# SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549

# FORM 10-K/A
(Amendment No. 3)

|(Mark One) |  |                                                                                                                                                                           
|---------- |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|[X]        |  | Annual Report pursuant Section 13 or 15(d) of the Securities Exchange Act of 1934 [No Fee Required] For the fiscal year ended December 31, 2003                           
|or        
|[   ]      |  | Transition report pursuant to section 13 or 15(d) of the Securities Exchange Act of 1934 [No Fee Required] For the transition period from ______________ to ______________

Commission File Number 0-24760

Orphan Medical, Inc.
(Exact name of registrant as specified in its charter)

|DELAWARE                                                    | 41-1784594                             
|----------------------------------------------------------- | ---------------------------------------
|(State or other jurisdiction of incorporation organization) | (I.R.S. Employer Identification Number)

|13911 Ridgedale Drive, Suite 250,       |                                
|--------------------------------------- | -------------------------------
|Minnetonka, MN 55305                    | (952) 513-6900                 
|(Address of principal executive offices | (Registrants telephone number,
|and zip code)                           | including area code)           

Securities registered pursuant to Section 12(b) of the Act: None

Securities registered pursuant to Section 12(g) of the Act: Common Stock, $.01 Par Value

Indicate by check mark whether the
registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the
Securities Exchange Act of 1934 during the preceding 12 months, and (2) has been subject
to such filing requirements for the past 90 days. Yes [X] No [   ]

Indicate by check mark whether the
registrant is an accelerated filer (as defined in Exchange Act Rule 12b-2). Yes [X] No [   ]

Indicate by check mark if disclosure
of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and
will not be contained, to the best of Registrants knowledge, in definitive proxy or
information statements incorporated by reference in Part III of this Form 10-K or any
amendment to this Form 10-K. [   ]

Aggregate market value of common
stock held by non-affiliates of Registrant, based upon the last sale price of the Common
Stock reported on the Nasdaq National Market tier of The Nasdaq Stock Market on June 30,
2003 was $83,493,000 based on approximately 9,135,000 shares held by non-affiliates at
that date.

As of April 30, 2004 the Company had
10,841,296 shares of Common Stock outstanding.

# Documents Incorporated By Reference

Portions of the Registrants
Definitive Proxy Statement filed with the Securities and Exchange Commission in
connection with the solicitation of proxies for the Registrants Annual
Meeting of Shareholders to be held on June 15, 2004 are incorporated by
reference in Part III, Items 10, 11, 12, 13 and 14 of this Form 10-K.

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EXPLANATORY NOTE
This Form 10-K/A Amendment No. 3 amends the Registrants Annual
Report on Form 10-K for the year ended December 31, 2003 filed on
March 15, 2004, as previously amended on March 19, 2004 and June 9, 2004.

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# PART I.

This Annual Report
contains forward-looking statements within the meaning of Section 27A of the Securities
Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as
amended. All forward-looking statements are inherently uncertain as they are based on
current expectations and assumptions concerning future events or future performance of the
Company. Readers are cautioned not to place undue reliance on these forward-looking
statements, which are only predictions and speak only as of the date hereof.
Forward-looking statements are not descriptions of historical facts. The words or phrases
will likely result, look for, may result, will
continue, is anticipated, expect, project, or
similar expressions are intended to identify forward-looking statements, and are subject
to numerous known and unknown risks and uncertainties. Actual results could differ
materially from those currently anticipated due to a number of factors, including those
identified in the Cautionary Statements filed as an Exhibit to this Annual
Report on Form 10-K, and in the Companys other filings with the Securities and
Exchange Commission. The Company undertakes no obligation to update or publicly announce
revisions to any forward-looking statements to reflect future events or developments.

Antizol®, Antizol-Vet®,
Cystadane®, Xyrem®, MedExpand, The Orphan Drug Company,
Xyrem Success ProgramSM, Orphan Medical, Inc.® and Dedicated to Patients
with Uncommon Diseases® are trademarks of the Company.

# ITEM 1.   BUSINESS

Overview

Orphan Medical, Inc. is a specialty
pharmaceutical company focused primarily on sleep disorders, pain and other central
nervous system (CNS) disorders. We seek to acquire, develop and market pharmaceutical
products that are prescribed by physician specialists and offer a major improvement in
the safety or efficacy of patient treatment and have no substantially equivalent
substitute.

The Companys lead product,
Xyrem® (sodium oxybate) solution is approved for the treatment of cataplexy, a
debilitating symptom of narcolepsy, a sleep disorder.   The Company markets Xyrem using a
37 person specialty sales force that focuses its selling efforts on physicians
specializing in the treatment of sleep disorders. Clinical trials conducted in accordance
with United States Food and Drug Administration (FDA) approved protocols have shown that
Xyrem consolidates sleep and increases sleep continuity and non-REM sleep, particularly
Stages III and IV, which stages are known as slow-wave sleep.  Stages III and IV are the
stages in which the body experiences the greatest level of restoration. Although
currently marketed hypnotics, as well as those in late stage clinical trials, facilitate
sleep onset and maintenance, they tend to reduce rather than increase slow-wave sleep.
The active ingredient of Xyrem, sodium oxybate or gamma hydroxybutyrate, has also been
shown to have other activity that may have therapeutic significance.

Recognizing the significant
long-term potential of Xyrem, the Company has initiated a range of clinical development
and product development programs. Two clinical trials that are near completion may
demonstrate that Xyrem treats excessive daytime sleepiness (EDS) and other symptoms of
narcolepsy. If the results of these trials are positive, Xyrem could be marketed to the
entire narcolepsy market, which is estimated to affect approximately .05% of the
population or 100,000 to 140,000 persons in the United States. We also expect to begin a
clinical trial in the first half of 2004 to assess Xyrem in treating the symptoms of
Fibromyalgia Syndrome (FMS). FMS is a chronic condition characterized by widespread
muscular pain, musculoskeletal discomfort, fatigue, and systemic symptoms. FMS is
estimated to affect over 4 million Americans. If Xyrem demonstrates efficacy in treating
certain FMS symptoms, additional trials will be conducted in order to obtain FDA approval
to market Xyrem to physicians treating this condition.

We are assessing another product,
butamben (butyl-p-amino benzoate), as a treatment for intractable cancer pain and,
depending on its safety and efficacy profile, other chronic pain conditions as well.
Butamben is a unique long-acting ester local anesthetic that is selective for afferent
pain fibers with no measurable residual sensory or motor effects. It also appears to
provide long-lasting effects, averaging about 6 months in humans in studies to date. We
expect to begin clinical trials after meeting with the FDA to present our development
plan for butamben.

In addition to expanding the
labeling of Xyrem and developing Butamben, we plan to build our presence in specialty CNS
markets through the acquisition of both development stage compounds and marketed
products. The Company generally seeks to develop products that (1) have some clinical
history, (2) have a straightforward formulation that can be readily manufactured with
established technologies, and (3) do not require excessive specialized processes for
development or manufacture. We do not conduct extensive basic research to discover new
chemical entities.

In 2003, we sold all rights to three
of our products in order to concentrate resources on Xyrem and enhance our focus on
sleep, pain and specialty CNS markets. Medicines developed or acquired in the future may
hold orphan drug status, although we may develop or acquire products that do not hold
such status if we can obtain appropriate proprietary protection through patents or
otherwise.  A drug that has orphan drug designation and which is the first product to
receive marketing approval for its product claim, indication or application, receives
orphan drug status and is entitled to a seven-year exclusive marketing period in the
United States for that product claim and a 10-year exclusive period in Europe for that
product claim, indication or application, subject to certain limitations.

Since its inception, the Company has
obtained New Drug Application (NDA) approvals from the United States Food and Drug
Administration (FDA) for six specialty pharmaceutical products. Each of the NDAs was
granted Orphan Drug Status by the FDA. We currently market three FDA approved drugs:

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Xyrem® (sodium oxybate) oral
solution, for the treatment of cataplexy associated with narcolepsy;
Antizol® (fomepizole) Injection, an antidote for ethylene glycol or suspected ethylene
glycol ingestion in humans and an antidote for methanol or suspected methanol ingestion
in humans; and Cystadane® (betaine anhydrous for oral solution), for homocystinuria, a
genetic disease.  Antizol-Vet® (fomepizole) for injection, an antidote for ethylene
glycol or suspected ethylene glycol ingestion in dogs was approved using a New Animal
Drug Application (NADA). The Company continues to market Antizol, Antizol-Vet, and
Cystadane, to treat disorders outside of CNS to help reduce losses since they have
attractive gross and operating margins.  In the second quarter of 2003, the Company sold
its rights to three products, Busulfex, Sucraid and Elliotts B Solution.

Our activities have consisted
primarily of obtaining the rights for pharmaceutical products, hiring the personnel
required to implement our business plan, managing the development of these products,
preparing for the commercial introduction of these products and raising capital to
support our business operations.

Orphan Medical, Inc. was
incorporated on June 17, 1994 as a Minnesota corporation to carry on the business
previously conducted by the Orphan Medical division of Chronimed, Inc. The business was
reincorporated as a Delaware corporation on September 1, 2000. We have not generated
sufficient levels of revenue from our approved products to date to fund our operating
activities and have sustained significant operating losses each year since inception. We
expect operating losses to continue at least through 2004. Our operations to date have
not been profitable and as of March 31, 2004 we have an accumulated deficit of $60.8 million since inception.

The Company continues to market two
smaller market products that treat conditions outside of CNS disorders. These products
are maintained to help reduce losses since they have attractive gross and operating
margins.

Our corporate offices are located at
13911 Ridgedale Drive, Suite 250, Minnetonka, Minnesota 55305. Our telephone number is
952-513-6900 and our website is www.orphan.com. The information on our website is not
incorporated into and is not intended to be a part of this report. We make available free
of charge on or through our website our annual report on Form 10-K, quarterly reports on
Form 10-Q, current reports on Form 8-K and amendments to those reports filed or furnished
pursuant to Section 13(a) or 15(d) of the Exchange Act as soon as reasonably practible
after we electronically file such material with, or furnish it to, the United States
Securities and Exchange Commission. Unless the context otherwise indicates, all
references to the Registrant, the Company, or Orphan Medical in
this Form 10-K relate to Orphan Medical, Inc.

# Our Strategy

Orphan Medical has set its
strategic vision on becoming an integrated CNS specialty pharmaceutical company.
In this regard, the Company has decided to focus its development and commercial
efforts, at least initially, in the areas of sleep disorders and pain. Other CNS
disorders will be considered as the Company progresses with its CNS specialty
pharmaceutical strategy.

The sleep disorders market
is a large therapeutic area affecting an estimated 70 million to 100 million
(Source: 2002 National Sleep Foundation Sleep in America Poll)
adults in the United States, yet sleep disorders is still a market with
significant unmet needs. Moreover, there is increasing recognition of the role
of sleep across a range of diseases and its role in health is becoming broadly
recognized. Sleep disorders have been underdiagnosed since symptoms are vague
and often are missed by physicians. Therefore, sleep disorders or related
illnesses may go undiagnosed and untreated for a number of years. The broader
specialty CNS area is one of significant opportunities. Outside the major
therapeutic areas of depression and schizophrenia, there is a wide range of
diseases with unmet medical needs. Our lead product, Xyrem, has the potential to
address a number of specialty CNS diseases including narcolepsy, insomnia and
fibromyalgia syndrome and the Company has built unique development and
commercial capabilities to address several of these opportunities. Epidemiolody
studies (including NSF 2002 and Epidemiology Catchment Assessment; Mattson, Jack
4/22/2002) estimate a prevalence for insomnia exceeding 40% of the adult
population in the United States. This is approximately 80 million people.
According to the Mayo Clinic in a publication dated April 22, 2003, fibromyalgia
affects three to eight million people in the United States. The market
opportunity associated with each of these indications exceeds $1.0 billion on an
annual basis. Other specialty CNS areas of high strategic interest to the
Company include Parkinsons disease, epilepsy, movement disorder,
Huntingtons disease, sleep apnea, Alzheimers disease and mild
cognitive impairment. Building on its current capabilities and expertise, the
Company believe it could develop a meaningful presence in these therapeutic
areas with key specialist audiences, i.e., sleep specialists, neurologists and
psychiatrists.

Xyrem and butamben are the
cornerstones of our strategy. Xyrem is currently approved for cataplexy
associated with narcolepsy and has application in several other sleep-related
disorders. It also has potential utility in fibromyalgia, an increasingly
recognized pain disorder. Butamben is expected to be developed for chronic
cancer pain, and possibly chronic pain from other causes.

Orphan Medical believes it
can apply its competitive advantages to build a specialty pharmaceutical company
focused on diseases of the CNS. The Company aims to:

- Avoid large market CNS diseases and concentrate on unmet needs in diseases that are treated by neurologists, psychiatrists, sleep specialists and pain specialists
- Build
on the Companys expertise in, and the science of, Gamma Hydroxybutyrate (GHB)

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- Expand the Companys marketing and sales presence in the sleep community in order to market other high value products that treat sleep disorders
- Assess and develop products that address pain treated by specialist physicians
- Acquire marketed as well as development stage products that can be marketed through the Companys sales organization and distribution systems

As in all industries, companies that
survive and grow long-term must have sustainable uniqueness. The factors of success in
the specialty segment of the pharmaceutical industry are:

- A strong and experienced management team
- The capability to develop medicines as well as the ability to acquire drugs in therapeutic areas that the Company has scientific and clinical expertise
- A marketing and sales presence that reaches a concentrated set of prescribers
- Products with growth potential that address unmet medical needs
- An ability to address regulatory issues
- Having good access to capital markets

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# Products

The following tables
summarize certain information relating to the Companys products:

# Marketed Products

|Approved Product                |  | Application              |  | NDAApprovalDate |  | Orphan DrugStatus**
|------------------------------- |  | ------------------------ |  | --------------- |  | -------------------
|Xyrem® (sodium oxybate) oral    |  | For the treatment of     |  | July 2002       |  | Granted            
|solution                        |  | cataplexy associated     | 
|                                |  | with narcolepsy          | 
|Antizol® (fomepizole) Injection |  | Antidote for ethylene    |  | December        |  | Granted            
|                                |  | glycol (antifreeze) or   |  | 1997            |  |                    
|                                |  | suspected ethylene       | 
|                                |  | glycol ingestion in      | 
|                                |  | humans                   | 
|                                |  | Antidote for methanol    |  | December        |  | Granted            
|                                |  | or suspected methanol    |  | 2000            |  |                    
|                                |  | ingestion in humans      | 
|Cystadane® (betaine anhydrous   |  | Homocystinuria, a        |  | October         |  | Granted            
|for oral solution)              |  | genetic disease          |  | 1996            |  |                    
|Antizol-Vet® (fomepizole)       |  | Antidote for ethylene    |  | November        |  | Five year          
|for injection                   |  | glycol (antifreeze) or   |  | 1996            |  | period of          
|                                |  | suspected ethylene       |  |                 |  | exclusivity        
|                                |  | glycol ingestion in dogs | 

# Products Under Development

|Investigational Product      |  | Proposed Application |  | Phase ofDevelopment* |  | Orphan DrugDesignation** | 
|---------------------------- |  | -------------------- |  | -------------------- |  | ------------------------ | 
|Xyrem® (sodium oxybate) oral |  | EDS/Narcolepsy       |  | III(b)               |  |                          | 
|solution                     | 
|Xyrem® (sodium oxybate) oral |  | Fibromyalgia         |  | IND                  | 
|solution                     | 
|Butamben***                  |  | Cancer Pain          |  | II                   | 

*      Development Phases are discussed under Business  The Regulatory Process.
**    Orphan Drug Designation and Status are discussed under Business  Proprietary Rights.
***  The Company holds an inactive investigational new drug application (IND) at the FDA. See discussion under PRODUCTS UNDER DEVELOPMENT.

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# 

Approved Products        Xyrem® (sodium oxybate) oral solutionNarcolepsy is a chronic neurologic sleep disorder in which sleep is
fragmented, and does not occur in an integrated and cohesive manner.
This fragmentation results in excessive daytime sleepiness (EDS), unavoidable
daytime sleep attacks, cataplexy (a sudden loss of muscle control provoked by
emotions), sleep paralysis (brief periods of muscle paralysis) and
hallucinations (vivid and sometimes frightening dreaming when falling asleep or
waking up). Other related symptoms include broken nighttime sleep, disturbances
of auditory and visual perception, and lapses of consciousness and memory
problems. These symptoms can lead to a variety of complications, such as
limitations on education and employment opportunities, driving or machine
accidents, difficulties at work resulting in disability, forced retirement or
job dismissal, and depression. Based on published epidemiology studies,
including Ohayon, MM. Prevalence of Narcolepsy Symptomology and Diagnosis in
European General Population, Neurology 2002; 58:1826-1833; Roln, 1998;
Mignot, 1998; Hublin et al., 1994c; Dement, et al., 1973 and Aldriaon, 1992,
narcolepsy is thought to affect approximately 100,000 to 140,000 persons in the
United States.

The second most common
symptom of narcolepsy is cataplexy. Cataplexy is the most specific feature of
narcolepsy and its presence is diagnostic. Published epdemiology studies,
including Basseth, C. Narcolepsy Neurology Clinics1996; 14(3): 545-550; Overcem,
S. Journal of Clinical Neurophysiology2001; 18(2): 78-105; and Chaud
Harg, M.D. The Journal of Family Practice 1993; 36(2): 207-213,
suggest that the prevalence of cataplexy in narcolepsy ranges from 60% to 90%.
However, according to published studies and our proprietary market research, only
about one-fourth to one-third of persons who are diagnosed with narcolepsy are
also diagnosed with, and treated for, cataplexy.

Estimating the number of patients
with narcolepsy who seek treatment is challenging. Utilizing national insurance databases,
it is estimated that approximately 55% or about 55,000 to 75,000 patients with narcolepsy are
diagnosed and treated. Furthermore, it is estimated that about one-third of the
55,000 to 75,000-treated narcolepsy patients, or 18,500-25,000 patients, are also diagnosed with and
treated for cataplexy. The one-third treatment rate contrasts with the 60% to 90%
prevalence rate of cataplexy in patients with narcolepsy. We estimate that the
average revenue per patient with Xyrem is approximately $4,000 annually.
Accordingly, we estimate the market for cataplexy associated with narcolepsy to
approach $100 million and could exceed $100 million if treatment rates for those
diagnosed with cataplexy increase in the future.

As discussed below under the heading
Xrem® (sodium oxybate) oral solution-Excessive Daytime Sleepiness we are
conducting clinical trials to expand the indication for Xyrem for the treatment of EDS
associated with narcolepsy. If approved for EDS, the potential market for Xyrem could be
in the range of $200 million to $300 million based on estimates of the number of people
with narcolepsy in the U.S.

The standard treatment for
excessive daytime sleepiness and sleep attacks in patients with narcolepsy are
stimulants or wakefulness promoting agents. The symptoms of cataplexy, sleep
paralysis and hypnagogic hallucinations have typically been treated with
tricyclic antidepressants (TCAs) or selective serotonin reuptake
inhibitors (SSRIs). These treatment regimens, in addition to limited
efficacy, are often unsatisfactory for a number of other reasons. Amphetamines
and other stimulants often cause undesirable side effects such as insomnia,
hypertension, palpitations, irritability and, at higher doses, may mimic the
symptoms of schizophrenia. Patients often build tolerance to the TCAs and SSRIs
and doses are increased to obtain clinical effectiveness. These medications can
cause the side effects of dry mouth, impotence, loss of libido, and increased
heart rate. Clinical results with Xyrem suggest that it is effective in the
treatment of narcolepsy symptoms. Administered at night, it is believed to
consolidate sleep and has been shown to reduce cataplexy attacks, and to reduce
the severity of daytime sleepiness when used in combination with stimulants
during the day. Following initial clinical trials and subsequent commercial use,
thousands of narcolepsy patients have been exposed to clinical doses with an
acceptable side effect profile. Xyrem does not appear to have the side effects
associated with TCAs and SSRIs. Narcoleptic patients could be treated with Xyrem
at night and, if needed, with stimulants during waking hours.

The Company submitted its NDA for
Xyrem on October 2, 2000 and was granted approval on July 17, 2002. The product is
indicated for the treatment of cataplexy associated with narcolepsy. The Company began
shipping product in September 2002 and the commercial launch commenced on October 7, 2002.
Through December 31, 2003 over 4,000 patients have been prescribed Xyrem by over
1,200 physicians.

Gamma hydroxybutyrate (GHB), also
known as sodium oxybate, is the active ingredient in Xyrem. Illicitly produced GHB has
been reported to be a drug of abuse. On February 18, 2000, President Clinton signed PL
106-172, a public law that makes GHB a Schedule I substance. Schedule I is the designation
by which illegal drugs are controlled. The bill further delineates GHB products being
studied under Food and Drug Administration (FDA) approved protocols or approved for
commercial sale as Schedule III substances.

Each state has the ability to
schedule products more strictly or equivalent to the federally designated schedule. Most
states have adopted, either administratively or legislatively, the I/III schedule as
described above. The Company continues its efforts to promote consistency of scheduling
across all states.

Sodium oxybate (GHB) is a known
compound and is not patentable. The Company has received orphan drug status for
its indicated use of Xyrem in the U.S. There are no license fees or royalty
payments associated with Xyrem revenues. FDA orphan drug status extends through
July 17, 2009. Upon expiration of orphan drug status, our products might be subject to competition from other pharmaceutical companies. The Company has an issued
formulation patent, which expires

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on December 22, 2019. Other
patents are pending. The Company has contracted with third-party bulk drug and
drug product manufacturers for the production of Xyrem under Good Manufacturing
Practices (GMP) conditions.

Antizol® (fomepizole) Injection
Antizol received marketing clearance from the FDA in December 1997 for
suspected or confirmed ethylene glycol poisonings and December 2000 for
suspected or confirmed methanol poisonings. We commenced shipping Antizol in
December 1997. Antizol is primarily used in a hospital setting and is
distributed for us by an affiliate of Cardinal Health. When ingested by humans,
ethylene glycol (found in antifreeze) and methanol (found in windshield wiper
fluid) can lead to death or permanent and serious physical damage. Based on
recent revenue trends, we believe that hospital pharmacies will continue to
stock Antizol because it is important to treat poisoned patients very quickly in
order to improve the chances of successful recovery. For 2003, Antizol
contributed approximately 41% of our total revenues. We estimate that over
one-third of all hospitals with emergency rooms currently stock the product.
Antizol has become the standard of care for toxic alcohol poisoning and
guidelines issued by the American Academy of Clinical Toxicologists recommended
Antizol as the drug of choice for such poisonings. Since not every hospital will
stock antidotes, we expect to see limited incremental stocking by hospitals in
2004. Future sales will be based more on usage as stocking levels are expected
remain constant. We have also received marketing approval for Antizol in Canada
for the treatment of suspected or confirmed ethylene glycol poisonings.

