the resources to pay them.

 

Ourresearch and development processes involve the controlled use of hazardous andradioactive materials.  We are subject tofederal, state, provincial and local laws and regulations governing the use,manufacture, storage, handling and disposal of such materials and wasteproducts.  The risk of accidentalcontamination or injury from handling and disposing of such materials cannot becompletely eliminated. In the event of an accident involving hazardous orradioactive materials, we could be held liable for resulting damages.  We are not insured with respect to thisliability. Such liability could exceed our resources.  In the future we could incur significantcosts to comply with environmental laws and regulations.

 

**Our success depends on attracting and retaining qualified personnel**

 

Wedepend on a core management and scientific team.  The loss of any of these individuals couldprevent us from achieving our business objective of commercializing our productcandidates.  Our future success willdepend in large part on our continued ability to attract and retain otherhighly qualified scientific, technical and management personnel, as well aspersonnel with expertise in clinical testing and government regulation.  We face competition for personnel from othercompanies, universities, public and private research institutions, governmententities and other organizations.  If ourrecruitment and retention efforts are unsuccessful, our business operationscould suffer.

 

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**Our revenues will depend upon the availability of reimbursement fromthird-party payors that are increasingly challenging the price and examiningthe cost effectiveness of medical products and services**

 

Salesof therapeutic products depend in part upon the availability of reimbursementfrom third-party payors, including government health administrationauthorities, managed care providers, private health insurers and otherorganizations.  These third-party payorsincreasingly attempt to contain costs by challenging the price of products andservices and limiting the coverage and level of reimbursement forpharmaceutical products.  Third partyreimbursement for our products may be inadequate to enable us to maintainprices that provide a return on our product development investment.  Governments continue to propose and passlegislation designed to reduce healthcare costs.  This legislation could further limitreimbursement.  If government andthird-party payors do not adequately reimburse patients for the costs of ourproducts, the market for our products may be limited.

 

**Our share price has been and is likely to continue to be highlyvolatile**

 

Ourshare price has been highly volatile in the past and is likely to continue tobe volatile. The price of our shares could be materially affected by factorsincluding:

 

•                  the announcement ofclinical trials results by us or our competitors;

 

•                  regulatory actions;

 

•                  safety issues;

 

•                  changes affectingpatents or exclusive licenses;

 

•                  future issuances ofshares;

 

•                  the announcement oftechnological innovations;

 

•                  the release oftechnical, financial, research and other publications;

 

•                  the development ofnew commercial products;

 

•                  changes inregulations;

 

•                  the release offinancial results;

 

•                  public concerns overrisks relating to biotechnology;

 

•                  sales of shares byexisting shareholders; and

 

•                  changes in analystrecommendations.

 

**Item 3.****  QUANTITATIVE AND QUALITATIVE DISCLOSURESABOUT MARKET RISK**

 

We use the Canadian dollaras our measurement and functional currency. As a result, we are exposed to foreign currency fluctuations through ouroperations because a substantial amount of our contract research anddevelopment spending has been transacted in other currencies, principally inU.S. dollars and British pounds.  We holdinvestment balances in the currencies in which we have expenditures plannedduring the foreseeable future.  Duringthe nine months of 2004, we purchased British pounds to mitigate our currencyexposure based on spending plans with Avecia. Our U.S. dollar denominated expenses and revenues are partially matchedby our bioreagent product sales, 95% of which are in U.S. dollars.  We translate monetary

 

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assets and liabilities intoCanadian dollars using the rates of exchange prevailing at our balance sheetdate. We record the resulting exchange gains and losses in our statement ofoperations.  Although we do not currentlyengage in hedging or other activities to reduce foreign currency risk, beyondmatching investments proportionately with anticipated spending, we may do so inthe future if conditions change.