We  have obtained
orphan drug status for Antizol as an antidote to treat ethylene glycol and
methanol poisonings, which provides marketing exclusivity to us through December
2004 for ethylene glycol and December 2007 for methanol. We have contracted with
a third party for the production of Antizol under GMP conditions. Through a
sublicense agreement with Mericon Investment Group, Inc. (MIG), we
have an exclusive, worldwide license to develop and market Antizol, which
expires in July 2013, subject to a five year renewal through July 2018
exercisable by MIG at our request. This agreement includes a royalty that is paid
quarterly.

Cystadane® (betaine anhydrous for oral solution)
Cystadane received marketing clearance from the FDA in October 1996. The
first commercial sales of Cystadane occurred in December 1996. Cystadane is
distributed by an affiliate of Cardinal Health to patients in the United States
through retail pharmacies. It is the first agent approved by the FDA for the
treatment of homocystinuria, an inherited metabolic disease. The clinical
consequences are wide-ranging and include dislocation of the ocular lens, early
(under age 30) thromboembolism, developmental and mental retardation and reduced
life span related to elevated plasma homocysteine levels. Based on published
epidemiology studies, it has been estimated that homocystinuria occurs
approximately once in every 200,000 live births worldwide (Sources: Sokalova et
al., 2001; Linnabank et al., 2001; Yap, 2003) and that there are estimated to be
1,000 patients with homocystinuria in the United States. Based on the
Companys historical domestic revenue growth rate of 10-15% for this
product, the Company estimates that the annual market potential for Cystadane
may approach $1.0-$1.5 million in the United States. The Company receives sales
revenue generated outside of the United States through its licensees. Cystadane
revenues met the Companys expectations in 2003 and are expected to grow
slightly in subsequent periods. The Company believes that the small size of the
market and the high medical value of Cystadane justify the limited resources
required by the Company to continue making this product available to patients.

The Company obtained orphan
drug status for Cystadane for the treatment of homocystinuria, which provided
marketing exclusivity to the Company through October 2003. The Company does not
expect the expiration of orphan drug protection to significantly impact the
sales of Cystadane in 2004 given the relatively small market size. The Company has
contracted with a third party for the production of Cystadane under GMP
conditions. No license was required for the Company to develop and market
Cystadane.

The Company is not
currently sponsoring any clinical trials with/for Cystadane but is aware of, and
supporting through unrestricted grants, clinical trials being conducted by
independent investigators affiliated with major hospitals to assess the safety
and efficacy of Cystadane as a stand alone or adjunctive therapy for the
following indications: Non-alcoholic steatohepatitis, Rett syndrome, rheumatoid
arthritis and hyperhomocystinemia. The Company does not expect that the results
of any of these clinical trials will significantly enhance or decrease the
current limited market potential for Cystadane in the near future. Depending on the results, these trials may result in potential long-term opportunities for us.

Antizol-Vet® (fomepizole) for injection
In November 1996, the Center for Veterinary Medicine of the FDA approved
Antizol-Vet as a treatment for dogs that have ingested or are suspected of
having ingested ethylene glycol. The first commercial sales of Antizol-Vet
occurred in January 1997. The earlier an ethylene
glycol poisoned dog is treated with Antizol-Vet, the more likely that there will
be a positive

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outcome. The annual market
potential for Antizol-Vet is expected to be under $300,000. We have found that
stocking of this product has been limited due to its high cost, but it is
ordered when a poisoning occurs. Antizol-Vet revenues met our expectations in
2003 and are expected to remain constant or decline in subsequent periods.
Revenues from this product have not been nor will they be material to our
product revenue.

Federal law provided us with
a marketing exclusivity period through November 2001 for the use of Antizol-Vet in dogs
for the approved indication. We have contracted with a third party for the
production of Antizol-Vet under GMP conditions.

We have partnered with
several leading regional and national veterinary wholesalers to distribute Antizol-Vet to
veterinary clinics. It is believed that the current partners effectively and efficiently
encompass the entire country with limited sales territory overlap, thus helping prevent
downward retail pricing pressures. We do not anticipate adding additional
distribution partners. These agreements do not result in material revenue.

Disposition of products
On June 10, 2003, we announced the disposition of Busulfex® (busulfan)
Injection to ESP Pharma, Inc. for $29.3 million plus the book value of
inventory, approximately $0.2 million. We announced the sale of the product
Sucraid® (sacrosidase) oral solution to a specialty pharmaceutical company
on May 6, 2003 for $1.5 million. We also divested a third product, Elliotts B
Solution® to the same specialty company for proceeds that were not material.
Proceeds from these dispositions will be used for further development and
marketing of Xyrem and for the creation of a stronger presence in the sleep and
central nervous system (CNS) markets.

Products Under Development
 We incurred $10.8 million, $8.7 million and $7.0 million of Product
Development expenses for the years ended December 31, 2003, 2002 and 2001,
respectively. We had $14.7 million of outstanding commitments for spending
associated with product development spending for the following development
projects at December 31, 2003.

Sleep Disorders  Investigational Products
        Xyrem® (sodium oxybate)® oral solution-Excessive Daytime SleepinessWe are conducting two Phase III (b) clinical trials for Xyrem. These
controlled clinical trials assess the efficacy of Xyrem in treating excessive
daytime sleepiness (EDS) related to narcolepsy. These trials continue to
progress toward completion in early 2004 with the data to be compiled into a
supplemental New Drug Application (sNDA) to the FDA expected in the second half
of-2004. We expect that the FDA will take action on this sNDA in mid 2005. If
approved, this sNDA may provide an expanded indication which could increase the
market opportunity for the product. We expect to incur approximately $5.0
million of expenses in 2004 for the completion of these trials. We incurred
expenses related to these trials of $5.0 million, $2.5 million and $1.5 million
in the fiscal years ended December 31, 2003, 2002 and 2001, respectively.

Xyrem® (sodium oxybate)® oral solution-Fibromyalgia
Fibromyalgia is a syndrome characterized by widespread pain that cannot be
explained by an inflammatory or degenerative musculoskeletal disorder. Fatigue,
depression, and somatic symptoms are also often present. The prevalence of
fibromyalgia has been reported in several epidemiological studies. The estimated
prevalence ranges from 1-4% of the adult population, a prevalence rate of 2% is
most commonly cited in the literature. Accordingly, about 4.2 million Americans
over the age of 18 have fibromyalgia.

We plan to initiate a
proof-of-principle trial at an estimated cost of $3.0 million to $4.0 million to
be incurred in 2004 and 2005 to assess the efficacy of Xyrem in the treatment of
the symptoms of fibromyalgia. Patient enrollment in this trial is expected to
begin in the second quarter of 2004. Data from this trial is expected to be
available in mid 2005. At that time we will determine whether or not to pursue a
development program in support of a regulatory application. The nature and scope
of a potential development program cannot be determined until this trial is
complete and the data is available. Therefore, the total costs and timing of a
potential development program are uncertain at this time.

Butamben (butyl-p-amino benzoate)
Butamben is a new treatment for pain. It is intended to provide physicians
with an effective adjunct for their patients who require long-term management of
moderate-to-severe chronic pain. Butamben is a unique, material-based,
long-acting local anesthetic that is delivered by epidural injection. It
selectively blocks pain afferentation by blocking transmission in A delta and C
fibers in peripheral nerves. Butamben blocks fast-sodium ion channels, which
leads to hyperpolarization of the neuronal membrane and long-term pain control.
It is non-neurolytic and non-narcotic. Butamben provides effective, long-term
relief from pain, with no motor blockade and minimal side effects. The product
will be used initially in patients who either have pain that is not alleviated
by escalating doses of oral analgesics or need relief from the side effects that
accompany these escalating doses. Treatment with butamben may allow patients to
reduce their doses of oral analgesics, and thereby reduce dose-related analgesic
side effects. Butamben is currently in Phase II clinical development. We
hold an inactive IND at the FDA for butamben. We are in the process of defining
the manufacturing process for butamben and, if successful, will submit a new
chemistry and manufacturing package to the FDA and then expect to meet with the
FDA to review a development program for this product. At that time, if we pursue
a product development program, we will take action to reactivate the IND at the
FDA. Human clinical trials will not begin until after we meet with the FDA to
review the proposed development program. Because the nature and scope of the
potential development program cannot be determined until after the currently
unscheduled meeting with the FDA, the costs and timing of a development program
are uncertain at this time. The total expected cost of defining the
manufacturing process and other related costs in determining whether or not to
pursue a development program is approimately $0.5 million, most of which will be
incurred in 2004. We do not expect any revenue from this product until at least
2007.

Product Development Risk Management
Our product strategy has been designed, in part, to mitigate
its overall business risk. We have pursued multiple distinct therapeutic
areas within CNS such as sleep and pain pharmaceuticals rather than
concentrating financial, development and marketing resources on a single
therapeutic area or a single platform technology. To reduce its product
development risk, we generally seek to develop products that (1) have

9

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some clinical history, (2) have a
straightforward formulation that can be readily manufactured with established
technologies, and (3) do not require excessive specialized processes for development or
manufacture. In addition, we generally seek to acquire products that are
already in Phase II or Phase III clinical trials, or in an earlier stage of development
with proof of concept established. When a product is licensed without the equivalent of
Phase II or III data, we may conduct one or more proof of concept trials
to better assess the likelihood of efficacy or safety. Each such pilot trial is narrowly
defined. We do not conduct extensive basic research to discover new chemical
entities. We may also purchase rights to approved products. To reduce its
marketing risk, we generally attempt to obtain some form of proprietary
protection, such as patent protection, orphan drug status, exclusive licensing
agreements, or sole supplier agreements.

Proprietary Rights
We believe it is important that our products receive patent
protection or orphan drug status or have other factors that limit potential
competition. When available and appropriate, we will seek orphan drug status to
enhance or provide proprietary protection to a product. A drug that has orphan
drug designation and which is the first product to receive marketing approval
for its product claim, indication or application, receives orphan drug status
and is entitled to a seven-year exclusive marketing period in the United States
for that product claim and a 10-year exclusive period in Europe for that product
claim, indication or application, subject to certain limitations. We have two
products with orphan drug status. Applications for orphan drug designation will
be made when and where appropriate and available for any additional indications
or products that may be licensed in the future.

Orphan drug protection is available
in Japan and the European Union under requirements similar to those in the United States.
An important distinction in the European Union is the ten-year period of marketing
exclusivity for products designated as orphan drugs, compared to seven years of
exclusivity in the United States. The period of exclusivity in the European Union also
begins upon marketing approval.

With respect to additional products
we may license in the future, if any, we expect that such licenses would
include, if such rights are available, an assignment of the licensors
proprietary rights with respect to the licensed product. We also seek foreign
patent protection for our products and have applied for patents outside the U.S.
for Xyrem. We have licensed two patents related to butamben, a product that is
being evaluated for development. We are in the process of defining the
manufacturing process for butamben and, if successful, expect to have a second
meeting with the FDA to finalize a development program for this product. We
evaluate the desirability of registering approved patents or other forms of
protection for our products in individual foreign markets based on the expected
costs and relative benefits of attaining such protection.

The Regulatory Process
Pharmaceutical products intended for therapeutic use in humans are governed
by extensive FDA and other federal regulations in the United States and by
comparable regulations in foreign countries. The process of seeking and
obtaining FDA approval for a previously unapproved new human pharmaceutical
product generally takes many years and involves the expenditure of substantial
resources and considerable risk.

Before a drug product can be
investigated or marketed in the United States, the following general steps are
required: (i) pre-clinical laboratory and animal safety tests, (ii) the
submission to the FDA of an IND, (iii) clinical and other studies to assess
safety and parameters of use, (iv) adequate and well-controlled clinical trials
to establish the safety and effectiveness of the drug product, (v) the
submission to the FDA of an NDA, (vi) FDA approval of the NDA prior to any
commercial sale or shipment of the product, (vii) marketing of the drug, and
(viii) post-approval safety and risk monitoring.

Typically, pre-clinical studies are
conducted in the laboratory and in animal model systems to gain preliminary information
on the products pharmacology and toxicology and to identify any potential safety
problems that would preclude testing in humans. The results of these studies, together
with the general investigative plan, protocols for specific human studies and other
information, are submitted to the FDA as part of the IND application. The FDA regulations
do not, by their terms, require FDA approval of an IND. Rather, if the FDA does not
notify the sponsor to the contrary within 30 days of receipt of the IND, they allow a
clinical investigation to commence. As a practical matter, however, FDA approval is often
sought before a company commences clinical investigations. That approval may come within
30 days of IND receipt, but may involve substantial delays if the FDA requests additional
information.

The initial phase of clinical
testing (Phase I) is conducted to evaluate the metabolism and pharmacological actions of
the experimental product in humans, as well as the side effects associated with
increasing doses, and, if possible, to gain early evidence of possible effectiveness.
Phase I studies can also evaluate various dosages,  methods and schedules of product
administration. These studies generally involve a small number of healthy volunteer
subjects, but may be conducted in people with the disease that the product is intended to
treat. The total number of subjects is generally in the range of 20 to 80. A
demonstration of therapeutic benefit is not required in order to complete Phase I trials
successfully. If acceptable product safety is demonstrated, Phase II trials may be
initiated.

Phase II trials are designed to
evaluate the effectiveness of the product in the treatment of a given disease and involve
patients with the disease under study. These trials often are well-controlled, closely
monitored studies involving a relatively small number of subjects, usually no more than
several hundred. The optimal dosages, methods and schedules of administration are
determined in these studies. If Phase II trials are successfully completed, Phase III
trials are often commenced, although Phase III trials are not always required,
particularly for drugs of high medical value intended for smaller patient populations.

Phase III trials are expanded,
controlled trials that are performed after preliminary evidence of the effectiveness of
the experimental product has been obtained. These trials are intended to gather the
additional information about safety and effectiveness needed to evaluate the overall
risk/benefit relationship of the experimental product. In addition, these trials provide
the substantial evidence of both effectiveness and safety necessary for product approval.
Phase III trials usually involve from several hundred to several thousand subjects.

A clinical trial may combine the
elements of more than one phase (i.e., a Phase I/II or II/III trial) and typically two or
more Phase III studies are required for FDA approval. A companys designation of a
clinical trial as being of a particular Phase is not necessarily indicative that such a
trial will be sufficient to satisfy the FDA requirements of that Phase because this
determination cannot be made until the protocol and data have been submitted to and
reviewed by the FDA. In addition, a clinical trial may contain elements of more than one
Phase notwithstanding the designation of the trial as being of a particular Phase. The
FDA closely monitors the progress of the Phases of clinical testing and may, at its
discretion, re-evaluate, alter, suspend or terminate the testing based on the data
accumulated and its assessment of the risk/benefit ratio to patients. It is not possible
to predict with certainty the time required to complete Phase I, II and III studies with
respect to a given product.

Upon the successful completion of
clinical testing, a marketing application (i.e., NDA) is submitted to the FDA for
approval. This application requires detailed data on the results of pre-clinical testing,
clinical testing and the composition of the product; proposed labeling to be used with
the drug; information on manufacturing methods; and samples of the product in some cases.
Since the passage of the Prescription Drug User Fee Act (PDUFA), the FDA
typically takes from six to eighteen months to review an NDA after it has been accepted
for filing. Following its review of a marketing application, the FDA typically raises
questions or requests additional information. The NDA approval process can, accordingly,
be very lengthy. Further, there is no assurance that the FDA will ultimately approve an
NDA. The FDA can also determine that a drug is approvable contingent on
satisfactory review of additional information requested by the FDA. We cannot assure you
that such requests by the FDA for additional information can be fulfilled in a timely
manner, if at all. If the FDA approves the NDA, the new product may be marketed for the
applications or

10

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treatments that have been approved
by the FDA. The claims with which a product can be marketed are also subject to review
and approval by the Division of Drug Marketing, Advertising and Communications (DDMAC),
the FDAs marketing surveillance department within the Center for Drugs. The FDA
often clears a product for marketing with a modification, or restriction to the proposed
label claims or requires that post-marketing surveillance, or Phase IV testing, to be
conducted. The method and system of a drugs distribution can also be controlled by
the FDA if approved under Subpart H.

Operating Functions
We have structured each of its operating functions to support its strategy.
Following is a general explanation of the typical steps in our processes of
product acquisition, development and marketing.

Product Acquisition
We actively search for product licensing opportunities. The continual
acquisition of products for development and/or commercialization is a key
element of our growth strategy. We attract product acquisition proposals through
a network of customer and industry contacts, licensing brokers and a growing
awareness of its activities by governmental, academic and industry sources.
Since its inception, we have evaluated many product opportunities. To date,
seventeen products have been acquired and, of these, three products were
developed, marketed and subsequently divested (Busulfex, Sucraid, and Elliotts B
Solution) and four products (Xyrem, Antizol, Cystadane and Antizol-Vet) have
been developed and are currently being marketed by us. In addition, Xyrem is
also currently under development for other indications.

We seek to
acquire pharmaceutical products within CNS markets that, in our opinion, generally:

Are of high medical value as defined by the customer (physician or patient) within a therapeutic area;
Treat diseases that affect distinct patient populations;
Are prescribed by physician specialists;
Can be marketed with a focused, specialized sales team to health care specialists, health care institutions, and patients;
Are likely to be eligible for reimbursement by third-party payors;
Have, or are candidates for, patent protection, orphan drug designation or have other characteristics that enhance our competitive position;
Treat diseases that have clinical endpoints (i.e., signs or symptoms) that are readily measured;
Are conventional pharmaceutical products that are relatively straightforward in formulation and development, and do not involve the application of new technologies;
Are in Phase II or Phase III clinical trials and have a relatively high likelihood of obtaining the approval of the FDA within three to five years of acquisition;
Offer attractive potential financial returns with relatively low development costs;
Complement our other products in order to leverage existing talent and resources.


In selecting additional products for
potential inclusion in its portfolio, we generally focus on acquiring rights to
medicines that serve niche or defined patient populations served by specialty physicians.
Major drug companies are less likely to address these niche markets because they do not
believe these markets will produce acceptable revenues and returns. This reluctance limits
the number of potential sources of competition. In addition, a product designed for
smaller patient populations may be eligible for orphan drug designation. By obtaining
orphan drug designation, we are granted exclusive marketing rights or status in
the United States for seven years, subject to certain limitations, after an NDA for a
product is approved, if we are the first to receive approval for the designated
drug and indication.

We seek to acquire
potential products that already have, or will not require, a substantial quantity of
clinical data to demonstrate their relative efficacy and safety. We also
search for product candidates that represent new delivery methods or dosage forms of
previously approved or known compounds because we believe these types of
products are more likely to be quickly approved by the FDA and accepted by the medical
community. In addition, we attempt to develop medicines where clear clinical
endpoints can demonstrate their effectiveness. Generally, we seek to acquire
products that can be developed to the point of FDA approval within three to five years of
their acquisition. Typically, we also focus our development efforts on one

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indication and, when possible, one
dosage form to minimize development costs. Potential additional indications or dosage
forms may be evaluated, but only after the primary NDA is submitted and/or approved.

An additional element of our
product development strategy is to acquire products that have or can have a
degree of proprietary protection. Generally, this goal is accomplished by selecting
products that are covered by patents, are eligible for orphan drug designation, or are the
subject of an exclusive license from a sole supplier or a manufacturer with specialized or
proprietary processes. The likely availability of adequate levels of reimbursement from
third-party payors is also an important factor in product acquisition decisions.

Product Development
Pharmaceutical product development is one of the Companys principal
activities. We have incurred in excess of $60 million in expenses
for research and development activities through December 31, 2003. In
addition, the Company estimates that it will need to incur at least an
additional $14.7 million of expense in research and development activities
over the next four quarters relating to the products it currently markets,
including obtaining any potential additional Xyrem indications. Although we believe we
have sufficient cash available for currently anticipated clinical trials, we may need
additional capital to fund clinical trials related to products that we may acquire or
develop in the future or for trials related to new indicators of existing products.

A major element of the
Companys product development strategy is to use third-parties or contract
research organizations (CROs) to assist in the conduct of safety and efficacy
testing and clinical studies, to assist the Company in guiding products through
the FDA review and approval process, and to manufacture and distribute any FDA
approved products. The Company believes that maintaining a limited
infrastructure will enable it to develop products efficiently and cost
effectively.

The Company believes the
use of third-parties to develop and manufacture its products has several
advantages. This approach generally allows a greater pool of resources to be
concentrated on a product than if these functions were performed by internal
personnel who were required to support all of the Companys products.
Although this approach will allow the Company to avoid the expense associated
with developing a large internal infrastructure to support its product
development efforts, it will result in the Company being dependent on the
ability of outside parties to perform critical functions for the Company. Over
time, the Company expects to build internal capabilities to replace certain
development functions now contracted to outside parties.

This contract approach to
product development requires project management by professionals with
substantial industry experience. The Company believes it has in-house experts in
areas of critical importance to all of its proposed products who can be
consulted by the development teams. These areas include regulatory affairs,
marketing and sales, quality assurance, manufacturing, clinical trials
management, finance, information systems and general management.

The product development
process is designed to identify problems associated with a proposed
products safety and effectiveness. The Company attempts to reduce the risk
that a proposed product will not be accepted in the marketplace by conducting
market research and defining commercial strategy with a products
development. A drug development portfolio cannot be completely insulated from
potential clinical and marketing failures. It is likely that some proposed
products selected for development by the Company will not produce the clinical
or revenue results expected. To date, the Company has discontinued development
activities with respect to eleven proposed products because either the products
were deemed unapprovable or the estimated financial returns of these proposed
products were unacceptable. In May and June 2003, the Company divested three
products from its commercially marketed product portfolio resulting in a net
gain of $30.3 million.

Manufacturing
The Company does not have and does not intend to establish any internal
product testing, drug or chemical synthesis of bulk drug substance, and
manufacturing capability for drug product. Manufacturers of the Companys
products are subject to applicable GMP as required by FDA regulations or other
rules and regulations prescribed by foreign regulatory authorities. The Company
is negotiating or has entered into bulk drug supply and drug product
manufacturing agreements with third-parties for all of its FDA approved products
and is dependent on such third parties for continued compliance with GMP and
applicable foreign standards. The Company believes that qualified manufacturers
will continue to be available in the future, at a reasonable cost to the
Company, although there can be no assurance that this will be the case.

12

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Due to FDA mandated dating
requirements and the limited market size for the Companys approved products, the
Company may be subject to complex manufacturing logistics, minimum order quantities that
could result in excess inventory as determined under the Companys accounting policy,
unsalable inventory as a result of product expiring prior to use, and competition with
others for manufacturing services when needed or expected. The Company has a
production-planning program to assess and manage the manufacturing logistics amongst the
vendors supplying the required finished product components of bulk drug substance, drug
product and packaging.

We generally use a single
contract drug product manufacturer for each of our products. The Company is in
the process of changing manufacturers of Cystadane which is the reason two
manufacturers are listed for that product. These manufacturers have been
approved by the FDA for the production of our approved products. Following is a
listing of the Companys contract drug product manufacturers:

|                                     | 
|------------------------------------ | 
|Contract Drug Product Manufacturer   | 
|An affiliate of Boehringer Ingelheim | 
|Ropack, Inc.; ProClinical Inc.       | 
|DSM Pharmaceuticals, Inc.            | 

In addition to the contract
drug product manufacturers, we use single suppliers for the bulk drug substance
for Antizol, Antizol-Vet and Xyrem. Ash Stevens, Inc. is the Companys sole
supplier of bulk drug substance for the manufacture of Antizol and Antizol-Vet;
while Lonza, Inc. is the Companys sole supplier of bulk drug substance for the
manufacture of Xyrem.

The loss of either a bulk
drug supplier or drug product manufacturer would require us to obtain regulatory
clearance in the form of a pre-approval submission and incur
validation and other costs associated with the transfer of the bulk drug or drug
product manufacturing process. We believe that it could take as long as two
years for the FDA to approve such a submission. Because our products are
targeted to relatively small markets and our manufacturing production runs are
small by industry standards, we have not incurred the added costs to certify and
maintain secondary sources of supply for bulk drug substance or backup product
manufacturers for some products. Should we lose either a bulk drug supplier or a
drug product manufacturer, we could run out of salable product to meet market
demands or investigational product for use in clinical trials, while we wait for
the FDA approval of a new bulk drug supplier or drug product manufacturer.

We believe that the
foregoing risks regarding the possible loss of a manufacturer or supplier could
be mitigated in a number of ways. First, the Companys currently effective
manufacturing and supply agreement provide for relatively long termination
periods, ranging from one to two years, during which the manufacturer or
supplier is required to continue to perform its obligations under its agreement
with us. During this time period, the Company would actively search for an
alternate manufacturing or supply source and it is managements current
belief that, given the relatively long time period, an alternate source could be
obtained during that period.

Second, during the
termination period, we expect that we would increase our inventory levels in
order to safeguard against delay in implementing a new manufacturing or supply
relationship. Given the longer expiration periods for the Companys current
products, the Company currently expects it would be able to sell increased
inventory levels prior to the expiration dates of the increased inventory.
Expiration periods for our products generally range from two to five years from
the date of manufacture. Given the foregoing, we believe that there are alternate
manufacturing and supply sources that would be available both on acceptable
terms and on a timely basis for our products.

Despite our expectation
that we would be able to take steps to mitigate the risk of loss of one or more
manufacturing or supply relationships, we cannot assure you that the change of a
bulk drug supplier or drug product manufacturer and the transfer of the
processes to another third party would be approved by the FDA, and if approved,
in a timely manner. Therefore, despite our efforts to mitigate risk, we may
experience additional costs and delay while switching providers, which in turn
could adversely affect sales revenue.

Marketing  United States
As part of its marketing efforts, the Company identifies and defines
appropriate therapeutic areas, identifies customer needs within each therapeutic
area, identifies specific product acquisition candidates within each therapeutic
area, works with the development team to insure clinical data are collected that
supports the desired indication and marketing claims, and if FDA approval is
obtained, designs and implements marketing plans for each of its approved
products. Market research is conducted to analyze the potential of products
prior to their acquisition. Once a product is acquired and is being developed,
further market research is completed and, based on this analysis; the
products marketing plan is developed and appropriate pre-launch programs
are initiated. Upon submission of the NDA to the FDA, the product management
responsibilities transition from the development team to the Companys
commercialization staff. The development group continues to provide support
where needed to enhance marketing and sales efforts. This group is responsible
for all aspects of a products marketing and sales, including product
forecasting, positioning, price, promotion and physical distribution to
successfully launch and commercialize the product. Senior sales and marketing
employees lead a cross functional team of internal and external personnel to
implement a products marketing and commercialization plan. In addition,
marketing and sales staff also supports the Companys international sales
efforts through support of and interfacing with international partners.

Marketing  Foreign
In general, the Company expects to out-license foreign marketing, sales and
distribution rights after an NDA is submitted or approved in the United States.
The Company contracts with foreign companies (usually pharmaceutical companies)
to market and distribute its products. The Company considers Europe and Japan to
be its most attractive foreign markets. The Company has entered into marketing,
sales and distribution agreements for Antizol and Cystadane in Europe, Cystadane
in Australia and New Zealand, Cystadane in Israel, Antizol and Cystadane in
Canada.

In October 2003, the
Company announced that it has licensed European sales and marketing rights for
Xyrem to Celltech Pharmaceuticals, a division of Celltech Group plc. Under the
terms of the agreement, Celltech will be responsible for the registration,
marketing and sales of Xyrem in Europe. The licensing agreement includes the use
of Xyrem in narcolepsy and provides Celltech with rights to negotiate for other
potential future indications including fibromyalgia syndrome.

The Companys
historical practice is to negotiate contracts with foreign distributors that
generally provide for minimum order and sales performance. Minimum fees
negotiated with foreign parties to date are not material and are not refundable,
nor subject to future performance criteria. The foreign contracting party is
responsible for obtaining

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marketing approval for the Companys
product to which the agreement relates and the Company is responsible for providing
selected U.S regulatory information to the foreign party on request. The Company cannot
unilaterally terminate these agreements without established evidence of default, but
these agreements do expire over a defined period of time and the Company may seek other
foreign parties to provide comparable services upon expiration if not satisfied with the
performance of its partners. The principal benefit a foreign party receives from entering
into these agreements with the Company and paying the minimum fees, if any, is a
contracted price for acquisition of product from the Company because the Company is the
sole supplier of its approved products on a worldwide basis.

Distribution
In the foreseeable future, the Company does not intend to develop internal
physical distribution capabilities because the Company believes its relatively
low-volume products can be more economically and efficiently distributed through
third-party distribution organizations. Cystadane, principally delivered to
patients through retail pharmacies, and Antizol, primarily used in a hospital
setting, are distributed by an affiliate of Cardinal Health. This distribution
system allows the sale of these products directly into hospitals or, if
customers prefer, through their primary wholesaler. Antizol-Vet is a product
used in veterinary clinics and is distributed by an affiliate of Cardinal Health
to individual veterinary clinics and a network of veterinary wholesalers.

The Company has a contract
with a central pharmacy, Express Scripts Specialty Distribution Services, Inc.,
to distribute Xyrem in the United States. Xyrem is classified as a Schedule III
controlled substance and approved under Subpart H of the FDAs review and
approval process, and distribution is strictly controlled. A specialty pharmacy
is the only source through which Xyrem can be obtained. Distribution is governed
by the FDAs Subpart H regulations and complies with the risk-management
controls jointly developed by Orphan Medical, the Drug Enforcement Agency and
law enforcement agencies. Every shipment of Xyrem is subject to stringent
safeguards to ensure it reaches only individuals for whom it has been
legitimately prescribed. The Companys agreement with the central pharmacy
calls for fees to be paid based on the number of bottles shipped to patients and
is for a term of three years, ending September 2005. This agreement may be
terminated for cause or noncompliance with appropriate notice given according to
the provisions of the agreement.

While we believe that there are other third parties that can provide these distribution services, we cannot
assure you that our distribution agreements with these entities or other third parties would be available, or
continue to be available to us on commercially acceptable terms.  Nonetheless, we do not believe the loss of a
distributor or the failure to renew agreements with our existing distributors would have a material adverse
effect on our sales revenue.

Competition
Potential competitors in the United States are numerous and include
pharmaceutical, chemical and biotechnology companies. The Company will
experience competition in several specific areas, including, but not limited to,
those described below.

| |  | Product
Acquisition  The Company will compete with other entities in acquiring
product rights from other companies, universities, other research institutions, as well
as from other potential licensors.
|- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | Product
Development Resources  The Company will compete for certain resources, such as
the services of clinical investigators, contract manufacturers, advisors and other
consultants. The Company will generally have little or no control over the allocation of
such resources.
|- |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | Orphan
Drug Designation  The Company is aware of another company that filed for and
received orphan drug designation on a product similar to one of its products. Teva
(formerly Biocraft) had been granted orphan drug designations for their sodium oxybate.
Sodium oxybate is the equivalent of the Companys Xyrem product. In 1999, the
Company entered into an agreement with Teva that, in effect, transfers Tevas
development data to the Company. While the Company is not aware of others holding or
seeking orphan drug designation for products that would compete with the Companys
products for NDA approval, there can be no assurance that the Companys products
will not have such competition from another formulation or drug of materially different
composition from being approved, with or without orphan drug status, for the same
indication.
|- |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | Marketing
And Sales  Each of the Companys current products will face competition
from other products or from other therapeutic alternatives. The Companys products
may compete against products whose marketers have substantially greater resources,
including large specialized sales forces, than the Company. The following is a
description of competition that our products face.
|- |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  |  | Xyrem:
for the cataplexy symptoms of narcolepsy, tricyclic and SSRI antidepressants are used
although they are not approved for this use.
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------------

| |  |  | Xyrem:
for excessive daytime sleepiness associated with narcolepsy, Provigil® / modafinil
(Cephalon) is approved as a wakefulness-promoting drug. Stimulant drugs are also used for
this symptom although not specifically approved for narcolepsy. Xyrem may not be directly
competitive with these agents as its use in combination with modafinil or stimulants may
be additive or, in fact, synergistic.
| | - |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  |  | Antizol:
prior to the introduction of Antizol, ethanol has been used for many years for the
treatment of ethylene glycol and methanol poisonings. Although not approved for this use,
it continues to be used in some hospitals.
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  |  | Cystadane:
no competitors.
| | - |  | --------------------------

| |  | Manufacturing  The
Company may also compete for limited manufacturing capacity or availability.
|- |  | ------------------------------------------------------------------------------------------------

Government Regulation
        General
Political, economic and regulatory influences are subjecting the health care
industry in the United States to fundamental change. Several potential
approaches are under consideration, including mandated basic health care
benefits, controls on health care spending through limitations on the growth of
private health insurance premiums and Medicare and Medicaid spending, price
discounts from drug manufacturers, the creation of large purchasing groups and
other significant changes to the health care delivery system. In addition, some
states have adopted or are considering price controls and various health care
reform proposals. The Company anticipates that Congress and state legislatures
will

14

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continue to review and assess
alternative health care delivery systems and payment methods and that public debate of
these issues will likely continue in the future. Because of uncertainties regarding the
ultimate features of reform initiatives and their enactment and implementation, the
Company cannot predict which, if any, of such reform proposals will be adopted, when they
may be adopted or what impact they may have on the Company or its prospects.

Reimbursement
Employers, through payments to their employee benefit plans, bear a
significant share of the health care costs of their employees. These plans are
typically administered by insurance companies, health maintenance organizations,
preferred provider organizations and other third-party payors. Health care
services and products, including pharmaceutical products, are also paid for by
government agencies such as Medicaid. Employers and the payors involved in
providing or administering health care benefits are increasingly turning to
managed caresystems to control health care costs. Under these
systems, the administrative requirements and standards of care are established
by the health care purchasers and providers and the benefit level depends on the
negotiated price. Managed care systems usually limit treatment options to
approved therapeutic regimens and formularies, or lists of approved
drugs and medical products.

Inclusion or listing on the
formularies of managed care groups is important to the commercial success of most
prescription medicines. A pharmaceutical must be included on a third-party payors
formulary or must be deemed medically necessary to be eligible for
reimbursement by that payor. In deciding whether a drug is to be included on a formulary,
payors will generally consider its therapeutic value and cost in comparison to other
available treatments. The Company believes that the proprietary nature and medical
usefulness of its products should assist it in its efforts to have its products approved
for reimbursement. No assurance can be given, however, that the Companys products
will be approved for reimbursement by third-party payors at acceptable levels, or at all.

Product Approvals
The Companys products require FDA approval in the United States and
comparable approvals in foreign markets before they can be marketed. The
development of investigational products and the marketing and supply of approved
products require continuing compliance with FDA regulations on the part of the
Company as well as its manufacturers and distributors.

Scheduled Products
Products that are designated controlled substances also require
compliance with regulations administered by the U.S. Drug Enforcement Agency
(DEA), and similar regulations administered by state regulatory
agencies. On February 28, 2000 President Clinton signed PL 106-172, a public
law that makes gamma hydroxybutyrate (GHB) a Schedule I substance.
Schedule I is the designation by which illegal and non-approved drugs are
controlled. The bill further delineates GHB products being studied under Food
and Drug Administration (FDA) approved protocols or approved for commercial sale
by the FDA as Schedule III substances.

Each state has the ability to
schedule products more strictly or equivalent to the federally designated schedule. Most
states have adopted, either administratively or legislatively, the bifurcated I/III
schedule as described above. The Company continues its efforts to ensure consistency of
scheduling across all states.

Manufacturing Regulation
All facilities and manufacturing processes used to manufacture products for
clinical use or sale in the United States must be operated in conformity with
Good Manufacturing Practices (GMP). These represent the FDA requirements
governing the production of pharmaceutical products. FDA approval is required
before a contract manufacturer can implement most changes in manufacturing
procedures for any of the Companys approved products. The Company has
established a quality assurance program to monitor third-party manufacturers of
its products to promote compliance by such manufacturers with domestic and
foreign regulations (based on country of use). In addition, FDA approval is
required to change contract manufacturers of approved products. Obtaining the
FDAs approval for a change in manufacturing procedures or change in
manufacturers could cause production delays and loss of revenue.

Foreign Regulation
Products marketed outside of the United States are subject to regulatory
approval requirements similar to those required in the United States, although
the requirements governing the conduct of clinical trials, product licensing,
pricing and reimbursement vary widely from country to country. No action can be
taken to market any product in a country until an

15

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appropriate application has been
approved by the regulatory authorities in that country. The current approval process
varies from country to country, and the time spent in gaining approval varies from that
required for FDA approval. In certain European countries, the price of a product must
also be approved. The pricing review period often begins after market approval is
granted. The Company intends to use foreign partners to apply for foreign marketing
approvals.

Insurance
Providing health care products entails an inherent risk of liability. In
recent years, participants in the health care industry have been subject to a
large number of lawsuits alleging malpractice, product liability or related
legal theories, many of which involve large claims and significant defense
costs. The Company may from time to time be subject to such suits as a result of
the nature of its business. The Company carries product liability insurance
coverage in the aggregate amount of $30 million. The Company also carries a $10
million general business insurance policy. The Company does not carry any
insurance to cover the financial risks associated with a potential FDA mandated
recall of an approved product. There can be no assurance, however, that such
insurance policies will be sufficient to fully indemnify the Company against any
asserted claims or that such insurance will continue to be available.

Human Resources
The Company has 79 full-time and six part-time employees. The Company
believes that its relationship with its employees is good. None of the
Companys employees is represented by a labor union.

Trade Secrets
The Company also relies on trade secrets and proprietary knowledge to
protect certain of its technologies and potential products. The Company requires
employees, consultants and advisors to enter into confidentiality agreements
that prohibit disclosure to any third-party or use of such secrets and knowledge
for commercial purposes. Company employees also agree to disclose and assign to
the Company all methods, improvements, modifications, developments, discoveries
and inventions conceived during their employment that relate to the
Companys business. We cannot assure, however, that these agreements will
be observed to prevent disclosure or that they will provide adequate protection
for the Companys confidential information and inventions.

Grants
Previously the Company used both FDA Office of Orphan Drug Products (orphan
drug grants) and the Small Business Administration (SBIR grants) to assist in
funding product development programs. The Company collected approximately $1.6
million in grant proceeds to product development expenses for certain products.
The Company currently has no active grants. The Company does not intend to use
grants as a primary source of funding for product development activities in the
future.

Discontinued Development Products
Through December 31, 2003, the Company discontinued development activities
on a total of eleven proposed products. There can be no assurance that the
Companys license rights and/or any clinical data related to a discontinued
product have any value to a third party and, if such rights or clinical data
have value, there can be no assurance that the Company can come to terms with a
third party for the sale of such rights or clinical data.

# ITEM 2.   PROPERTIES

The Company currently occupies
approximately 15,000 square feet of leased office space at a monthly rent of approximately
$25,000, including operating expenses. This lease expires on October 31, 2004.

# ITEM 3.   LEGAL PROCEEDINGS

None.

# ITEM 4.   SUBMISSION OF MATTERS TO VOTE OF SECURITY HOLDERS

None.

16

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# ITEM 4A.   EXECUTIVE OFFICERS OF THE REGISTRANT

The executive officers of
the Company and their ages as of March 1, 2004.

|Name                    |  | Age |  | Title                                                             | 
|----------------------- |  | --- |  | ----------------------------------------------------------------- | 
|                       
|John Howell Bullion     |  | 52  |  | Chief Executive Officer and Chairman of the Board                 | 
|                       
|William Houghton, M.D   |  | 61  |  | Executive Vice President and Chief Scientific and Medical Officer | 
|                       
|Mark Perrin             |  | 47  |  | Executive Vice President and Chief Commercial Officer             | 
|                       
|Timothy G. McGrath      |  | 39  |  | Vice President and Chief Financial Officer                        | 
|                       
|Dayton T. Reardan, Ph.D |  | 48  |  | Vice President of Regulatory Affairs                              | 
|                       
|Pamela J. Stahl         |  | 38  |  | Vice President of Commercial Operations                           | 

Executive officers of the Company
serve at the discretion of the Board of Directors with no fixed term. There are no family
relationships between or among any of the executive officers or directors of the Company.

Mr. Bullion has been
Chief Executive Officer of the Company since June 24, 1994 and Chairman of the
Board of Directors since December 30, 1998. Mr. Bullion is a co-founder of
Chronimed Inc., the company from which Orphan Medical, Inc. was spun-off in
1994. Prior to joining Orphan Medical, Mr. Bullion served as President of
Bluestem Partners, an investment and consulting company; Dahl & Associates,
a soil and ground water remediation company; and Concurrent Knowledge Systems,
Inc., a software development company. Mr. Bullion also served as partner and
Vice President with First Bank System Venture Capital Company for seven years.

Dr. Houghton has been
the Companys Executive Vice President, Chief Scientific and Chief Medical
Officer since May 2002. Prior to that Dr. Houghton served as the Companys
Chief Operating Officer since joining the Company in August 1998. Dr.
Houghtons most recent position was Chief Scientific Officer and Vice
President of Clinical and Regulatory Affairs at Iotek, Inc. from April 1995 to
August 1998. At Iotek, Dr. Houghton was responsible for all research activities,
regulatory and clinical research, and served as the medical liaison with
Ioteks Medical advisory Board. From February 1984 to March 1995, Dr.
Houghton also held a variety of management positions with Abbott Australasia and
Abbott Laboratories in the United States.

Mr. Perrin has been
the Companys Executive Vice President and Chief Commercial Officer since
May 2002. From 1995 to 2001, Mr. Perrin was Executive Vice President, Commercial
Operations at COR Therapeutics responsible for all aspects of sales marketing
and manufacturing. Prior to that Mr. Perrin held sales, marketing and commercial
operations management positions at Burroughs Wellcome Company from 1992 to 1995
and Lederle Laboratories from 1979 to 1992.

Mr. McGrath has been
the Companys Vice President and Chief Financial Officer since October
1999. Previously, Mr. McGrath had worked as consultant providing financial
services to growing companies in the Minneapolis and Saint Paul area. From 1994
to 1998, he was Vice President of Finance at E. W. Blanch Holdings, Inc., a
publicly traded provider of integrated risk management and distribution
services. Prior to joining E.W. Blanch Holdings, Mr. McGrath was with Ernst
& Young LLP in Minneapolis.

Dr. Reardan has been
the Companys Vice President of Regulatory Affairs since May 1995 and had
been the Director of Regulatory Affairs since joining the Company in 1994. From
1993 to 1994, he was Director of Development at CV Therapeutics. From 1984 to
1993, he held a variety of scientific, development and management positions at
Xoma Corporation.

Ms. Stahl has been the Companys
Vice President of Commercial Operations since October 2001. Most recently, Ms. Stahl was
Vice President of Sales at American TeleCare, Inc. an emerging telemedicine company where
she had responsibility for sales, marketing, and distribution. Previously, she held
several management positions in sales, managed care, and sales training at AstraZeneca
L.P. During her tenure at AstraZeneca L.P., Ms. Stahl was a member

17

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of the team that launched Prilosec®,
the leading treatment of acid related disorders. She also worked at Merck & Co., Inc.
in sales and training positions supporting Zocor® and Pepcid®. In her position at
Orphan Medical, Ms. Stahl manages the Companys U.S. and international sales,
distribution, and patient affairs functions.

18

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# PART II

# ITEM 5.   MARKET FOR REGISTRANTS COMMON STOCK AND RELATED STOCKHOLDER MATTERS

The Companys Common Stock
trades on the National Market tier of The Nasdaq Stock Market under the Symbol: ORPH. The
following table sets forth the quarterly high and low sales prices for the Companys
Common Stock for the years ended December 31, 2003 and December 31, 2002.

|                              |  | High    |  | Low     | 
|----------------------------- |  | ------- |  | ------- | 
|Year Ended December 31, 2003  | 
|January 1 through March 31    |  | $10.500 |  | $ 7.670 | 
|April 1, through June 30      |  | $10.470 |  | $ 5.450 | 
|July 1 through September 30   |  | $13.140 |  | $ 8.580 | 
|October 1 through December 31 |  | $11.590 |  | $ 8.300 | 
|Year Ended December 31, 2002  | 
|January 1 through March 31    |  | $15.000 |  | $10.310 | 
|April 1, through June 30      |  | $13.060 |  | $ 9.000 | 
|July 1 through September 30   |  | $12.200 |  | $ 5.950 | 
|October 1 through December 31 |  | $11.350 |  | $ 6.960 | 

# Equity Compensation Plan Information As Of December 31, 2003

The following table summarizes
information as of December 31, 2003 relating to equity compensation plans of the Company
pursuant to which grants of options, restricted stock, or other rights to acquire shares
may be granted from time to time. As of December 31, 2003, the Company had no equity
compensation plans that were not approved by security holders.

|Plan Category       |  | Number of securities to beissued upon exercise ofoutstanding options, warrants and rights(1) |  | Weighted-average exerciseprice of outstandingoptions, warrants andrights(2) |  | Number of securitiesremaining available forfuture issuance underequity compensation plans(excluding securitiesreflected in column (1))(3) | 
|------------------- |  | -------------------------------------------------------------------------------------------- |  | --------------------------------------------------------------------------- |  | ----------------------------------------------------------------------------------------------------------------------------------------- | 
|                   
|Equity compensation |  | 2,131,796                                                                                    |  | $8.14                                                                       |  | 833,382                                                                                                                                   | 
|plans approved by   | 
|security holders    | 

As of March 1, 2004, the
Companys Common Stock was held by approximately 250 shareholders of record and the
Company estimates that there were approximately 3,000 beneficial owners of its Common Stock
on such date.

The Company has never declared or
paid any dividends on its Common Stock and does not anticipate paying dividends on its
Common Stock in the foreseeable future. The Company currently intends to retain future
earnings, if any, for use in the Companys business. The payment of any future
dividends on its Common Stock will be determined by the Board of Directors in light of
conditions then existing, including the Companys earnings, financial condition and
requirements, restrictions in financing agreements, business conditions and other factors.