 

A hypothetical change in U.S dollar exchange rates calculated byapplying a 10% change to the September 30, 2004 foreign exchange rate,then applying that rate to our average level of U.S. investments during 2004,would result in a $1,088,000 impact.  Ifthe value of the Canadian dollar relative to the U.S. dollar were to increaseby 10%, our net loss would decrease by $1,088,000.  Further, if the value of the Canadian dollarrelative to the U.S. dollar were to decrease by 10%, our net loss wouldincrease by $1,088,000.

 

A hypothetical change in British pound exchange rates calculated by applyinga 10% change to our September 30, 2004 foreign exchange rate, thenapplying that rate to our average level of British pound investments during theyear, would result in a $472,000 impact. If the value of the Canadian dollar relative to the British pound wereto increase by 10%, our net loss would decrease by $472,000.  Further, if the value of the Canadian dollarrelative to the British pound were to decrease by 10%, our net loss wouldincrease by $472,000.

 

We are also exposed tointerest rate risk because we maintain cash equivalents and short-terminvestment portfolio holdings of various issuers, types, and maturity dateswith large banks and investment banking institutions.  The market value of these short-terminvestments on any day during the investment term may vary as a result ofmarket interest rate fluctuations.

 

To differentiate between the affect of a change in the market valuationof securities caused by market interest rate changes versus a change in theannual rate of interest we could earn on a security, we calculated that ahypothetical change in interestrates comparable to a 10% change to our average rate of return would result ina $83,000 impact.  If interest rates wereto increase by 10%, our net loss would decrease by $83,000.  Further, if interest rates were to decreaseby 10%, our net loss would increase by $83,000.

 

We have not used derivativefinancial instruments in our investment portfolio.  We classify our investments asavailable-for-sale at the time of purchase and re-evaluate this designation asof each balance sheet date. We had $31,716,000 in cash, cash equivalents andshort-term investments as of September 30, 2004.

 

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**Item 4.**  CONTROLS AND PROCEDURES

** **

Our chief financial officer and chief executive officer concluded as ofSeptember 30, 2004 that our disclosure controls and procedures (as definedin Rule 15d-15(e) promulgated under the Securities Exchange Act of 1934, asamended) are effective and designed to alert them to material informationrelating to Stressgen and its consolidated subsidiaries, based on theevaluation of these controls and procedures as required by paragraph (b) ofRule 15d-15.

 

**PART II****—OTHER INFORMATION**

#### ** **

**Item 6. EXHIBITS**

###### ** **

For a list of exhibits filed with this report, refer to the Index to Exhibits set forth after the signature page hereto.

 

**SIGNATURES**

 

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

 
|                              | Stressgen Biotechnologies Corporation                                                                                                                                              |
|-----------------------------------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|  Date: October 27, 2004 | /s/ Gregory M. McKee                                                                                                                                                          |   |
|                              |                                                                                                                                                                               |   |
|                              | Gregory M. McKee                                                                                                                                                                   |
|                              | Vice President, Corporate Development  and Chief Financial Officer  (Principal Financial and Accounting  Officer duly authorized to sign  this report on behalf of the registrant) |

 

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INDEX OF EXHIBITS

 
| **Exhibit No.** | ** ** | **Description**                                                                                                                                                 |
|-----------------|------------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 3.9*            |       | Articles of Continuance of the Company                                                                                                                          |
| 3.10*           |       | By-Laws of the Company                                                                                                                                          |
| 4.4*            |       | Form of Stock Certificate                                                                                                                                       |
| 10.17           |       | Employment Agreement dated September 1, 2004 between Daniel L.  Korpolinski and Stressgen Biotechnologies Corporation and Stressgen  Biotechnologies, Inc. |
| 31.1            |       | Rule 13a-14(a)/15d-14(a) Certification of Chief Financial Officer                                                                                               |
| 31.2            |       | Rule 13a-14(a)/15d-14(a) Certification of Chief Executive Officer                                                                                               |
| 32              |       | Section 1350 Certification                                                                                                                                 |

 

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*Incorporated by reference to the Company’s Form 10-Q for the quarter ended June 30,2001, as filed with the Commission on August 2, 2001

 

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