19

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# ITEM 6.   SELECTED FINANCIAL DATA

The following selected
financial data of the Company as of December 31, 2003 and 2002 and for the three
years ended December 31, 2003, 2002 and 2001, are derived from, and are
qualified by reference to, the financial statements of the Company audited by
Ernst & Young LLP, independent registered public accounting firm, included
elsewhere in this Form 10-K. The selected financial data as of December 31,
2001, 2000 and 1999 and for the years ending December 31, 2000 and 1999 are
derived from financial statements, which are not included herein. The
information set forth below should be read in conjunction with
Managements Discussion and Analysis of Financial Condition and
Results of Operations, the Financial Statements and Notes thereto and
other financial information included elsewhere in this Form 10-K.

|FINANCIAL POSITION             
|-------------------------------
|                               
|
|
|Cash, cash equivalents and     
|available-for-sale securities  
|Working capital                
|Total assets                   
|Long term debt                 
|Deferred revenue               
|Accumulated deficit            
|Total shareholders equity     
|                               
|                               
|FINANCIAL RESULTS              
|                               
|
|Revenues                       
|Cost of sales                  
|                               
|Gross profit                   
|Operating expenses             
|Product development            
|Sales and marketing            
|General and administrative     
|                               
|Loss from operations           
|Other income, net              
|                               
|Net income (loss) before taxes 
|Income tax expense             
|                               
|Net income (loss)              
|Less: Preferred stock          
|Dividend                       
|                               
|Net income (loss) applicable to
|common shareholders            
|                               
|Earnings (loss) per            
|Common share                   
|Basic                          
|Diluted                        
|Weighted average               
|shares outstanding             
|Basic                          
|Diluted                        
|                               

At December 31, 2003, the Company
reclassified certain operating expenses to align the financial statements with the Companys
current management of its operations.  These expenses were reclassified from General
and Administrative expenses to Product Development and Sales and Marketing expenses.

20

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In June 2003, the Company announced
the disposition of Busulfex (busulfan) Injection to ESP Pharma, Inc. for $29.3 million
plus the book value of inventory, approximately $0.2 million. The Company announced the
sale of the product Sucraid (sacrosidase) oral solution to a specialty pharmaceutical
company in May 2003 for $1.5 million. The Company also divested a third product, Elliotts
B Solution to the same specialty company for proceeds that were not material. Proceeds
from these dispositions will be used for further development and marketing of Xyrem and
for the creation of a stronger presence in the sleep and central nervous system (CNS)
markets. The Company recorded a gain of $30.3 million related to these transactions in the second quarter of 2003.

Remainder of page intentionally left blank

21

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# ITEM 7.   MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

# General

Orphan Medical, Inc. (the
Company or we) acquires, develops, and markets products of high medical
value intended to treat sleep disorders, pain and other central nervous system
(CNS) disorders that are addressed by physician specialists. A drug has high
medical value if it offers a major improvement in the safety or efficacy of
patient treatment and has no substantially equivalent substitute. The Company
has had six pharmaceutical products approved for marketing by the United States
Food and Drug Administration (FDA). Three of these products have been divested,
and the Company is now focusing its resources on Xyrem® (sodium oxybate)
oral solution, a medication approved for cataplexy, a significiant and
debilitating symptom of narcolepsy. The Company is conducting clinical trials to
assess Xyrem in treating excessive daytime sleepiness and fragmented nighttime
sleep, the other prominent symptoms of narcolepsy. A new compound, Butamben
(butyl-p-aminobenzoate) suspension for injection, is being evaluated for
development as a treatment of pain. The Company is seeking other approved or
development-stage products in the specialty CNS areas it serves. The Company
also markets Antizol® (fomepizole) Injection, as a treatment for suspected
or confirmed ethylene glycol or methanol poisonings and Cystadane® (betaine
anhydrous for oral solution) for the treatment of homocystinuria, an inherited
metabolic disease.

Since its inception, the Company has
experienced recurring losses from operations and has generated an accumulated deficit
through December 31, 2003 of $56.3 million. The accumulated deficit declined in 2003 as a
result of the gain on the divestment of certain products. In addition, the Company expects
to incur additional losses from operations in 2004.

# Recent Developments

In October 2003, the Company
announced that it had licensed European sales and marketing rights for Xyrem to
Celltech Pharmaceuticals, a division of Celltech Group plc (Celltech). Under the terms of
the agreement, Celltech will be responsible for the registration, sales and
marketing of Xyrem in Europe. Celltech has made an upfront payment of $2.5
million to Orphan Medical and will make further payments of up to $6 million
tied to product development milestones and up to $7 million tied to
sales-related milestones. Celltech will also pay Orphan Medical a royalty on
sales of the product which is expected to begin no earlier than 2005. The
licensing agreement includes the use of Xyrem in narcolepsy and provides
Celltech with rights to negotiate in regard to other potential future
indications including fibromyalgia syndrome. The term of this agreement is for
10 years from the date of approval in Europe with automatic extension until
Celltech provides 12 months notice to Orphan Medical. The agreement may be
terminated under certain conditions including material breach of contract
provisions prior to the initial ten year term.

On June 10, 2003, the Company
announced the disposition of Busulfex to ESP Pharma, Inc. for $29.3 million plus
the book value of inventory, approximately $0.2 million. The Company announced
the sale of the product Sucraid to a specialty pharmaceutical company on May 6,
2003 for $1.5 million. The Company also divested a third product, Elliotts B
Solution to the same specialty company for proceeds that were not material.
Proceeds from these dispositions will be used for further development and
marketing of Xyrem and for the creation of a stronger presence in the sleep and
central nervous system (CNS) markets.

On March 28, 2003, the Company
cancelled its existing line of credit facility and entered into a new facility with a
commercial bank. The new line of credit facility, which has a term of one-year, includes a
borrowing base equal to 75% of eligible accounts receivable up to a maximum amount of $2.5
million. Certain other assets have also been pledged as collateral for this facility. The
interest rate is equal to two points over the banks prime rate. The Company will be
subject to certain other requirements during the term of the facility, including minimum
quarterly net equity amounts.

# Critical Accounting
Policies

Revenue Recognition
Sales for all products, except Xyrem, are recognized at the time a product
is shipped to the Companys customers and are recorded net of reserves for
discounts for prompt payment. Sales of Xyrem are recognized at the time product
is shipped from the specialty pharmacy to the patient and are recorded net of
discounts for prompt payment. Except for Xyrem, the Company is obligated to
accept, for exchange only, from all domestic customers products that have reached
their expiration date, which range from three to five years depending on the
product. The Company is not obligated to accept exchange of outdated product
from its international distribution partners. The Company establishes a reserve
for the estimated cost of the exchanges. Management bases these reserves
on historical experience and these estimates are subject to change.

Deferred revenue represents
the initial payment received by the Company per the terms of the Companys
license agreement with Celltech. Upon expiration of refund conditions, this fee
will be recognized ratably over the expected regulatory approval period. Future
milestone payments are expected to be recognized as earned based on the
achievement of the milestone as indicated in the license agreement. See Note 5
to the financial statements for additional details regarding the Celltech
transaction.

22

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Accounts Receivable Allowance
The Company determines an allowance amount based upon an analysis of the
collectibility of specific accounts and the aging of the accounts receivable.
There is a concentration of sales to larger medical wholesalers and
distributors. The Company performs periodic credit evaluations of its
customers financial conditions. Domestic receivables are due within 30
days of the invoice date. International receivables are generally due within 60
to 90 days of invoice date. Credit losses relating to customers have not been
material since the Companys inception.

Inventories
Inventories are valued at the lower of cost or market determined using the
first-in, first-out (FIFO) method. The Companys policy is to establish an
excess and obsolete reserve for its products in excess of the expected demand
for such products. Inventory used in clinical trials is expensed at the time of
production and included in the reserve until used.

Income Taxes
As part of the process of preparing its financial statements, the Company is
required to estimate its income taxes in each of the jurisdictions in which it
operates. This process involves estimating its actual current tax exposure,
together with assessing temporary differences resulting from differing treatment
of items for tax and accounting purposes. These differences result in deferred
tax assets and liabilities.

The Company records a valuation
allowance to reduce the carrying value of its net deferred tax asset to the amount that is
more likely than not to be realized. For the year ended December 31, 2003, the Company
recorded a $27.3 million valuation allowance related to its net deferred tax assets of
$27.3 million. In the event the Company were to determine that it would be able to realize
its deferred tax assets in the future, an adjustment to the deferred tax asset would
increase net income in the period such determination is made. On a quarterly basis, the
Company evaluates the realizability of its deferred tax assets and assesses the
requirement for a valuation allowance.

# Results of Operations

At December 31, 2003, we
reclassified certain operating expenses to align the financial statements with
our current management of its operations.  These expenses
were reclassified from General and Administrative expenses to Development and
Sales and Marketing expenses.

Twelve Months Ended
December 31, 2003 Vs. Twelve Months Ended December 31, 2002

In June 2003, we announced the disposition of Busulfex to ESP Pharma, Inc.
for $29.3 million plus the book value of inventory, approximately $0.2 million.
We announced the sale of the product Sucraid to a specialty pharmaceutical
company on May 6, 2003 for $1.5 million. We also divested a third product,
Elliotts B Solution to the same specialty company for proceeds that were not
material. Proceeds from these dispositions will be used for further development
and marketing of Xyrem and for the creation of a stronger presence in the sleep
and central nervous system (CNS) markets. Total gain from the divestment of
these products of $30.3 million is recorded as Gain on Divestment of
Products.

Product Revenue SummaryThe
following is a summary of product revenue for the year ended December 31, 2003 compared
to product revenue for the year ended December 31, 2002:

|              | Year ended December 31, | Variance
|------------- | ----------------------- | --------
|
|              |                        
|Antizol       |                         |         
|Antizol-Vet   |                         |         
|Cystadane     |                         |         
|Xyrem         |                         |         
|Busulfex(1)   |                         |         
|Elliotts B(1) |                         |         
|Sucraid(1)    |                         |         
|              |                        
|Total         |                         |         
|              |                        

(1) - These products were divested
during the second quarter of 2003.

Revenue decreased $0.6 million or 4%
to $15.5 million for the year ended December 31, 2003 compared to $16.1 million the prior
year. The decrease is the result of the product divestments completed in June 2003,
offset by increases in Xyrem, Antizol and Cystadane revenues. The divested products
contributed $3.5 million of revenue through the divestment date in 2003 compared to $8.5
million of revenue in fiscal 2002. Revenue from Xyrem was $3.9 million for the year ended
December 31, 2003 compared to $0.3 million in fiscal 2002. This increase is the result of
increased prescription volume for the product.  The product was commercially launched in
early October 2002.  Antizol revenue increased $0.5 million or 9% as hospital stocking of
the product rose slightly, along with an increase in the number of uses resulting from
poisonings during the year.  Cystadane revenue increased $0.2 million or 19% as a result
of increased in the number of prescriptions during the year.  The Company expects total
revenue in fiscal 2004 to be in the $18.0-- $20.0 million range with Xyrem contributing
$12.0-- $14.0 million.

Cost of sales increased
$0.2 million or 10% to $2.4 million for the twelve months ended December 31,
2003 from $2.2 million for the twelve months ended December 31, 2002. The
increase is primarily attributable to the change in product sales mix in 2003 as
a result of the product divestments discussed earlier. The gross margin for 2003
was 84% compared to 86% the prior year. The margins on all products decreased
slightly in 2003 as a result of increases in the costs of product liability
insurance, a component of cost of sales. The products that were divested during
the year had a lower combined margin, 81% than the combined margin on the
remaining products, 86%. Cost of sales as a percentage of revenues will
fluctuate from quarter to quarter and from year to year depending on, among
other factors, demand for the Companys products, new product introductions
and the mix of approved products shipped. The Company expects its gross margins
for Xyrem as well as its other products to be in the 85% range in 2004.

Product development expense
increased $2.1 million or 24% to $10.8 million for the year ended December 31,
2003 compared to $8.7 million for the prior year. This increase is attributable
to increased clinical trial activity in 2003 compared to the prior year. At
December 31, 2003, we had two Phase III(b) trials underway to evaluate Xyrem
as a treatment for excessive daytime sleepiness associated with narcolepsy. We
had only one Phase III(b) trial underway in

23

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2002. We expect
product development expense in 2004 to increase from 2003. This increase will be attributable to
the completion of the Phase III(b) trials, the initiation of a clinical trial evaluating
Xyrem as a treatment for fibromyalgia, the ongoing Xyrem extended release formulation
activities and the continued evaluation of Butamben as a treatment for chronic malignant
pain.

Sales and marketing expense
increased $3.6 million or 28% to $16.4 million from the $12.8 expense
recorded in 2002. The primary reason for the increase is a full-year of expense
associated with the commercialization of Xyrem. These costs included
$7.4 million for the sales force for Xyrem, hired late in the third quarter
of 2002, and the sales administration functions compared to $1.8 million the
prior year; $5.1 million of expenses for marketing programs for Xyrem
compared to $4.2 million in 2002; and other smaller increases. These
increases were offset by certain expense savings associated with the divestment
of products in 2003, $2.5 million. Sales and marketing expense include
the costs of the field sales force, marketing programs and marketing and sales
administration costs. The Company expects sales and marketing expense to decline
slightly in 2004 as a result of the elimination of expenses associated with the
products that were divested in 2003.

General and administrative
expense increased $0.7 million or 16% to $4.8 million for the year ended
December 31, 2003 compared to $4.1 million the prior year. This increase is the
result of increased staffing and other infrastructure expenses to support the
Companys growth. The Company expects general and administrative expenses
in 2004 to be consistent with or slightly less than expense levels in 2003.

Interest income declined
from the prior year as the rate of investment return on the Companys
excess cash declined from 2002.

We
recorded minimum interest expense associated with its line of credit facility,
its capital lease and the amortization of warrants issued in connection with the
line of credit facility entered into in March 2003. The amortization of warrants
is over the term of the credit facility or one year.

We have a history of
pre-tax losses and had not generated taxable income since inception until 2003.
While the Company had pre-tax income in 2003, the Company utilized a portion of
its net operating loss carryforward and therefore, only recorded income tax
expense for the alternative minimum taxes that were owed.

As of December 31, 2003,
we had $35.9 million of net operating loss carryforwards available to
offset future taxable income which begin to expire in 2010. In addition, under
the Tax Reform Act of 1986, the amounts of and benefits from net operating loss
carryforwards may be impaired or limited in certain circumstances, including
significant changes in ownership interests. Future use of the Companys net
operating loss carryforwards may be restricted due to changes in ownership or
from future tax legislation.

The Company has established a
valuation allowance against the entire amount of its deferred tax asset because it has not
been able to conclude that it is more likely than not that it will be able to realize the
deferred tax asset, due primarily to its history of operating losses.

Preferred stock dividends relate to
the Senior Convertible Preferred Stock that was issued on July 23, 1998 and Series B
Convertible Preferred Stock issued on August 2, 1999. Both have dividend rates of 7.5%.
Preferred stock dividends were $0.9 million for the twelve months ended December 31, 2003
and 2002. Preferred stock dividends, which commenced on February 1, 1999, are payable in
arrears on August 1 and February 1 of each year. Prior to February 2001, the Company
satisfied its dividend payment obligation by issuing additional preferred stock, as
permitted by the terms of the Senior Convertible Stock. Subsequent to February 2001, the
Company intends to continue to satisfy its future dividend payment obligations by the
issuance of unregistered common shares of stock for the Senior Convertible Preferred Stock
and additional preferred stock for the Series B Convertible Preferred Stock, which will
cause preferred stock dividends to increase in subsequent quarters.

Net income applicable to common
shareholders was $10.1 million for the twelve months ended December 31, 2003
compared to a net loss of $12.3 million for the twelve months ended December 31,
2002. Basic and diluted income per share for the year ended December 31, 2003
were $0.95 and $0.85. Basic and diluted loss per common share for the year ended
December 31, 2002 was $1.19. The loss for 2003 excluding the gain on
the divested products was $19.7 million and a net loss per share of $1.86.

Twelve Months Ended December 31, 2002 Vs. Twelve Months Ended December 31, 2001Product Revenue Summary
The following is a summary of product revenue for the year ended December 31, 2002 compared to product revenue for the
year ended December 31, 2001:

|               | Year
ended December 31, |  | Variance
|-------------- | ----------------------- |  | --------
|               |                         |  |         
|
|               |                         | 
|Antizol        |                         |  | $       
|Antizol Vet    |                         |  |         
|Cystadane      |                         |  |         
|Xyrem          |                         |  |         
|Busulfex (1)   |                         |  |         
|Elliotts B (1) |                         |  |         
|Sucraid (1)    |                         |  |         
|               |                         | 
|Total          |                         |  | $       
|               |                         | 

Revenues increased to $16.1 million for the twelve months ended December 31,
2002 from $11.3 million for the twelve months ended December 31, 2001, an
increase of $4.8 million or 43%. Sales of both Antizol and Busulfex exceeded
revenue expectations in 2002. Antizol performed very well throughout 2002. Sales
of the antidote experienced 34%

24

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growth as compared to the prior year
and Antizol is being stocked in over one-third of all hospitals with emergency
departments. Antizol is established as the standard of care for confirmed or suspected
ethylene glycol and methanol poisonings. Use of Busulfex in preparative regimens for bone
marrow transplantation also continued to realize significant growth in the United States,
Canada and other countries. Busulfex continued to advance into new research areas in
place of oral busulfan or total body irradiation, and achieved an approximate 55 percent
market share of the transplants that include a busulfan-based regimen. The sales of
Cystadane, Sucraid Antizol-Vet and Elliotts B met the Companys expectations in
2002.

Cost of sales increased to $2.2
million for the twelve months ended December 31, 2002 from $1.6 million for the twelve
months ended December 31, 2001, an increase of $0.6 million or 38%. The increase is
primarily attributable to the increase in sales in 2002. The gross margins for both 2002
and 2001 were 86%.

Product development expense increased to $8.7
million for the twelve months ended December 31, 2002 from $7.0 million for the twelve
months ended December 31, 2001, an increase of $1.7 million or 24%. The increase is the
result of increased activity in ongoing trials for Xyrem and other development activities
related to Xyrem and other products. The two Phase III(b) trials for Xyrem, now underway,
will increase research and development spending in subsequent quarters, as will additional
trials and data updates requested by the FDA.

Sales and marketing expense
increased to $12.8 million for the twelve months ended December 31, 2002 from
$5.7 million for the twelve months ended December 31, 2001, an increase of $7.1
million or 125%. This increase is largely attributable to activities for Xyrem,
including the development of marketing materials and the ongoing activities
associated with initial introduction of a new product ($3.1 million), the
recruitment and training of a dedicated specialty sales force ($1.8 million) and the
implementation of the specialty distribution system ($0.6 million). The Company
had an increase of $1.4 million of costs associated with the marketing and
selling of its Busulfex and Antizol product lines.

General and administrative expense
increased to $4.1 million for the twelve months ended December 31, 2002 from $3.2 million
for the twelve months ended December 31, 2001, an increase of $0.9 million or 28%. The
increase in general and administrative expenses is related to building infrastructure for
the launch and subsequent support of Xyrem.

Other income consists of interest
income from investment activities net of interest expense. Other income was $0.3 million
for the twelve months ended December 31, 2002 and 2001. Even though the equity transaction
completed in December 2001 increased the cash available for investment in 2002, the lower
interest rates and the cash used to fund development and working capital activities of the
Company resulted in no increase in interest income for 2002 over 2001. Other income is
expected to decrease in 2003 as a result of cash used to fund development and working
capital activities of the Company.

Preferred stock dividends relate to
the Senior Convertible Preferred Stock that was issued on July 23, 1998 and Series B
Convertible Preferred Stock issued on August 2, 1999. Both have dividend rates of 7.5%.
Preferred stock dividends were $0.9 million for the twelve months ended December 31, 2002
and 2001. Preferred stock dividends, which commenced on February 1, 1999, are payable in
arrears on August 1 and February 1 of each year. Prior to February 2001, the Company
satisfied its dividend payment obligation by issuing additional preferred stock, as
permitted by the terms of the Senior Convertible Stock. Subsequent to February 2001, the
Company intends to continue to satisfy its future dividend payment obligations by the
issuance of unregistered common shares of stock for the Senior Convertible Preferred Stock
and additional preferred stock for the Series B Convertible Preferred Stock, which will
cause preferred stock dividends to increase in subsequent quarters.

Net loss applicable to common
shareholders was $12.3 million for the twelve months ended December 31, 2002 compared to a
net loss of $6.9 million for the twelve months ended December 31, 2001. Basic and diluted
loss per common share for these respective periods were $1.19 and $0.80.

Liquidity and Capital Resources

Since July 2, 1994, the effective
date the Company was spun-off from Chronimed Inc., it has financed its operations
principally from net proceeds from several public and private financings, interest income
and product sales. The various public and private placement transactions since inception
resulted in aggregate net proceeds, after commissions

25

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and expenses, of $60.5 million. In
addition the Company raised approximately $30.9 million net proceeds from the divestment of three
products in June 2003.

Net working capital (current assets
less current liabilities) increased to $19.8 million at December 31, 2003 from $6.7
million at December 31, 2002. Cash and cash equivalents increased to $23.3 million at
December 31, 2003 from $6.9 million at December 31, 2002. The Company invests excess cash
in short-term, interest-bearing, investment grade securities.

The primary sources of
capital for the year ended December 31, 2003 were from product revenues and
gross proceeds of $30.9 million from the divestment of three of its products in June 2003. These divestments were completed to focus the
Companys resources on Xyrem in the treatment of certain symptoms of narcolepsy
and the conduct of certain clinical trials assessing the effectiveness of Xyrem
in treating additional symptoms of narcolepsy.

In October 2003, the Company
announced that it had licensed European sales and marketing rights for Xyrem
(sodium oxybate) oral solution to Celltech Pharmaceuticals, a division of
Celltech Group plc. Under the terms of the agreement, Celltech will be
responsible for the registration, sales and marketing of Xyrem in Europe.
Celltech has made an initial payment of $2.5 million to Orphan Medical and will
make further payments of up to $6 million tied to product development milestones
and up to $7 million tied to sales-related milestones. Celltech will also pay
Orphan Medical a royalty on sales of the product which is expected to begin no
earlier than 2005. The ten-year licensing agreement includes the use of Xyrom in
narcolepsy and provides Celltech with rights to negotiate in regard to other
potential future indications including fibromyalgia syndrome. The term of this
agreement is for 10 years from the date of approval in Europe with automatic
extension until Celltech provides 12 month notice to Orphan Medical. The
agreement may be terminated under certain conditions including material breach
of contract provisions prior to the ten year initial term.

The Company used more
capital than its operations generated in 2003. The Company expects to incur a
loss from operations resulting in 2004 and 2005, which will decrease capital.
The Company continues to invest its capital in product development activities
that may provide opportunities to enhance the commercial opportunities for
Xyrem. The Company has committed $14.7 million to future product development
activities. In addition, the Company also continues to use capital to develop
and enhance the commercial programs for Xyrem. The Company expects that these
efforts may result in increased Xyrem revenues. In the longer term, the Company
expects that its current cash balances, cash flow from product revenues and any
milestone payments received in accordance with the terms of the Celltech
agreement will be sufficient to fund operations well into 2005. The Company may
consider additional sources of capital should it decide to expand its product
development programs or acquire additional products.

On April 14, 2004, the
Company filed a shelf registration statement with the Securities and
Exchange Commission (SEC) for the registration of 4,000,000 shares of common
stock. Although we believe we have sufficient cash available for currently
anticipted clinical trials, proceeds might be used for trials related to
products that we may acquire or develop in the future or for trials related to
new inducations of existing products.

The Company entered into a line
of credit facility with a commercial bank on March 28, 2003. The facility was amended in
June 2003 as part of the product divestments in June. The line of credit facility, which
has a term of one-year, includes a borrowing base equal to 75% of eligible accounts
receivable up to a maximum amount of $2.5 million as amended in June 2003. Certain other
assets have also been pledged as collateral for this facility. The interest rate is equal
to two points over the banks prime rate, with a minimum rate of 6.75%. The Company
will be subject to certain other requirements during the term of the facility, including
minimum quarterly net equity amounts and maximum monthly net losses. At December 31, 2003,
there was $1.8 million available under this facility. In late March 2004, the Company extended
this facility to September 30, 2004 under the same terms described above. The Company has not
borrowed under this facility.

The Companys commitments for
outside development spending increased to approximately $14.7 million at December 31, 2003
from $5.7 million at December 31, 2002. These commitments are generally for less than one
year. The increase is principally attributable to the clinical trials for Xyrem
development activities, including both the current Phase III(b) trials and the
Fibromyalgia trial, which is expected to begin patient enrollment in the second quarter of
2004. The Company expects development spending to increase as the two Xyrem Phase III(b)
clinical trials progress and post approval surveillance studies are completed. In
addition, the Company continues to look at new product opportunities and any new
initiatives will increase development spending. Due to the dependence of this estimate on
the results of the studies and other variable components, the actual result of this
estimate may be different.

The Company has future contractual
commitments for the following cash obligations in thousands:

|                                                                                                              
|--------------------------------------------------------------------------------------------------------------
|
|                                                                                                              
|Capital lease                                                                                                 
|obligations                                                                                                   
|                                                                                                              
|Operating lease                                                                                               
|obligations (1)                                                                                               
|                                                                                                              
|Outside Development                                                                                           
|Spending                                                                                                      
|                                                                                                              
|Total contractual                                                                                             
|cash obligations                                                                                              
|                                                                                                              
|(1)   These amounts include facilities, office equipment, and automobiles for the Companys field sales force.

The Company expects that sales and
marketing spending will decrease compared to 2003 spending levels. Management
believes that existing cash, expected milestone payments from the Celltech
agreement and operating cash flows from product sales will be sufficient to fund
its operations at least through December 31, 2004.

For continued listing on the NASDAQ
National Market, a company must satisfy a number of requirements, which in the
Companys case include either: (1) minimum net equity in excess of $10.0 million or
(2) a market capitalization of at least $50.0 million. The Company met both requirements
at December 31, 2003. Although the Company does not expect to be profitable in 2004, the
Company nevertheless expects to continue to meet the requirements for listing on the
NASDAQ National Market. However there can be no assurance that the Company will continue
to have adequate capital to meet the requirements through the year 2004 and thereafter.

In connection with the 1998 and 1999
private placements of convertible preferred stock, the Company agreed to certain
restrictions and covenants, which could limit its ability to obtain additional financing.
The most important of the restrictions are: (1) the Company cannot incur additional
indebtedness, except for indebtedness secured solely by the Companys trade
receivables, until it has profitable operations, subject to certain limitations and (2)
the Company cannot, without the approval of a majority of the preferred stockholders,
issue additional equity securities unless the

26

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selling price per share exceeds the
then conversion price of the outstanding convertible preferred stock or the sale of
equity is accomplished in a public offering. The present conversion price is $8.14 for
the Senior Convertible Preferred Stock and $6.50 for the Series B Convertible Preferred
Stock. Even without these restrictions, the Company can make no assurances that
additional financing opportunities will be available or, if available, on acceptable
terms.

Off-Balance Sheet Arrangements
We do not participate in transactions or have relationships or other
arrangement with an unconsolidated entity, which include special purpose and
similar entities or other off-balance sheet arrangements.

Recent Accounting Pronouncements
In January 2003, the FASB issued Financial Interpretation No. 46, or
FIN 46, Consolidation of Variable Interest Entities, and in December
2003, issued a revision to FIN 46 (FIN 46R). FIN 46 requires that
if an entity has a controlling financial interest in a variable interest entity,
the assets, liabilities and results of activities of the variable interest
entity should be included in the consolidated financial statements of the
entity. FIN 46 is effective immediately for all new variable interest
entities created or acquired after January 31, 2003. For variable interest
entities created or acquired prior to February 1, 2003, the provisions of
FIN 46 must be applied for the first interim or annual period ending after
December 15, 2003. The adoption of FIN 46 will not have a material
effect on our results of operations, cash flows or financial position.

In May 2003, the FASB
issued SFAS No. 150, Accounting for Certain Financial Instruments with
Characteristics of Both Liabilities and Equity. SFAS No. 150
establishes standards for how an issuer classifies and measures in its statement
of financial position certain financial instruments with characteristics of both
liabilities and equity. SFAS No. 150 requires that an issuer classify
a financial instrument that is within its scope as a liability (or an asset in
some circumstances) because that financial instrument embodies an obligation of
the issuer. This statement is effective for financial instruments entered into
or modified after May 31, 2003, and otherwise is effective at the beginning
of the first interim period beginning after June 15, 2003. The Company
adopted SFAS No. 150 as of July 1, 2003. The adoption of
SFAS No. 150 did not have a material effect on our results of
operations, cash flows or financial position.

RISK FACTORS
An investment in our common stock involves a number of risks, including
among others, risks associated with companies that operate in the pharmaceutical
industry. These risks are substantial and inherent in our operations and
industry. Any investor or potential investor should carefully consider the
following information about these risks before buying shares of common stock.

# We have a history of losses, which we expect to continue.

We have been unprofitable, with the
exception of 2003 due to the divestment of three products, since our inception in January
1993. We expect operating losses at least through 2004 because anticipated gross profits
from product revenues will not offset our operating expenses and additional spending to
continue drug development activities. The amount of these losses may vary significantly
from year-to-year and quarter-to-quarter. Our actual losses will depend on, among other
factors, the timing of product development, regulatory approval, and market demand for our
Food and Drug Administration approved products. We cannot assure you that we will ever
generate sufficient product revenues to achieve profitability.

# We cannot be sure that
future capital will be available to meet our expected capital requirements.

Although we believe that we have
sufficient capital to meet out current business objectives, if we expand our business
plans, we may need additional capital. Adequate funds for our operations, continued
development, and expansion of our business plans, whether from financial markets or from
other sources, may not be available when needed on acceptable terms, or at all. If we
issue additional securities your holding may be diluted.

In addition there are restrictions
on our ability to raise additional capital that are part of the terms of the
sales of our preferred stock. On July 23, 1998, we completed the private sale to
UBS Capital of $7.5 million of Senior Convertible Preferred Stock. On August 2,
1999, we completed another private sale to UBS Capital of $2.95 million of
Series B Convertible Preferred Stock. In conjunction with the issuance of the
preferred shares, we agreed to several restrictions and covenants, and granted
certain voting and other rights to the holders of the preferred shares. One of
the most important of these restrictions is that we cannot incur additional
indebtedness, except for indebtedness secured solely by our trade receivables,
until we have profitable operations, subject to certain limitations. Another
important restriction is that, without the approval of a majority of the
preferred stockholders, we cannot issue additional equity securities unless the
selling price per share exceeds the then conversion price of the outstanding
convertible preferred stock or the sale of equity is accomplished in a public
offering. The present conversion price is $8.14 per share for the Senior
Convertible

27

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Preferred Stock and $6.50 for the
Series B Convertible Preferred Stock. These restrictions could make it more difficult and
more costly for us to obtain additional capital. We cannot assure you that additional
sources of capital will be available to us or, if available, on terms acceptable to us.

# Possible Price Volatility and Limited Liquidity of Common Stock.

There is generally significant
volatility in the market prices and limited liquidity of securities of early stage
companies, and particularly of early stage pharmaceutical companies. Contributing to this
volatility are various factors and events that can affect our stock price in a positive or
negative manner. These factors and events include, but are not limited to:

- announcements by us or our competitors of new product developments or clinical testing results;
- governmental approvals, refusals to approve, regulations or actions;
- developments or disputes relating to patents or proprietary rights;
- public concern over the safety of therapies;
- financial performance;
- fluctuations in financial performance from period to period; and
- small float or number of shares of our stock available for sale and trade.

There is also a risk that the market value
and the liquidity of the public float for our common stock could be adversely affected in
the event we no longer meet the Nasdaqs requirements for continued listing on the
National Market. For continued listing on the Nasdaq National Market, a company must
satisfy a number of requirements, which in our case includes either: (1) minimum net
equity in excess of $10.0 million as reported on Form 10-Q or Form 10-K or (2) a market
capitalization of at least $50.0 million. Market capitalization is defined as total
outstanding shares multiplied by the last sales price quoted by Nasdaq. We met both
criteria as of December 31, 2003, however, we cannot assure you that the market
capitalization threshold will continue to be met or that we will be able to generate
adequate capital to meet the net tangible asset requirement.

These and other factors and events
may have a significant impact on our business and on the market price of the common stock.

# There is a limited market for our products.

Most orphan drugs have a potential
United States market of less than $25 million annually and many address annual markets of
less than $1 million. Although we expect combined revenue from the sales of Antizol,
Cystadane, and Antizol-Vet in 2004 to be approximately $7.0 million, we believe that the
total market opportunity for these three products is not likely to exceed $10.0 million
in the foreseeable future.

We expect revenue from Xyrem in 2004
to be approximately $12.0 million to $14.0 million. We believe that the market
opportunity for Xyrem may be substantially larger for the indication of cataplexy in
narcolepsy, and, if our clinical trials in our product development programs that are
underway produce positive data, they may result in increased market opportunity for
Xyrem. However, we cannot assure you that sales of our products will be adequate to make
us profitable even if the products are accepted by medical specialists and used by
patients.

# We currently rely on the limited
protection of the Orphan Drug Act for certain products.

Since our inception, all of
our products have been granted orphan drug status by the FDA. Medicines
developed or acquired in the future may hold orphan drug status, although we may
develop or acquire products that do not hold such status if we can obtain
appropriate proprietary protection through patents or otherwise. Currently, two
of our products have orphan drug status: Xyrem, with an expiration date of
July 17, 2009, and Antizol, with an expiration date of December 6,
2004.

United States
Under the Orphan Drug Act, the FDA may grant orphan drug designation to
drugs intended to treat a rare disease or condition. The Orphan Drug
Act generally defines rare disease or condition as one that affects
populations of fewer than 200,000 people in the United States. The Orphan Drug
Act provides us with certain limited protections for our products.

28

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The first step in obtaining the
limited protection under the Orphan Drug Act is acquiring the FDAs approval of
orphan drug designation, which must be requested before submitting a New Drug
Application (NDA). After the FDA grants orphan drug designation, it publishes
the generic identity of the therapeutic agent and the potential orphan use specified in
the request. Orphan drug designation does not constitute FDA approval. In addition, orphan
drug designation does not convey any advantage in, or shorten the duration of, the
regulatory approval process.

The second step in obtaining the
limited protection under the Orphan Drug Act is acquiring the FDAs
recognition of orphan drug status. The Orphan Drug Act confers
orphan drug status upon the first company to receive FDA approval to market a
drug with orphan drug designation for a specific designated
indication. Orphan drug status does not protect against another formulation or
drug of materially different composition from being approved, with or without
orphan drug status, for the same indication. FDA approval also results in United
States marketing exclusivity for a period of seven years, subject to certain
limitations. Although obtaining FDA approval to market a product with orphan
drug status can be advantageous, we cannot assure you that the scope of
protection or the level of marketing exclusivity will remain in effect in the
future. In addition, United States orphan drug status does not provide any
marketing exclusivity in foreign markets. Although certain foreign countries
provide development and marketing benefits to orphan drugs, we cannot assure you
that such benefits can be obtained or, if obtained, will be of material value to
us. The FDA has granted us orphan drug status for Xyrem, Antizol, and Cystadane.
Upon expiration of orphan drug status, our products might be subject to
competition from other pharmaceutical companies.

Even if the FDA approves an NDA for
a drug with orphan drug designation, the FDA may still approve the same drug for a
different indication, or a molecular variation of the same drug for the same indication.
In addition, the FDA does not restrict doctors from prescribing an approved drug for uses
not approved by the FDA for that drug. Thus, a doctor could prescribe another companys
drug for indications for which our product has received FDA approval and orphan drug
status. Significant off label use, that is, prescribing approved drugs for
unapproved uses, could adversely affect the marketing potential of any of our products
that have received orphan drug status and NDA approval by FDA.

The possible amendment of the Orphan
Drug Act by Congress has been the subject of congressional discussion from time to time
over the last ten years. Although Congress has made no significant changes to the Orphan
Drug Act for a number of years, members of Congress have from time to time proposed
legislation that would limit the application of the Orphan Drug Act. We cannot assure you
that the Orphan Drug Act will remain in effect or that it will remain in effect in its
current form. The precise scope of protection that orphan drug designation and marketing
approval may afford in the future is unknown. We cannot assure you that the current level
of exclusivity will remain in effect.

Europe
An orphan drug act was enacted in the European Union that provides up to ten years of
market exclusivity for a drug that meets the requirements of the act. For a
pharmaceutical product to qualify for the benefits of the act, the prevalence or
incidence (whichever is greater) must not exceed five patients per 10,000 in the
population. Our European partners have obtained orphan drug designation for
Cystadane in Europe. The Company has obtained orphan drug designation for Xyrem
and Antizol, for use in methanol poisonings, in Europe. European orphan drug
designation of Antizol was withdrawn by the Company in 2003. We cannot provide
assurance that any of our pharmaceutical products will qualify for orphan drug
protection in the European Union or that another company will not obtain an
approval that would block us from marketing our product in the European Union.

# Patents and other
proprietary rights are important factors in our business.

The pharmaceutical industry and the
investment community place considerable importance and value on obtaining patent,
proprietary, and trade secret protection for new technologies, products and processes. The
patent position of pharmaceutical firms is often highly uncertain and generally involves
complex legal, technical and factual questions. Our success depends on several issues,
including, but not limited to our ability:

- to obtain, and enforce proprietary protection for our products under United States and foreign patent laws and other intellectual property laws;
- to preserve the confidentiality of our trade secrets; and
- to operate without infringing the proprietary rights of third parties.

We evaluate the desirability of
seeking patent or other forms of protection for our products in foreign markets based on
the expected costs and relative benefits of attaining such protection. We cannot assure
you that any patents will be issued from any applications or that any issued patents will
afford us adequate protection or competitive advantage. Also, we cannot assure you that
any issued patents will not be challenged, invalidated, infringed or circumvented. Parties
not affiliated with us have obtained or may obtain United States or foreign patents or
possess or may possess proprietary rights relating to our products. We cannot assure you
that patents now in existence or later issued to others will not adversely affect the
development or commercialization of our products.

We believe that the active
ingredients or compounds in our FDA-approved products, Cystadane, Antizol, Antizol-Vet,
and Xyrem, are in the public domain and presently are not subject to patent protection in
the United States. We have a patent with respect to our formulation of Xyrem oral
solution.

We have orphan drug protection for
Antizol and Xyrem, which provides proprietary protection against potential competition.
We could, however, incur substantial costs asserting any infringement claims that we may
have against others. Upon expiration of orphan drug status our products might be subject
to competition from other pharmaceutical companies.

We seek to protect our proprietary
information and technology, in part, through confidentiality agreements and
inventors rights agreements with our employees. We cannot assure you that these
agreements will not be breached, that we will have adequate remedies for any breach, or
that our trade secrets will not otherwise be disclosed to or discovered by our
competitors. We also cannot assure you that our planned activities will not infringe
patents owned by others. We could incur substantial costs in defending infringement suits
brought against us. We also could incur substantial costs in connection with any suits
relating to matters for which we have agreed to indemnify our licensors or distributors.
An adverse outcome in any such litigation could have a material adverse effect on our
business and prospects. In addition, we often must obtain licenses under patents or other
proprietary rights of third parties. We cannot assure you that we can obtain any such
licenses on acceptable terms, if at all. If we cannot obtain required licenses on
acceptable terms, we could encounter substantial difficulties in developing, manufacturing
or marketing one or more of our products.

# The FDA must
agree with investigational new drug applications prior to the initiation of
clinical development programs.

Prior to the initiation of a clinical development program, companies submit an
investigational new drug application (IND) to the FDA. If the FDA notifies the
submitting sponsor that the IND requires additional information or is not
approvable, the potential development program may be significantly delayed or
terminated. We cannot assure you that IND applications submitted by us to the
FDA, including butamben, will proceed in a timely manner. Further, it is possible
that FDA action may result in the termination of the potential development
program.

# The FDA and
foreign regulatory authorities must approve any new products we may develop,
including butamben, before such products can be commercially sold.

Government regulation in the United
States and abroad is a significant factor in the testing, production and marketing of our
current and future products. Each product must undergo an extensive regulatory review
process conducted by the United States Food and Drug Administration and by comparable
agencies in other countries. We cannot market any medicine we may develop or license as a
prescription product in any jurisdiction, including foreign countries, in which the
product does not receive regulatory approval. The approval process can take many years and
requires the expenditure of substantial resources.

We depend on external laboratories
and medical institutions to conduct our pre-clinical and clinical analytical testing in
compliance with good clinical and laboratory practices established by the FDA. The data
obtained from pre-clinical and clinical testing is subject to varying interpretations that
could delay, limit or prevent regulatory approval. In addition, changes in FDA policy for
drug approval during the period of development and in the requirements for regulatory
review of each submitted NDA could result in additional delays or outright rejection.

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We cannot assure you that
the FDA or any foreign regulatory authority will approve a regulatory marketing
application in a timely manner, if at all, with respect to any products we
develop. Generally, the FDA and foreign regulatory authorities approve only a
very small percentage of newly discovered pharmaceutical compounds that enter
pre-clinical development. Moreover, even if the FDA approves a product, it may
place commercially unacceptable limitations on the uses, or
indications, for which a product may be marketed. This would result
in additional cost and delay to the extent that further studies are required to
provide additional data on safety or effectiveness.

# FDA approval
does not guarantee financial success.

Four of our currently
marketed products have been approved for marketing by regulatory authorities in
the United States and elsewhere. We cannot assure you that any of our products
will be commercially successful or achieve the expected financial results as a
result of limited markets for our products as discussed in the risk factor
entitled, There is a limited market for our products. We may
encounter unanticipated problems relating to the development, manufacturing,
distribution and marketing of our products. Some of these problems may be beyond
our financial and technical capacity to solve. The failure to adequately address
any such problems could have a material adverse effect on our business and our
prospects. In addition, the efforts of government entities and third party
payors to contain or reduce the costs of health care may adversely affect our
sales and limit the commercial success of our products.

We cannot completely
insulate our drug development portfolio from the possibility of clinical or
commercial failures or generic competition. Some products that we have selected
for development may not produce the results expected during clinical trials or
receive FDA approval. Drugs approved by the FDA may not generate product sales
of an acceptable level. We have discontinued the development of eleven products
from our portfolio since inception.

In addition we continue to
invest in the development of additional indications for Xyrem. This spending,
along with costs associated with the on-going marketing and selling of Xyrem,
resulted in a loss from operations in fiscal 2003. We expect that we will incur
a loss from operations in 2004 and 2005.

# Significant
government regulation continues once a product is approved for sale.

After a reviewing division
of the FDA approves a drug, the FDAs Division of Drug Marketing,
Advertising and Communication must accept such drugs marketing claims,
which are the basis for the drugs labeling, advertising and promotion. We
cannot be sure that the Division of Drug Marketing, Advertising and
Communication will accept our proposed marketing claims. The failure of the
Division of Drug Marketing, Advertising and Communication to accept our proposed
marketing claims could have a material adverse effect on our business and
prospects.

The FDA can require that a
company conduct post-marketing adverse event surveillance programs
to monitor any side effects that occur after the companys drug is approved
for marketing. If the surveillance program indicates unsafe side effects, the
FDA may recall the product, and suspend or terminate a companys
authorization to market the product. The FDA also regulates the manufacturing
process for an approved drug. The FDA may impose restrictions or sanctions upon
the subsequent discovery of previously unknown problems with a product or
manufacturer. One possible sanction is requiring the withdrawal of such product
from the market. The FDA must approve any change in manufacturer as well as most
changes in the manufacturing process prior to implementation. Obtaining the
FDAs approval for a change in manufacturing procedures or change in
manufacturers is a lengthy process and could cause production delays and loss of
sales, which would have a material adverse effect on our business and our
prospects.

Certain foreign countries
regulate the sales price of a product after marketing approval is granted. We
cannot be sure that we can sell our products at satisfactory prices in foreign
markets even if foreign regulatory authorities grant marketing approval.

# We rely on
others for product development opportunities.

We engage only in limited
research to identify new pharmaceutical compounds. To build our product
portfolio, we have adopted a license and acquisition strategy. This strategy for
growth requires us to identify and acquire pharmaceutical products targeted at
niche markets within selected therapeutic market segments. These products
usually require further development and approval by regulatory bodies before
they can be marketed. We cannot assure you that any such products can be
successfully acquired, developed, approved or marketed. We must rely upon the
willingness of others to sell or license pharmaceutical product opportunities to
us. Other companies, including those with substantially greater resources,
compete with us to acquire such products. We cannot assure you that we will be
able to acquire rights to additional products on acceptable terms, if at all.
Our failure to acquire or license any new

30

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pharmaceutical products, or our
failure to promote and market any products successfully within an existing therapeutic
area, could have a material adverse effect on our business and our prospects.

We have contractual development
rights to certain compounds through various license agreements. Generally, the licensor
can unilaterally terminate these agreements for several reasons, including, but not
limited to the following reasons:

- for cause if we breach the contract;
- if we become insolvent or bankrupt;
- if we do not apply specified minimum resources and efforts to develop the compound under license; or
- if we do not achieve certain minimum royalty payments, or in some cases, minimum sales levels.

We cannot assure you that we can meet
all specified requirements and avoid termination of any license agreements. We cannot
assure you that if any agreement is terminated, we will be able to enter into similar
agreements on terms as favorable as those contained in our existing license agreements.

We have invested most of
our capital in the development of products already licensed to or under the
control of the Company, therefore this risk has not had a material impact on our
business in the past. However as we look for additional opportunities to expand
our product portfolio, this risk factor may have an adverse effect on our
business.

# A failure by
our manufacturers or suppliers to deliver product timely could adversely affect
sales revenue.

We do not have and do not
currently intend to establish any manufacturing capability for drug products.
Instead, we engage third parties to manufacture our products. Failure by parties
with whom we contract to adequately perform their responsibilities may delay the
submission of products for regulatory approval, impair our ability to deliver
our products on a timely basis or otherwise adversely affect our business and
our prospects.

The loss of either a bulk
drug supplier or drug product manufacturer would require us to obtain regulatory
clearance in the form of a pre-approval submission and incur
validation and other costs associated with the transfer of the bulk drug or drug
product manufacturing process. We believe that it could take as long as two
years for the FDA to approve such a submission. Because our products are
targeted to relatively small markets and our manufacturing production runs are
small by industry standards, we have not incurred the added costs to certify and
maintain secondary sources of supply for bulk drug substance or backup drug
product manufacturers for some products. Should we lose either a bulk drug
supplier or a drug product manufacturer, we could run out of salable product to
meet market demands or investigational product for use in clinical trials, while
we wait for the FDA approval of a new bulk drug supplier or drug product
manufacturer.

During the course of
negotiations in the ordinary course of business to renew or extend an agreement with a manufacturing vendor, on occasion, the
Companys vendors have indicated that if price increases cannot be
successfully negotiated that their agreement may need to be terminated. If this were to occur, we believe
that there are alternate manufacturing and supply sources that would be
available both on acceptable terms and on a timely basis for our products.
In addition, our agreements generally require the manufacturer or supplier to
continue to perform their obligations under these agreements for at least one
year, and in some cases, two years, following formal notice of termination,
during which period we would seek to implement new manufacturing and supply
relationships. However, we cannot assure you that the change of a bulk drug
supplier or drug product manufacturer and the transfer of the processes to
another third party will be approved by the FDA, and if approved, in a timely
manner. Therefore, we may experience additional costs and delay which switching
providers, which in turn could adversely affect sales revenue.

Bulk Drug Supply

Bulk drug substance is the active
chemical compound used in the manufacture of our drug products. We currently have
a single supplier for the supply of bulk drug substance used in Antizol and Antizol-Vet.
If we were to lose this company as a supplier, we would be required to identify a new
supplier for the bulk drug substance. We also currently use a single supplier for
the supply of bulk drug substance used in Xyrem, which is expected to account for
approximately 65% of our revenue in 2004. If we were to lose this company as a supplier,
we would be required to identify a new supplier.

Drug Product Manufacture

From bulk drug substance, drug
product manufacturers formulate a finished drug product and package the product for sale
or for use in clinical trials. We also use a single supplier for drug
product manufacturing of Antizol, Antizol-Vet and a different supplier has been
authorized to manufacture Xyrem. If we were to lose either of these

31

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companies as a manufacturer, we
would be required to identify a new manufacturer; We cannot assure you that our drug
product manufacturing arrangements with either or both of these suppliers will not change.

# We cannot
control our contractors compliance with applicable regulations.

The FDA defines and
regulates good manufacturing practices to which bulk drug suppliers and drug
product manufacturers are subject. The Drug Enforcement Agency (DEA) defines and
regulates the handling and reporting requirements for certain drugs which have
abuse potential, known as scheduled drugs. Foreign regulatory
authorities prescribe similar rules and regulations. Our supply and
manufacturing contractors must comply with these regulatory requirements.
Failure by our contractors to comply with FDA or DEA requirements or applicable
foreign requirements could result in significant time delays or in our inability
to commercialize or continue to market a product. Either result could have a
material adverse effect on our business and prospects. Failure to comply with
good manufacturing practices or other applicable legal requirements can lead to
federal seizure of violative products, injunctive actions brought by the federal
government, or potential criminal and civil liability for Orphan Medical, our
officers, or our employees. This risk has not impacted us in the past and
we are not aware of any instances of noncompliance with applicable regulations
that may materially impact our business. We cannot assure you that we will be able to
maintain relationships either domestically or abroad with contractors whose
facilities and procedures comply or will continue to comply with FDA or DEA
requirements or applicable foreign requirements.

# We have a
single distribution for three of our products: Antizol, Antizol-Vet and
Cystadane.

We have an agreement with a
single distribution contractor to provide integrated distribution and operations
services to support transactions between us and our wholesalers, specialty
distributors, and direct customers. This contractor also provides reimbursement
management, patient assistance and information hotline services and specialty
distribution and marketing services to physician practices with respect to our
products. The contractor currently distributes Antizol, Antizol-Vet and
Cystadane. The contractor may also distribute future products should those
products receive marketing clearance from the FDA. A failure by this distributor
to fulfill its responsibilities might have an adverse affect on our ability to
meet customer demand in a timely manner.

We cannot assure you that
our distribution arrangements with this entity or other third parties would be
available, or continue to be available to us on commercially acceptable terms.
The loss of a distributor or failure to renew agreements with an existing
distributor could have a material adverse effect on our business and prospects.

Xyrem is clasified as a Schedule III
controlled substance.

We have an agreement with a
specialty pharmacy to distribute Xyrem. Xyrem is classified as a Schedule III controlled
substance and approved under Subpart H of the FDAs review process, and distribution is
strictly controlled. The specialty pharmacy is the only source through which Xyrem can be
obtained. Distribution is governed by the FDAs Subpart H regulations and complies with
the risk-management controls jointly developed by Orphan Medical, the FDA, the Drug
Enforcement Agency and law enforcement agencies. Every shipment of Xyrem is subject to
stringent safeguards to ensure it reaches only individuals for whom it has been
legitimately prescribed.

Our purchases of sodium oxybate, the
active ingredient in Xyrem, for use in the production of Xyrem are subject to quota that
is approved by the U.S. Drug Enforcement Administration. Supply disruption could result
from delays in obtaining DEA approvals or the receipt of approvals for quantitities of
sodium oxybate that are insufficient to meet current or projected product demand. The
quota system also limits our ability to build inventories as a method of insuring against
possible supply disruptions.

# We rely on
foreign marketing alliances and have no assurance of foreign licensees.

Our strategy to sell our
products in foreign markets is to license foreign marketing and distribution
rights to a foreign company after a new drug application is submitted or
approved in the United States. We consider Europe, Asia, and Canada our most
attractive foreign markets. Our current foreign arrangements are:

- Europe. We
have licensed the marketing and distribution rights for Xyrem and Cystadane in Europe. If
our licensees are unsuccessful in their registration and distribution efforts, we may
find it difficult to contract with other distributors for these products within Europe.
Distribution of all products except Antizol is limited to named patient or
emergency use basis until full regulatory approval is obtained. Antizol has
been approved for use in the United Kingdom but is limited to named patient basis
in other parts of Europe. This distribution of the Companys products is expected to
result in a limited contribution to the Companys revenues.

32

---

- Australia
and New Zealand. We have licensed marketing and distribution rights for
Cystadane in Australia and New Zealand, but sales of these products have not
been material. We do not expect sales to increase in the near future to the
point that they become material.

- Israel. We
have licensed marketing and distribution rights for Antizol and Cystadane in
Israel. Full regulatory approval for Cystadane was obtained in Israel in
February 2000. We do not expect such distribution to result in material
revenues.

- Canada. We
have licensed marketing and distribution rights for Antizol in Canada. For Cystadane we
have only licensed the distribution rights in Canada. We do not expect such distribution
to result in material revenues.

We depend on our foreign licensees
for the regulatory registration of our products in foreign countries. We cannot be sure
that our licensees can obtain such registration. In addition, we cannot be sure that we
will be able to negotiate commercially acceptable license agreements for our other
products or in additional foreign countries. Furthermore, we cannot assure you that these
companies will be successful in marketing and selling our products in their respective
territories.

# Our products might be
recalled.

A product can be recalled at our
discretion or at the discretion of the FDA, the U.S. Federal Trade Commission, or other
government agencies having regulatory authority for marketed products. A recall may occur
due to disputed labeling claims, manufacturing issues, quality defects, safety issues, or
other reasons. We cannot assure you that a product recall will not occur. We do not carry
any insurance to cover the risk of a potential product recall. Any product recall could
have a material adverse effect on our business and prospects. To date, no recall of
products marketed by the Company has occurred.

# We face limits on price
flexibility and third-party reimbursement.

The flexibility of prices that we can
charge for our products depends on government regulation, both in the United States and
abroad, and on other third parties. One important factor is the extent to which
reimbursement for our products will be available to patients from government health
administration authorities, private health insurers and other third-party payors.
Government officials and private health insurers are increasingly challenging the price of
medical products and services. We are uncertain as to the pricing flexibility we will have
with respect to, and if we will be reimbursed for, newly approved health care products.

In the United States, we expect
continuing federal and state proposals to implement greater government control of the
pricing and profitability of prescription pharmaceuticals. Cost controls, if mandated by a
government agency, could decrease, or limit, the price we receive for our products or
products we may develop in the future. We may not be able to recover our development
costs, which could be substantial. We may not be able to realize an appropriate profit
margin. This could have a material adverse effect on our business. Furthermore, federal
and state regulations govern or influence reimbursement of health care providers for
medical treatment of certain patients. We cannot assure you that actions taken by federal
and/or state governments, if any, with regard to health care reform will not have a
material adverse effect on our business and prospects.

Certain private health insurers and
third-party payors may attempt to control costs further by selecting exclusive providers
of pharmaceuticals. If such arrangements are made with our competitors, these insurers and
third-party payors would not reimburse patients who purchase our competing products. This
would diminish the market for our products and could have a material adverse effect on our
business and prospects.

33

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# We face intense
competition in our industry.

Competition in the pharmaceutical
industry is intense. Potential competitors in the United States are numerous and include
pharmaceutical, chemical and biotechnology companies. Many of these companies have
substantially greater capital resources, marketing experience, research and development
staffs and facilities than we do. We seek to limit potential sources of competition by
developing products that are eligible for orphan drug status upon NDA approval or other
forms of protection. We cannot assure you, however, that our competitors will not succeed
in developing similar technologies and products more rapidly than we can. Similarly, we
cannot assure you that these competing technologies and products will not be more
effective than any of those that we have developed or are currently developing.

# We expect rapid
technological and other change to be constant in our industry.

The pharmaceutical industry has
experienced rapid and significant technological change as well as structural changes, such
as those brought about by changes in heath care delivery or in product distribution. We
expect that pharmaceutical technology will continue to develop and change rapidly, and our
future success will depend, in large part, on our ability to develop and maintain a
competitive position. Technological development by others may result in our products
becoming obsolete before they are marketed or before we recover a significant portion of
the development and commercialization expenses incurred with respect to such products. In
addition, alternative therapies, new medical treatments, or changes in the manner in which
health care is delivered or products provided could alter existing treatment regimes or
health care practices, and thereby reduce the need for one or more of our products, which
would adversely affect our business and our prospects.

34

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# We face substantial
product liability and insurance risks.

Testing and selling health care
products entails the inherent risk of product liability claims. The cost of product
liability insurance coverage has increased and is likely to continue to increase in the
future. Substantial increases in insurance premium costs in many cases have rendered
coverage economically impractical. We currently carry product liability coverage in the
aggregate amount of $30 million for all claims made in any policy year. Although to date
we have not been the subject of any product liability or other claims, we cannot assure
you that we will be able to maintain product liability insurance on acceptable terms or
that our insurance will provide adequate coverage against potential claims. A successful
uninsured product liability or other claim against us could have a material adverse effect
on our business and prospects.

# ITEM 7A.   QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

Interest Rate Exposure
We manage our investment portfolio in accordance with our investment policy.
The primary objectives of our investment policy are to preserve principal,
maintain a high degree of liquidity to meet operating needs, and obtain
competitive returns subject to prevailing market conditions. Investments are
made with average maturities matching the liquidity needs of the Company. These
types of investments are subject to risk of default, changes in credit rating
and changes in market value. These investments are also subject to interest rate
risk and will decrease in value if market interest rates increase. Due to the
conservative nature of our investments and relatively short effective maturities
of the debt instruments, we believe interest rate risk is mitigated. Our
investment policy specifies the credit quality standards for our investments and
limits the amount of exposure from any single issue, issuer or type of
investment.

Foreign Currency Exposure
Most of our revenue, expenses and capital spending are transacted in U.S.
dollars. Our foreign currency transactions are translated into U.S. dollars at
prevailing rates. Gains or losses resulting from foreign currency transactions
are included in current period income or loss as incurred. Currently, all
material transactions are denominated in U.S. dollars, and we have not
entered into any material transactions that are denominated in foreign
currencies.

# ITEM 8.   FINANCIAL
STATEMENTS AND SUPPLEMENTAL DATA

The financial statements of the
Company as of December 31, 2003 and 2002 and for the three years ended December
31, 2003 begin on page F-1 of this Annual Report.

# ITEM 9.   CHANGES AND DISAGREEMENTS WITH ACCOUNTANTS AND FINANCIAL DISCLOSURE

None.

# ITEM 9A.   CONTROLS AND PROCEDURES

The Companys
management, with participation of the Companys Chief Executive Officer and
Chief Financial Officer, has evaluated the effectiveness of the Companys
disclosure controls and procedures as of December 31, 2003. Based on that
evaluation, the Companys Chief Executive Officer and Chief Financial
Officer concluded that the Companys disclosure controls and procedures
were effective as of December 31, 2003. There were no material changes in
the Companys internal control over financial reporting during the fourth
quarter of 2003.

35

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PART III

ITEM 10.   DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT

(a)   Directors of the Registrant.
The information required by this item is incorporated by reference from the
information under the caption Election of Directors contained in the
Companys Proxy Statement to be filed with the Securities and Exchange
Commission in connection with the solicitation of proxies for the Companys
Annual Meeting of Shareholders to be held on June 15, 2004 (the Proxy
Statement).

(b)   Executive Officers of the Registrant.
Information concerning Executive Officers of the Company is included in this
Annual Report in Item 4A under the caption Executive Officers of the
Registrant.

(c)   Identification of the Audit Committee; Audit Committee Financial Expert.
The information required in this item is incorporated by reference from the
information under the caption Board of Directors Meetings and
Committees in the Companys Proxy Statement.

(d)    Compliance with 16(a) of the Securities Exchange Act of 1934.
The information required by this item is incorporated by reference from the
information under the caption Section 16(a) Reporting contained in
the Proxy Statement.

(e)    Code of Ethics.
The information required by this item is incorporated by reference from the
information under the caption "Ethics Policy" contained in the proxy statement.

# ITEM 11.   EXECUTIVE COMPENSATION

The information required by
this item is incorporated by reference from the information under the caption
Executive Compensation contained in the Proxy Statement.

# ITEM 12.   SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS

The table on the following
page sets forth, as of March 1, 2003, certain information with respect to
the beneficial ownership of the Companys Common Stock by (i) each
person who, to the knowledge of the Company, owned beneficially more than five
percent of such stock, and (ii) each director, (iii) each executive
officer named in the Summary Compensation Table above, and
(iv) all directors and executive officers as a group. Unless otherwise
noted, the shares listed in the table below are subject to sole voting and
investment power of the indicated person.

Beneficial ownership is
determined and presented in the table on the following page in accordance with
rules of the Securities and Exchange Commission, and includes general voting
power and/or investment power with respect to the securities. Shares of the
Companys Common Stock subject to options currently exercisable or
exercisable within 60 days of March 1, 2004, are deemed to be outstanding
for purposes of computing the percentage of the person holding such options, but
are not deemed outstanding for computing the percentage of any other person.
With respect to UBS Capital II LLC, the percentage of ownership calculation
is based on Common Shares outstanding as of March 1, 2004, plus 1,069,533
shares of Common Stock, which represents 8,706 shares of Senior Convertible
Preferred Stock owned by UBS Capital II LLC on an as converted basis.

|Name and Address of Beneficial Owner    | Amount andNature ofBeneficialOwnership |           | Percentage ofCommon StockOutstanding
|--------------------------------------- | -------------------------------------- | --------- | ------------------------------------
|                                       
|Alta Partners II, Inc. (1)              |                                        | 1,212,121 |                                     
|One Embarcadero Center, Suite 4050      |                                       
|San Francisco, CA 94111                 |                                       
|OrbiMed Advisors LLC (2)                |                                        | 1,617,302 |                                     
|767 Third Avenue  6th Floor            |                                       
|New York, NY 10017-2023                 |                                        |           |                                     
|UBS Capital II LLC (3)                  |                                        | 1,250,406 |                                     
|299 Park Avenue                         |                                       
|New York, NY 10171-0026                 |                                        |           |                                     
|Galleon Group (4)                       |                                        | 882,358   |                                     
|135 East 57th Street, 16th Floor        |                                       
|New York, NY 10022-2050                 |                                        |           |                                     
|John Howell Bullion (5)                 |                                        | 594,362   |                                     
|William Houghton, M.D. (6)              |                                        | 190,341   |                                     
|Mark D. Perrin (7)                      |                                        | 62,750    |                                     
|Timothy G. McGrath (8)                  |                                        | 65,739    |                                     
|Farah Champsi (9)                       |                                        | 13,000    |                                     
|Michael Greene (10)                     |                                        | 28,000    |                                     
|Thomas King (11)                        |                                        | 13,000    |                                     
|Julius A. Vida, Ph.D. (12)              |                                        | 28,000    |                                     
|William M. Wardell, M.D., Ph.D. (13)    |                                        | 59,500    |                                     
|All directors and executive officers as |                                       
|a group (11 persons)(14)                |                                        | 1,214,158 |                                     

_________________

*  Less than one percent.

|(1) | Alta Partners II, Inc. serves as the management advisory company of various
funds which hold shares of the Companys Common Stock. In this capacity,
Alta Partners II, Inc. is affiliated with Alta BioPharma Partners II, L.P., Alta
Embarcadero BioPharma Partners II, LLC, Alta BioPharma Management Partners II,
LLC, Alta Partners II, Inc. and Jean Deleage, Alix Marduel and Farah Champsi.
The beneficial ownership information is based on a schedule 13D filed by Alta
Partners on December 17, 2001.
|--- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

36

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|(2) | OrbiMed Advisors LLC has shared voting and dispositive power with respect to
1,617,302 shares of the Companys Common Stock. The number of shares
beneficially owned is based on a schedule 13G filed by OrbiMed Advisors on
February 14, 2003. Mr. Samuel Isaly has voting power for these shares.
|--- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(3) | UBS Capital II LLC has sole voting and investment power with respect to: 8,706
shares of Senior Convertible Preferred Stock, which is convertible into
1,069,533 shares of Common Stock, and 180,873 shares of unregistered Common
Stock. The shares of Senior Preferred Convertible Stock vote on an as-converted
basis. In addition, UBS Capital owns (i) 3,677 shares of non-voting Series B
Convertible Preferred Stock, which is convertible into 565,692 shares of Common
Stock, (ii) a warrant to purchase up to 2,050 shares of non-voting Series C
Convertible Preferred Stock or 315,385 shares of Series D Non-Voting Convertible
Preferred Stock or any combination thereof up to a maximum aggregate purchase
price of $2,050,000 and (iii) a warrant to purchase up to 282,353 shares of
Series D Non-Voting Convertible Preferred Stock. Mr. Michael Greene, a director
of the Company, has voting power for these shares.
|--- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(4) | Based on a schedule 13F filed by Galleon Group LP on February 6, 2004.
Mr. Rajaratram, Managing Member of Galleon Management, L.P.s General
Partner, has voting power for these shares.
|--- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(5) | Includes 466,650 shares issuable upon the exercise of options that are currently
exercisable or will become issuable pursuant to options exercisable within 60
days after March 1, 2004.
|--- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(6) | Includes 175,370 shares issuable upon the exercise of options that are currently
exercisable or will become issuable pursuant to options exercisable within 60
days after March 1, 2004.
|--- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(7) | Includes 62,750 shares issuable upon the exercise of options that are currently
exercisable or will become issuable pursuant to options exercisable within 60
days after March 1, 2004.
|--- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(8) | Includes 63,635 shares issuable upon the exercise of options that are currently
exercisable or will become issuable pursuant to options exercisable within 60
days after March 1, 2004.
|--- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(9) | Includes 13,000 shares issuable upon the exercise of options that are currently
exercisable or will become issuable pursuant to options exercisable within 60
days after March 1, 2004. Ms. Champsi is affiliated with Alta Partners II, Inc.
and she disclaims beneficial ownership of any shares of Common Stock
beneficially owned by Alta Partners II, Inc. and its affiliates.
|--- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(10) | Includes 28,000 shares issuable upon the exercise of options that are currently
exercisable or will become issuable pursuant to options exercisable within 60
days after March 1, 2004.
|---- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(11) | Includes 13,000 shares issuable upon the exercise of options that are currently
exercisable or will become issuable pursuant to options exercisable within 60
days after March 1, 2004.
|---- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(12) | Includes 28,000 shares issuable upon the exercise of options that are currently
exercisable or will become issuable pursuant to options exercisable within 60
days after March 1, 2004.
|---- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(13) | Includes 58,000 shares issuable upon the exercise of options that are currently
exercisable or will become issuable pursuant to options exercisable within 60
days after March 1, 2004.
|---- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(14) | Includes 1,054,765 shares that may be acquired within 60 days of March 1, 2004
through the exercise of options by all executive officers and directors as a
group.
|---- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------

# ITEM 13.   CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS

The information required by
this item is incorporated by reference from the information contained under the
caption Certain Transactions contained in the Proxy Statement.

# ITEM 14.   PRINCIPAL ACCOUNTING FEES AND SERVICES

The information required in this item
is incorporated by reference from the information under the caption Audit Fees
in the Companys Proxy Statement.

37

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# PART IV

# ITEM 15.   FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K

(a)(1).   Financial Statements

|Description                                  | Page NumberIn ThisAnnual Report
|-------------------------------------------- | -------------------------------
|Audited Financial Statements:                |                                
|Report of Independent Auditors               |                                
|Balance Sheets                               |                                
|Statements of Operations                     |                                
|Statements of Cash Flows                     |                                
|Statement of Changes in Shareholders Equity |                                
|Notes to Financial Statements                |                                

(a)(2).   Financial Statement Schedules
The following financial statement schedule should be read in conjunction with
the Audited Financial Statements referred to under Item 15(a)(1) above. Financial
statement schedules not included in the Form 10-K have been omitted because they are not
applicable or the required information is shown in the Audited Financial Statements or
Notes thereto.

|Description                                                                                                             | Page NumberIn ThisAnnual Report
|----------------------------------------------------------------------------------------------------------------------- | -------------------------------
|Schedule II  Valuation and Qualifying Accounts: Years Ended December 31,                           2003, 2002 and 2001 |                                

(a)(3).   Listing of Exhibits

|ExhibitNumber | Description                                                                                                                 | Methodof Filing
|------------- | --------------------------------------------------------------------------------------------------------------------------- | ---------------
|3.1           | Certificate of Incorporation                                                                                                | (2)            
|3.2           | Bylaws of OMI, as amended                                                                                                   | (1)            
|4.1           | OMI 1994 Stock Option Plan                                                                                                  | (1)            
|4.2           | OMI Employee Incentive Stock Option Agreement                                                                               | (1)            
|4.3           | OMI Non-Incentive Stock Option Agreement                                                                                    | (1)            
|4.4           | OMI Non-Incentive Stock Option Agreement                                                                                    | (1)            
|10.01         | Distribution and Spin-off Agreement between OMI and Chronimed effective July 2, 1994                                        | (3)            
|10.02         | Sublicense Agreement regarding 4-Methylpyrazole between Chronimed and Mericon Investment Group, Inc.dated December 17, 1993 | (4)            
|10.03         | Employment Agreement between OMI and John Howell Bullion dated October 29, 1999                                             | (7)            

38

---

|ExhibitNumber | Description                                                                                                                                    | Methodof Filing
|------------- | ---------------------------------------------------------------------------------------------------------------------------------------------- | ---------------
|10.04         | Assumption Agreement and Consent to Assignment regarding 4-Methylpyrazole between OMI and Mericon Investment Group, Inc. dated October 5, 1994 | (5)            
|10.05         | License Agreement regarding 4-Methylpyrazole between Kenneth McMartin and Mericon Investment Group, Inc. dated July 6, 1993                    | (6)            
|10.06         | IRS tax qualification letter dated January 10, 1996 regarding the favorable determination of the tax status of the OMI 401(k) Savings Plan     | (8)            

39

---

|ExhibitNumber | Description                                                                                                                                                                     | Methodof Filing
|------------- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- | ---------------
|10.07         | Stock Purchase Agreement between OMI and UBS Capital II LLC dated July 23, 1998.                                                                                                | (9)            
|10.08         | Common Stock Purchase Warrant between OMI and R.J. Steichen dated January 1, 1999.                                                                                              | (10)           
|10.09         | Purchase Agreement and Letter of Intent between OMI and Caduceus Capital Trust, Caduceus Capital II L.P., PaineWebber Eucalyptus Fund LLC, and PaineWebber Eucalyptus Fund Ltd. | (11)           
|10.10         | Purchase Agreement and Letter of Intent between DG LUX LACUNA APO BIOTECH FUND                                                                                                  | (12)           
|10.11         | Stock Purchase Agreement between OMI and UBS Capital II LLC dated August 2, 1999                                                                                                | (13)           
|10.12         | Warrant to purchase shares of Series C Convertible Preferred Stock or Series D Non-Voting Preferred Stock                                                                       | (14)           
|10.13         | Warrant to purchase shares Series D Non-Voting Preferred Stock                                                                                                                  | (15)           
|10.14         | Form of Change in Control Agreement to be entered into between the OMI and Certain Executives                                                                                   | (16)           
|10.15         | License agreement for Xyrem between OMI and Celltech Pharmaceuticals plc dated October 30, 2003                                                                                 | (17)           
|10.16         | Distribution and Services Agreement between OMI and Express Script Specialty Distribution Services, Inc. date July 29, 2002                                                     | (18)           
|23.1          | Consent of Ernst & Young LLP                                                                                                                                                    | Filed herewith 
|24            | Power of Attorney                                                                                                                                                               | (19)           
|31.1          | Certification of Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002                                                                              | Filed herewith 
|31.2          | Certification of Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002                                                                              | Filed herewith 
|32.1          | Certification of Chief Executive Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002                                                                              | Filed herewith 
|32.2          | Certification of Chief Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002                                                                              | Filed herewith 

|(1) | Incorporated
by reference to the corresponding exhibit numbers in OMIs Registration
Statement on Form 10 filed on August 31, 1994, Commission File No. 0-24760.
|--- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------

|(2) | Incorporated
by reference to the corresponding exhibit number in OMIs Registration Statement on
Form S-3 filed on February 5, 2002, Commission FileNo. 333-82222.
|--- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(3) | Incorporated
by reference to Exhibit 10.3 to OMIs Registration Statement on
Form 10 filed on August 31, 1994, Commission File No. 0-24760.
|--- | -------------------------------------------------------------------------------------------------------------------------------------------

|(4) | Incorporated
by reference to Exhibit 10.9 to OMIs Registration Statement on
Form 10 filed on August 31, 1994, Commission File No. 0-24760.
|--- | -------------------------------------------------------------------------------------------------------------------------------------------

|(5) | Incorporated
by reference to Exhibit 10.14 to OMIs Registration Statement on Form S-1 filed on
March 3, 1995, Commission File No. 033-89916.
|--- | ---------------------------------------------------------------------------------------------------------------------------------------------

|(6) | Incorporated
by reference to Exhibit 10.15 to OMIs Registration Statement on Form S-1 filed on
March 3, 1995, Commission File No. 033-89916.
|--- | ---------------------------------------------------------------------------------------------------------------------------------------------

|(7) | Incorporated
by reference to Exhibit 10.11.1 to OMIs Annual Report on Form 10-K for
the year ended December 31, 1999, Commission FileNo. 0-24760.
|--- | --------------------------------------------------------------------------------------------------------------------------------------------------

|(8) | Incorporated
by reference to Exhibit 10.36 to OMIs Registration Statement on Form S-1 filed on
March 11, 1996, Commission File No. 333-02200.
|--- | ----------------------------------------------------------------------------------------------------------------------------------------------

|(9) | Incorporated
by reference to Exhibit 10.48 to OMIs Quarterly Report on Form 10-Q for the
quarter ended June 30, 1998, Commission File No. 0-24760.
|--- | ---------------------------------------------------------------------------------------------------------------------------------------------------

|(10) | Incorporated
by reference to Exhibit 10.52 to OMIs Annual Report on
Form 10-K for the year ended December 31, 1998, Commission FileNo. 0-24760.
|---- | ------------------------------------------------------------------------------------------------------------------------------------------------

|(11) | Incorporated
by reference to Exhibit 10.53 to OMIs Annual Report on Form 10-K for
the year ended December 31, 1999, Commission FileNo. 0-24760.
|---- | ------------------------------------------------------------------------------------------------------------------------------------------------

|(12) | Incorporated
by reference to Exhibit 10.54 to OMIs Annual Report on Form 10-K for
the year ended December 31, 1999, Commission FileNo. 0-24760.
|---- | ------------------------------------------------------------------------------------------------------------------------------------------------

|(13) | Incorporated
by reference to Exhibit 10.55 to OMIs Quarterly Report on Form 10-Q for the
quarter ended June 30, 1999, Commission File No. 0-24760.
|---- | ---------------------------------------------------------------------------------------------------------------------------------------------------

|(14) | Incorporated
by reference to Exhibit 10.57 to OMIs Quarterly Report on Form 10-Q for the
quarter ended June 30, 1999, Commission File No. 0-24760.
|---- | ---------------------------------------------------------------------------------------------------------------------------------------------------

|(15) | Incorporated
by reference to Exhibit 10.58 to OMIs Quarterly Report on Form 10-Q for the
quarter ended June 30, 1999, Commission File No. 0-24760.
|---- | ---------------------------------------------------------------------------------------------------------------------------------------------------

|(16) | Incorporated
by reference to Exhibit 10.59 to OMIs Annual Report on
Form 10-K for the year ended December 31, 1999, Commission FileNo. 0-24760.
|---- | ------------------------------------------------------------------------------------------------------------------------------------------------

|(17) | Incorporated
by reference to Exhibit 10.15 to OMIs Annual Report on
Form 10-K/A (Amendment No. 2) for the year ended December 31, 20039, Commission FileNo. 0-24760.
|---- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(18) | Incorporated
by reference to Exhibit 10.16 to OMIs Annual Report on
Form 10-K/A (Amendment No. 2) for the year ended December 31, 2003, Commission FileNo. 0-24760.
|---- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(19) | Incorporated
by reference to Exhibit 24 to OMIs Annual Report on
Form 10-K for the year ended December 31, 2003, Commission FileNo. 0-24760.
|---- | ---------------------------------------------------------------------------------------------------------------------------------------------

40

---

| | (b).   Reports on Form 8-K
Current Report on Form 8-K filed October 23, 2003 under Item 12, Disclosure
of Results of Operations and Financial Condition reporting 2003 Third Quarter results and
financial condition.
| | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | Current Report on Form 8-K filed October 31, 2003 under Item 5, Other Events reporting a
licensing agreement with Celltech plc.
| | ---------------------------------------------------------------------------------------------------------------------------------

| | (c).   Exhibits
See Item 15(a)(3) above.
| | ----------------------------------------

| | (d).   Financial Statement Schedules
See Item 15(a)(2) above.
| | -------------------------------------------------------------

41

---

# SIGNATURES

Pursuant to the requirements of Section 13 or 15(d) of the
Securities Act of 1934, the registrant has duly caused this report on Form 10-K/A to be signed on its behalf by the
undersigned thereunto duly authorized, in the City of Minnetonka, Minnesota, on the 20th day of July, 2004.

| |                                            |                      |  |                           | 
| | ------------------------------------------ | -------------------- |  | ------------------------- | 
| |                                            | ORPHAN MEDICAL, INC.
| |                                            | By:                  |  | /s/   John Howell Bullion | 
| |                                           
| | John Howell BullionChief Executive Officer |                     
| |                                            |                      |  | /s/   Timothy G. McGrath  | 
| |                                           
| | Timothy G. McGrathChief Financial Officer  |                     

Pursuant to the requirements of the Securities Act of 1934 this
report has been signed by the following persons on behalf of the Registrant and in the capacities indicated as of
July 20, 2004.

|SIGNATURE                     |  | TITLE                                                   
|----------------------------- |  | --------------------------------------------------------
|                             
|/s/   John Howell Bullion     |  | Chief Executive Officer (Principal Executive Officer)   
|                              |  | and a Director                                          
|John Howell Bullion           |  |                                                         
|                             
|*                             |  | Director                                                
|                             
|Michael Greene                |  |                                                         
|                             
|*                             |  | Director                                                
|                             
|Julius A. Vida                |  |                                                         
|                             
|*                             |  | Director                                                
|                             
|Farah Champsi                 |  |                                                         
|                             
|*                             |  | Director                                                
|                             
|William M. Wardel Ph.D., M.D. |  |                                                         
|                             
|*                             |  | Director                                                
|                             
|Thomas King                   |  |                                                         
|                             
|/s/   Timothy G. McGrath      |  | Chief Financial Officer (Principal Financial Officer and
|                              |  | Accounting Officer)                                     
|Timothy G. McGrath            |  |                                                         

|By: |                                       | /s/   John Howell Bullion | 
|--- | ------------------------------------- | ------------------------- | 
|    |                                      
|    | John Howell Bullion, Attorney-In-Fact

- John Howell Bullion, pursuant to the Powers of Attorney executed by
each of the officers and directors above whose name is marked by a *, by signing his name hereto, does
hereby sign and execute this Annual Report on behalf of each of the officers and directors in the capacities in which
the name of each appears above.

42

---

# Report of Independent Registered Public Accounting Firm

Board of Directors and Shareholders
Orphan Medical, Inc.

We have audited the accompanying balance
sheets of Orphan Medical, Inc. as of December 31, 2003 and 2002, and the related
statements of operations, changes in shareholders equity, and cash flows for each of
the three years in the period ended December 31, 2003. Our audits also included the
financial statement schedule listed in Item 15(a)(2). These financial statements and schedule
are the responsibility of the Companys management. Our responsibility is to express
an opinion on these financial statements and schedule based on our audits.

We conducted our audits in accordance
with the standards of the Public Company Accounting Oversight Board (United States). Those standards require
that we plan and perform the audit to obtain reasonable assurance about whether the
financial statements are free of material misstatement. An audit includes examining, on a
test basis, evidence supporting the amounts and disclosures in the financial statements.
An audit also includes assessing the accounting principles used and significant estimates
made by management, as well as evaluating the overall financial statement presentation. We
believe that our audits provide a reasonable basis for our opinion.

In our opinion, the financial
statements referred to above present fairly, in all material respects, the
financial position of Orphan Medical, Inc. at December 31, 2003 and 2002, and
the results of its operations and its cash flows for each of the three years in
the period ended December 31, 2003, in conformity with U.S. generally accepted
accounting principles. Also in our opinion, the financial statement schedule
referred to above, when considered in relation to the basic financial statements
taken as a whole, presents fairly in all material respects the information set
forth therein.

|Minneapolis, Minnesota February 6, 2004 | /s/   Ernst & Young LLP
|--------------------------------------- | -----------------------

F-1

---

# Orphan Medical, Inc.
Balance Sheets
(In thousands except share and per share data)

|                                                      | December 31,
|----------------------------------------------------- | ------------
|
|Assets                                                |             
|Current assets:                                       |             
|Cash and cash equivalents                             |             
|Restricted cash                                       |             
|Accounts receivable, less allowance for doubtful     
|accounts of $112 and $25, respectively                |             
|Inventories                                           |             
|Prepaid expenses and other                            |             
|                                                      |             
|Total current assets                                  |             
|Office equipment and software                         |             
|Accumulated depreciation                              |             
|                                                      |             
|                                                      |             
|                                                      |             
|Total assets                                          |             
|                                                      |             
|Liabilities and shareholders equity                  |             
|Current liabilities:                                  |             
|Accounts payable                                      |             
|Accrued royalties                                     |             
|Accrued compensation                                  |             
|Deferred revenue                                      |             
|Accrued expenses                                      |             
|                                                      |             
|Total current liabilities                             |             
|Capital lease obligation-less current maturities      |             
|Commitments                                           |             
|Shareholders equity:                                 |             
|Senior Convertible Preferred Stock, $.01 par value;   |             
|14,000 shares authorized 8,706 shares issued and      |             
|outstanding; liquidation preference of $8,706         |             
|Series B Convertible Preferred Stock, $.01 par value;
|5,000 shares authorized; 3,957 and 3,677 shares      
|issued and outstanding; liquidation preference of     |             
|$3,957 and $3,677                                     |             
|Series C Convertible Preferred Stock, $.01 par value; |             
|4,000 shares authorized; 0 shares issued and          |             
|outstanding                                           |             
|Series D Convertible Preferred Stock, $.01 par value;
|1,500,000 shares authorized; 0 shares issued and     
|outstanding                                           |             
|Common stock, $.01 par value; 23,477,000 shares       |             
|authorized; 10,747,656 and 10,460,283 issued and      |             
|outstanding                                           |             
|Additional paid-in capital                            |             
|Accumulated deficit                                   |             
|                                                      |             
|Total shareholders equity                            |             
|                                                      |             
|Total liabilities and shareholders equity            |             
|                                                      |             

See accompanying notes.

F-2

---

Orphan Medical, Inc.
Statements of Operations
(In thousands except share and per share data)

|                                          | For the YearEndedDecember 31,2003 |  | For the YearEndedDecember 31,2002 |            | For the YearEndedDecember 31,2001
|----------------------------------------- | --------------------------------- |  | --------------------------------- | ---------- | ---------------------------------
|Revenues                                  |                                   |  | $                                 | 15,526     |                                  
|Cost of sales                             |                                   |  |                                   | 2,415      |                                  
|                                          |                                   |  |                                   |            |                                  
|Gross profit                              |                                   |  |                                   | 13,111     |                                  
|Operating expenses:                       |                                   | 
|Product development                       |                                   |  |                                   | 10,805     |                                  
|Sales and marketing                       |                                   |  |                                   | 16,361     |                                  
|General and administrative                |                                   |  |                                   | 4,773      |                                  
|                                          |                                   |  |                                   |            |                                  
|Total operating expenses                  |                                   |  |                                   | 31,939     |                                  
|                                          |                                   |  |                                   |            |                                  
|Loss from operations                      |                                   |  |                                   | (18,828    | )                                
|Gain on divestment of products            |                                   |  |                                   | 30,267     |                                  
|Other income, net                         |                                   |  |                                   | 51         |                                  
|Interest income                           |                                   |  |                                   | 135        |                                  
|Interest expense                          |                                   |  |                                   | (119       | )                                
|                                          |                                   |  |                                   |            |                                  
|Net income (loss) before taxes            |                                   |  |                                   | 11,506     |                                  
|Income tax expense                        |                                   |  |                                   | (509       | )                                
|                                          |                                   |  |                                   |            |                                  
|Net income (loss)                         |                                   |  |                                   | 10,997     |                                  
|Less:  Preferred stock dividends          |                                   |  |                                   | 945        |                                  
|                                          |                                   |  |                                   |            |                                  
|Net income (loss) applicable to common   
|shareholders                              |                                   |  | $                                 | 10,052     |                                  
|                                          |                                   |  |                                   |            |                                  
|Income (loss) per common share applicable |                                   | 
|to common shareholders                    |                                   | 
|Basic                                     |                                   |  | $                                 | 0.95       |                                  
|Diluted                                   |                                   |  | $                                 | 0.85       |                                  
|Weighted average number of                |                                   | 
|shares outstanding                        |                                   | 
|Basic                                     |                                   |  |                                   | 10,612,965 |                                  
|Diluted                                   |                                   |  |                                   | 12,966,954 |                                  

See accompanying notes.

F-3

---

# Orphan Medical, Inc.
Statements of Cash Flows
(In thousands)

|                                                            | For the YearEndedDecember 31,2003 |  | For the YearEndedDecember 31,2002 |         | For the YearEndedDecember 31,2001
|----------------------------------------------------------- | --------------------------------- |  | --------------------------------- | ------- | ---------------------------------
|Operating activities                                        |                                   |  |                                   |         |                                  
|Net income (loss)                                           |                                   |  | $                                 | 10,997  |                                  
|Adjustments to reconcile net income (loss) to net cash      |                                   | 
|used in operating activities:                               |                                   | 
|Gain on divestment of products                              |                                   |  |                                   | (30,267 | )                                
|Depreciation                                                |                                   |  |                                   | 441     |                                  
|Amortization of warrants                                    |                                   |  |                                   | 65      |                                  
|Compensatory options                                        |                                   |  |                                   |        |                                  
|Issuance of Common stock for        charitable contribution |                                   |  |                                   | 115     |                                  
|Changes in operating assets and liabilities:                |                                   | 
|Accounts receivable and other current assets                |                                   |  |                                   | (668    | )                                
|Inventories                                                 |                                   |  |                                   | 324     |                                  
|Accounts payable and accrued expenses                       |                                   |  |                                   | 952     |                                  
|Deferred revenue                                            |                                   |  |                                   | 2,500   |                                  
|                                                            |                                   |  |                                   |         |                                  
|Net cash used in operating activities                       |                                   |  |                                   | (15,541 | )                                
|Investing activities                                        |                                   | 
|Purchase of office equipment and software                   |                                   |  |                                   | (39     | )                                
|Decrease (increase) in restricted cash                      |                                   |  |                                   | 123     |                                  
|Net proceeds from divestment of products                    |                                   |  |                                   | 30,267  |                                  
|Maturities of short term investments                        |                                   |  |                                   |        |                                  
|                                                            |                                   |  |                                   |         |                                  
|Net cash provided by (used in) investing activities         |                                   |  |                                   | 30,351  |                                  
|Financing activities                                        |                                   | 
|Proceeds from common stock offering                         |                                   |  |                                   |        |                                  
|Proceeds from                                              
|Employee Stock Purchase Plan                                |                                   |  |                                   | 48      |                                  
|Proceeds from stock option and warrants                     |                                   |  |                                   | 1,522   |                                  
|Principal payments on capital lease                         |                                   |  |                                   | (15     | )                                
|Preferred stock dividend                                    |                                   |  |                                   | (1      | )                                
|                                                            |                                   |  |                                   |         |                                  
|Net cash provided by financing activities                   |                                   |  |                                   | 1,554   |                                  
|                                                            |                                   |  |                                   |         |                                  
|Increase(decrease) in cash and cash equivalents             |                                   |  |                                   | 16,364  |                                  
|Cash and cash equivalents at the beginning of year          |                                   |  |                                   | 6,921   |                                  
|                                                            |                                   |  |                                   |         |                                  
|Cash and cash equivalents at the end of year                |                                   |  | $                                 | 23,285  |                                  
|                                                            |                                   |  |                                   |         |                                  
|Schedule of non-cash investing and financing activities     |                                   | 
|Issuance of preferred stock dividends                       |                                   |  | $                                 | 933     |                                  
|Capital lease for equipment                                 |                                   |  |                                   |        |                                  
|Supplemental disclosures of cash flow information           |                                   |  |                                   |         |                                  
|Income taxes paid                                           |                                   |  |                                   | 410     |                                  
|Interest paid                                               |                                   |  |                                   | 53      |                                  

See accompanying notes.

F-4

---

Orphan Medical, Inc.
Statement of Changes in Shareholders Equity
(In thousands except share data)

|                                                             | Preferred Stock |  | Common Stock
|------------------------------------------------------------ | --------------- |  | ------------
|
|Balance at December 31, 2000                                 |                 |  |             
|Net proceeds from                                            |                 | 
|private offering                                             |                 | 
|of Common Stock                                              |                 |  |             
|Options and warrants exercised                               |                 |  |             
|Proceeds from Employee                                       |                 | 
|Stock Purchase Plan                                          |                 |  |             
|Compensatory options                                         |                 |  |             
|Preferred stock dividends                                    |                 |  |             
|Comprehensive loss:                                          |                 | 
|Net loss                                                     |                 |  |             
|Unrealized loss on                                           |                 | 
|available-for-sale                                           |                 | 
|securities                                                   |                 |  |             
|                                                             |                 |  |             
|Subtotal  comprehensive                                     |                 | 
|loss                                                         |                 |  |             
|                                                             |                 |  |             
|Balance at December 31, 2001                                 |                 |  |             
|Offering costs from December                                
|2001 private offering                                        |                 |  |             
|Options and warrants exercised                               |                 |  |             
|Proceeds from Employee                                      
|Stock Purchase Plan                                          |                 |  |             
|Preferred stock dividends                                    |                 |  |             
|Net loss                                                     |                 |  |             
|                                                             |                 |  |             
|Balance at December 31, 2002                                 |                 |  |             
|Options and warrants exercised                               |                 |  |             
|Proceeds from Employee                                       |                 | 
|Stock Purchase Plan                                          |                 |  |             
|Preferred stock dividends                                    |                 |  |             
|Issuance of common     stock for charitable     contribution |                 |  |             
|Warrants issued                                             
|with line of credit                                          |                 |  |             
|Net income                                                   |                 |  |             
|                                                             |                 |  |             
|Balance at December 31, 2003                                 |                 |  |             
|                                                             |                 |  |             

See accompanying notes.

F-5

---

Orphan Medical, Inc.
Notes to Financial Statements
December 31, 2003
(Dollars in thousands)

1.   Business Activity
Orphan Medical, Inc. (the Company) acquires, develops, and
markets products of high medical value intended to treat sleep disorders, pain
and other central nervous system (CNS) disorders that are addressed by physician
specialists. A drug has high medical value if it offers a major improvement in
the safety or efficacy of patient treatment and has no substantially equivalent
substitute. The Company has had six pharmaceutical products approved for
marketing by the United States Food and Drug Administration (FDA). Three of
these products have been divested, and the Company is now focusing its resources
on Xyrem® (sodium oxybate) oral solution, a medication approved for
cataplexy, a significant and debilitating symptom of narcolepsy. The Company is
conducting clinical trials to assess Xyrem in treating excessive daytime
sleepiness and fragmented nighttime sleep, the other prominent symptoms of
narcolepsy. A new compound, Butamben (butyl-p-aminobenzoate) suspension for
injection, is being evaluated for development as a treatment of pain. The
Company is seeking other approved or development-stage products in the specialty
CNS areas it serves. The Company also markets Antizol® (fomepizole)
Injection, as a treatment suspected or confirmed ethylene glycol or methanol
poisonings and Cystadane® (betraine anhydrous for oral solution) for the
treatment of homocystimuria, an inherited metabolic disease.

2.   Summary of Significant Accounting Policies
Use of Estimates
The preparation of financial statements in conformity with accounting
principles generally accepted in the United States requires management to make
estimates and assumptions that affect the amounts reported in the financial
statements and accompanying notes. Actual results could differ from those
estimates.

Revenue Recognition
Sales for all products, except Xyrem® (sodium oxybate) oral solution,
are recognized at the time a product is shipped to the Companys customers
and are recorded net of reserves for discounts for prompt payment. Sales of
Xyrem are recognized at the time product is shipped from the specialty pharmacy
to the patient and are recorded net of discounts for prompt payment. Except for
Xyrem, the Company is obligated to accept, for exchange only, from all domestic
customers products that have reached their expiration date, which range
from three to five years depending on the product. The Company is not obligated
to accept exchange of outdated product from its international distribution
partners. The Company establishes a reserve for the estimated cost of the
exchanges. Management bases this reserve on historical experience and these
estimates are subject to change.

Deferred revenue represents the
initial payment received by the Company per the terms of the Companys
license agreement with Celltech Pharmaceuticals, a division of Celltech Group
plc (Celltech). Upon expiration of refund conditions, this fee will be
recognized ratably over the expected regulatory approval period. Future
milestone payments are expected to be recognized as earned based on the
achievement of the milestone as indicated in the license agreement. See
Note 5 for additional details regarding the Celltech transaction.

Cost of Sales
Cost of sales includes primarily third-party manufacturing and distribution
costs and royalties due to third parties on sales. The Company makes royalty
payments of 7% on one of its products and 1% on a second product. Royalty
expense for prior years included royalty expenses for two products that were
divested in 2003. Royalty expense was $663, $854, and $614 for the years ended
December 31, 2003, 2002 and 2001 respectively.

Product Development Costs
All product development costs are charged to operations as incurred.
Product development costs consist principally of preclinical and clinical
testing costs, certain salary and related expenses, bulk drug and drug product
costs incurred in support of clinical testing and for validation lots required
by the FDA, toxicology studies and various technical consulting costs.

Cash Equivalents and Available-for-Sale Securities
The Company considers all highly liquid investments with remaining
maturities of 90 days or less when purchased to be cash equivalents. The Company
considers all highly liquid investments with remaining maturities of more than
90 days when purchased to be available-for-sale securities. Cash equivalents are
carried at cost plus accrued interest, which approximates market value. There
were no available-for-sale securities at December 31, 2003 and 2002.

F-6

---

Orphan Medical, Inc.
Notes to Financial Statements (continued)
(Dollars in thousands)

2.   Summary of Significant Accounting Policies (continued)
Concentration of Credit Risk
The Company invests its excess cash in U.S. government agency securities,
investment grade commercial paper, and other money market instruments and has
established guidelines relative to diversification and maturities in an effort
to maintain safety and liquidity. These guidelines are periodically reviewed to
take advantage of trends in yields and interest rates. The Company has not
experienced any significant losses on its cash equivalents or available-for-sale
securities.

There is a concentration of sales to
larger medical wholesalers and distributors. The Company performs periodic credit
evaluations of its customers financial condition. Domestic receivables are due
within 30 days of the invoice date. International receivables are generally due within 60
to 90 days of invoice date. Credit losses relating to customers have not been material
since the Companys inception.

Significant Customers
The following is a summary of sales to significant customers that
individually account for more than 10% of net sales.

|                              | Year ended December 31,
|----------------------------- | -----------------------
|
|Cardinal Health, Inc.         |                        
|AmerisourceBergen Corporation |                        
|McKesson Corporation          |                        

Inventories
Inventories are valued at the lower of cost or market determined using the
first-in, first-out (FIFO) method. The Companys policy is to establish an
excess and obsolete reserve for its products in excess of the expected demand
for such products. Inventory used in clinical trials is expensed at the time of production and included in the reserve until used.
The reserve at December 31, 2003 and 2002 was $290 and $142, respectively.

|                            | December 31,
|--------------------------- | ------------
|
|Raw materials and packaging |             
|Finished goods              |             
|                            |             
|                            |             
|                            |             

Office Equipment and Software
The Company has contractual arrangements with third parties for the
manufacture of its products and does not currently have material investment in
manufacturing or packaging equipment. Office equipment and software are stated
at cost. Maintenance and repairs are expensed as incurred. Depreciation is
computed using the straight-line method over the assets estimated useful
lives of three to seven years.

Long-Lived Assets
The Company performs reviews for the impairment of long-lived assets
whenever events or changes in circumstances indicate that the carrying amount of
an asset may not be recoverable. An impairment loss would be recognized when the
estimated undiscounted future cash flows expected to result from the use of the
asset and its eventual disposition is less than its carrying amount.

Recent Accounting
PronouncementsIn January 2003, the FASB issued Financial
Interpretation No. 46, or FIN 46, Consolidation of Variable Interest Entitites,
and in December 2003, issued a revision to FIN 46 (FIN 46R). FIN 46 requires
that if an entity has a controlling financial interest in a variable interest
entity, the assets, liabilities and results of activities of the variable
interest entity should be included in the consolidated financial statements of
the entity. FIN 46 is effective immediately for all new variable interest
entities created or acquired after January 31, 2003. For variable interest
entities created or acquired prior to February 1, 2003, the provisions of FIN 46
must be applied for the first interim or annual period ending after December 15,
2003. The adoption of FIN 46 will not have a material effect on our results of
operations, cash flows or financial position.

In May 2003, the FASB
issued SFAS No. 150, Accounting for Certain Financial Instruments with
Characteristics of Both Liabilities and Equity. SFAS No. 150 establishes
standards for how an issuer classifies and measures in its statement of
financial position certain financial instruments with characteristics of both
liabilities and equity. SFAS No. 150 requires that an issuer classify a
financial instrument that is within its scope as a liability (or an asset in
some circumstances) because that financial instrument embodies an obligation of
the issuer. This statement is effective for financial instruments entered into
or modified after May 31, 2003, and otherwise is effective at the beginning of
the first interim period beginning after June 15, 2003. The Company adopted SFAS
No. 150 as of July 1, 2003. The adoption of SFAS No. 150 did not have a material
effect on our results of operations, cash flows or financial position.

Stock-Based Compensation
At December 31, 2003 the Company has a stock-based employee compensation
plan, which is described more fully in Note 10. The Company accounts for this
plan under the recognition and measurement principles of Accounting Principles
Board Opinion No. 25, Accounting for Stock Issued to Employees, and
related interpretations. No stock-based compensation cost is reflected in the
net income (loss) in 2003 and 2002, as all options granted under this plan had an
exercise price equal to market value of the underlying common stock on the date
of grant. In 2001 the Company modified the terms of options granted to an
employee. As a result the Company recognized compensation expense of $240. The
following table illustrates the effect on net income (loss) and net income (loss) per
share if the Company had applied the fair value recognition provisions of
Statement of Financial Accounting Standards No. 123, Accounting for
Stock-Based Compensation, to stock-based employee compensation.

F-7

---

Orphan Medical, Inc.
Notes to Financial Statements (continued)
(Dollars in thousands)

# 2.   Summary of Significant Accounting Policies (continued)

|                                       | 2003 |  | Year EndedDecember 31,2002 |        | 2001
|-------------------------------------- | ---- |  | -------------------------- | ------ | ----
|Net income (loss) as reported          |      |  | $                          | 10,052 |     
|Add stock-based employee compensation  |      | 
|included in net loss                   |      |  |                            |       |     
|Deduct total stock-based employee      |      | 
|compensation expense determined under  |      | 
|fair value-based method for all awards |      |  |                            | (2,375 | )   
|                                       |      |  |                            |        |     
|Pro forma net income (loss)            |      |  | $                          | 7,677  |     
|                                       |      |  |                            |        |     
|Income (loss) per share  as reported  |      | 
|Basic                                  |      |  | $                          | 0.95   |     
|                                       |      |  |                            |        |     
|Diluted                                |      |  | $                          | 0.85   |     
|                                       |      |  |                            |        |     
|Income (loss) per share  as proforma  |      | 
|Basic                                  |      |  | $                          | 0.72   |     
|                                       |      |  |                            |        |     
|Diluted                                |      |  | $                          | 0.70   |     
|                                       |      |  |                            |        |     

Income Taxes
The Company accounts for income taxes using the liability method. Deferred
income taxes are provided for temporary differences between the financial
reporting and tax bases of assets and liabilities.

Reclassifications
At December 31, 2003, the Company reclassified certain operating expenses to
align the financial statements with the Companys current management of its
operations.  These expenses were reclassified from General and
Administrative expenses to Product Development and Sales and Marketing expenses. Certain
prior year balances have been reclassified in order to conform to current year
presentation. These reclassifications have no impact on net loss or
shareholders equity as previously reported.

3.   Income (Loss) per Share
Income (loss) per share is computed in accordance with SFAS No. 128,
Earnings per Share. Basic income (loss) per share is computed based
on the weighted average number of common shares outstanding during the period.
Diluted income per share is computed based on the weighted average shares
outstanding and the dilutive impact of common stock equivalents outstanding
during the period. The dilutive effect of employee stock options and warrants is
measured using the treasury stock method. The dilutive effect of both series of
outstanding convertible preferred stock is computed using the
if-converted method. Common stock equivalents are not included in
periods where there is a loss, as they are antidilutive and therefore basic and
diluted loss per share are the same in the loss periods. The following is a
reconciliation of net income (loss) and weighted average

F-8

---

common shares outstanding for purposes of calculating basic and diluted
income (loss) per share:

|                                                  | Year ended December 31,
|------------------------------------------------- | -----------------------
|
|Numerator                                         |                        
|Numerator for basic income (loss) per share      |                        
|income available to common shareholders           |                        
|Add back to effect assumed conversions:           |                        
|Preferred stock dividends                         |                        
|                                                  |                        
|Numerator for diluted income (loss) per share     |                        
|                                                  |                        
|Denominator                                       |                        
|Denominator for basic income (loss) per share    |                        
|weighted average shares                           |                        
|Effect of dilutive securities:                    |                        
|Convertible preferred shares                      |                        
|Stock options                                     |                        
|Warrants                                          |                        
|                                                  |                        
|Denominator for diluted income (loss) per share  |                        
|weighted average shares and assumed conversions   |                        
|                                                  |                        
|Basic income (loss) per share                     |                        
|                                                  |                        
|Diluted income (loss) per share                   |                        
|                                                  |                        

Employee stock options of
719,858, 1,997,478 and 1,526,978 have been excluded from the diluted income
(loss) per share calculations for 2003, 2002 and 2001, respectively, because the
effect would be antidilutive. All warrants were included in the diluted income
per share calculation for 2003. Warrants of 602,738 have been excluded from the
diluted loss per share calculation for 2002 and 2001 because the effect would be
antidilutive. All outstanding convertible preferred stock was included in the
income per share calculation for 2003. All outstanding convertible preferred
stock was excluded from the loss per share calculations for 2002 and 2001
because the effect would be antidilutive.

4.   Divestment of products
On June 10, 2003, the Company announced the disposition of Busulfex(R)
(busulfan) Injection to ESP Pharma, Inc. for $29.3 million plus the book value
of inventory, approximately $0.2 million. The Company announced the sale of the
product Sucraid(R) (sacrosidase) oral solution to a specialty pharmaceutical
company on May 6, 2003 for $1.5 million. The Company also divested a third
product, Elliotts B Solution(R) to another company for proceeds that were not
material. Proceeds from these dispositions will be used for further development
and marketing of Xyrem(R) (sodium oxybate) oral solution and for the creation of
a stronger presence in the sleep and central nervous system (CNS) markets. The
gain from these transactions, $30.3 million, is reflected in the Statement of
Operations.

Revenues for the divested
products for the years ended December 31, 2003, 2002 and 2001 were
$3.5 million, $8.5 million and $5.7 million, respectively, Cost
of sales for the divested products was $0.6 million, $1.3 million and
$0.8 million for the years ended December 31, 2003, 2002 and 2001,
respectively.

F-9

---

Orphan Medical, Inc.
Notes to Financial Statements (continued)
(dollars in thousands)

5.   Product
LicenseIn October 2003, the Company announced that it had licensed European sales
and marketing rights for Xyrem® (sodium oxybate) oral solution to Celltech
Pharmaceuticals, a division of Celltech Group plc. Under the terms of the
ten-year agreement, Celltech will be responsible for the registration, sales and
marketing of Xyrem in Europe. Celltech has made an initial payment of $2.5
million to Orphan Medical and will make further payments of up to $6 million
tied to product development milestones and up to $7 million tied to
sales-related milestones. Celltech will also pay Orphan Medical a royalty on
sales of the product which are expected to begin no earlier than 2005. The
licensing agreement includes the use of Xyrem in the treatment of certain
indications of narcolepsy and provides Celltech with rights to negotiate in
regard to other potential future indications including fibromyalgia syndrome.
The Celltech agreement provides that in the event that following and as a result
of the pre-submission meeting with the EMEA, the parties mutually agree that it
is not possible or commercially viable to obtain Registration for the Product in
the Major European Countries, the parties may agree to terminate this Agreement,
and such termination shall be subject to the terms of the Agreement. Upon any
such termination, Orphan Medical shall refund to Celltech 50% of the initial
payment within ninety (90) days of Celltechs providing to Orphan Medical input
relating to the pre-submission meeting and 30% of the initial payment ninety
(90) days thereafter.

At March 31, 2004, the
marketing applicaton had been submitted to the EMEA and the refund provisions
had expired.

6.   Leases
The Company has a non-cancelable operating lease for office space that
expires on October 31, 2004. The Company also has operating leases for certain
office equipment expiring at various times through August 2005. The Company also
leases vehicles for the Companys sales force. The term of this lease runs
through October 2006. The number of vehicles leased may increase as the sales
force expands. The vehicle lease requires the Company to maintain $128 in an
account securing a letter of credit. This cash has been disclosed as restricted
in the balance sheet. In December 2002, the Company entered into a capital lease
for phone equipment that expires in December 2007. The lease contains a bargain
purchase option. Amortization expense for the equipment under the capital lease
is included in depreciation expense.

Future minimum lease payments,
including current real estate taxes and operating expenses under the facility lease, the
auto lease, and the equipment leases are as follows:

|                              | Capital Lease |  | Operating Lease
|----------------------------- | ------------- |  | ---------------
|2004                          |               |  | $              
|2005                          |               |  |                
|2006                          |               |  |                
|2007                          |               |  |                
|                              |               |  |                
|Minimum lease payments        |               |  |                
|                              |               |  |                
|Amounts representing interest |               |  |                
|                              |               | 
|Present value of net minimum  |               | 
|lease payments                |               |  |                
|Less current maturities       |               |  |                
|                              |               | 
|                              |               |  | $              
|                              |               | 

Total rent expense was
approximately $657, $476, and $303 for the years ended December 31, 2003, 2002,
and 2001, respectively.

7.   Borrowings
The Company entered into a line of credit facility with a commercial
bank on March 28, 2003. The line of credit facility has a term of one-year
and includes a borrowing base equal to 75 percent of eligible accounts
receivable up to a maximum amount of $2.5 million. Certain other assets have
also been pledged as collateral for this facility. The interest rate is equal to
two points over the banks prime rate, with a minimum rate of 6.75%. The
Company is also subject to certain other requirements during the term of the
facility if borrowings are outstanding, including (a) minimum quarterly net
tangible equity of $6.0 million plus 50 percent of the proceeds of any equity
securities or subordinated debt offering and (b) maximum monthly operating loss
of $2.7 million. The Companys borrowing capacity at December 31, 2003 was
$1.8 million. The Company had not borrowed under this facility through December 31, 2003.

F-10

---

Orphan Medical, Inc.
Notes to Financial Statements (continued)
(dollars in thousands)

8.   Income Taxes
The provision for income taxes consists of the following (in thousands):

|                              | 2003 |  | 2002 |        | 2001
|----------------------------- | ---- |  | ---- | ------ | ----
|Current                       |      |  |      |        |     
|Federal                       |      |  | $    | 335    |     
|State                         |      |  |      | 174    |     
|Deferred                      |      |  |      |        |     
|Federal                       |      |  |      | 1,456  |     
|State                         |      |  |      | 116    |     
|Change in valuation allowance |      |  |      | (1,572 | )   
|                              |      |  |      |        |     
|                              |      |  | $    | 509    |     
|                              |      |  |      |        |     

The Company provided tax expense of
$509 in 2003. This expense is the alternative minimum tax incurred as a result of the gain on
the divestment of three products in fiscal 2003. No current income taxes have been
provided for the years ended December 31, 2002 and 2001 as the Company had a loss for both
financial reporting and tax purposes.

The difference between the provision
for taxes on income and the amount computed by applying the federal statutory income tax
rate to income before taxes is explained below (in thousands):

|                                    | 2003 |  | 2002 |        | 2001
|----------------------------------- | ---- |  | ---- | ------ | ----
|Income tax provision (benefit) at   |      |  |      |        |     
|federal statutory rate              |      |  | $    | 3,912  |     
|State taxes, net of federal benefit |      |  |      | 372    |     
|Change in valuation allowance       |      |  |      | (2,019 | )   
|Orphan drug credits                 |      |  |      | (1,782 | )   
|Other                               |      |  |      | 26     |     
|                                    |      |  |      |        |     
|                                    |      |  | $    | 509    |     
|                                    |      |  |      |        |     

As of December 31, 2003, the Company
had net operating loss (NOL) carryforwards of approximately $35,948, credit for increasing
research activities (the R&D credit) carryforwards and orphan drug credit carryforwards of approximately
$13,368, available to reduce its
future tax liabilities. These carryforwards will begin expiring after 2010.

Significant components of the
Companys net deferred tax assets are as follows (in thousands):

|                                            | December 31,2003 |  | December 31,2002
|------------------------------------------- | ---------------- |  | ----------------
|Deferred tax assets:                        |                  |  |                 
|Net operating loss carryforwards            |                  |  | $               
|R&D and orphan drug credit carryforwards    |                  |  |                 
|Alternative minimum tax credit              |                  |  |                 
|Deferred revenue                            |                  |  |                 
|Inventory reserves                          |                  |  |                 
|All other reserves                          |                  |  |                 
|Deferred tax liabilities:                   |                  | 
|Depreciation                                |                  |  |                 
|Valuation allowance for deferred tax assets |                  |  |                 
|                                            |                  |  |                 
|Net deferred tax assets                     |                  |  | $               
|                                            |                  |  |                 

The Company has recorded a
valuation allowance to reduce the carrying value of its net deferred tax asset
to an amount that is more likely than not to be realized.

As a result of the 1995 public stock
offering, the Company exceeded the limits allowable under Section 382 of the Internal
Revenue Code related to changes in ownership percentage which governs future utilization
of NOL, R&D credit, and orphan drug credit carryforwards (collectively, tax
benefit carryforwards). The effect of this occurrence is to limit the annual
utilization of a portion of the Companys tax benefit carryforwards attributable to
the period prior to the change in ownership. Should another change in ownership occur,
future utilization of the Companys tax benefit carryforwards may be subject to
additional limitations under Section 382.

F-11

---

Orphan Medical, Inc.
Notes to Financial Statements (continued)
(dollars in thousands)

9.   Employee Benefit Plans
The Company maintains a 401(k) Savings Plan, which is funded by elective
salary deferrals by employees. The Plan covers substantially all employees
meeting minimum eligibility requirements. The Plan does not require mandatory
contributions by the Company, but discretionary contributions may be made at the
election of the Company. The Company has not made any provision for
discretionary contributions to the Plan.

The Company has a stock purchase plan
that is funded by employee contributions, generally through payroll deductions. All
employees are eligible subject to certain requirements. The purchase price is 85% of the
lower of the average of the high and the low trade on the first and last trading day of
each purchase period, defined as each calendar quarter. The Company reserved 200,000
shares of its common stock for future issuance at the Plans inception. From the
Plans inception through December 31, 2003, there have been 120,636 shares issued
under the Plan.

10. Stock Options
The Company has a stock option plan for employees and non-employees, the
1994 Stock Option Plan (the Plan). The Plan provides the Company may
grant employee incentive stock options and non-qualified stock options at a
price of not less than 100% of fair market value. Vesting terms for each option
grant are established at the time of the grant. Generally vesting terms are 20%
at the date of grant and 20% on each of the following four annual anniversary
dates of the option grant. Options are exercisable as prescribed by the Plan and
expire up to ten years from the grant date. At December 31, 2003, the Plan has
3,675,000 shares of Common Stock reserved for issuance.

Options outstanding were granted as
follows:

|                             | PlanOptionsOutstanding |  | Weighted AverageExercise Price
|---------------------------- | ---------------------- |  | ------------------------------
|
|Balance at December 31, 2000 |                        |  |                               
|Options granted              |                        |  |                               
|Options canceled             |                        |  |                               
|Options exercised            |                        |  |                               
|                             |                        | 
|Balance at December 31, 2001 |                        |  |                               
|Options granted              |                        |  |                               
|Options canceled             |                        |  |                               
|Options exercised            |                        |  |                               
|                             |                        | 
|Balance at December 31, 2002 |                        |  |                               
|Options granted              |                        |  |                               
|Options canceled             |                        |  |                               
|Options exercised            |                        |  |                               
|                             |                        | 
|Balance at December 31, 2003 |                        |  |                               
|                             |                        | 

The following table summarizes
information about the stock options outstanding at December 31, 2003:

|                | Options Outstanding |  | Options Exercisable
|--------------- | ------------------- |  | -------------------
|
|$5.00 - $5.37   |                     |  |                    
|$5.38 - $6.875  |                     |  |                    
|$6.88 - $10.00  |                     |  |                    
|$10.01 - $14.50 |                     |  |                    
|                |                     |  |                    
|$5.00 - $14.50  |                     |  |                    
|                |                     |  |                    

F-12

---

Orphan Medical, Inc.
Notes to Financial Statements (continued)
(dollars in thousands)

10.   Stock Options (continued)
Fully vested and exercisable options were 1,398,625, 1,302,368, and
1,251,772 as of December 31, 2003, 2002, and 2001, respectively. The weighted
average exercise prices for the fully vested and exercisable options as of
December 31, 2003, 2002, and 2001, were $7.07, $6.86, and $6.24, respectively.

Pro Forma Information:
The Company applies the intrinsic-value method in accounting for stock
issued to employees and directors. Accordingly, compensation expense is
recognized only when options are granted with an exercise price less than fair
market value of the common stock on the date of grant. Any such compensation
expense is recognized ratably over the associated service period, which is
generally the option vesting period.

Pro forma net income (loss) and
income (loss) per share information, as required by Statement of Financial Accounting
Standards No. 123, Accounting for Stock Based Compensation (SFAS 123), has
been determined as if the Company had accounted for employee stock options under the fair
value method. The fair value of these options was estimated at grant date using a
Black-Scholes option pricing model with the following assumptions for 2003, 2002, and
2001, respectively

|                                | 2003 |         | 2002 |          | 2001
|------------------------------- | ---- | ------- | ---- | -------- | ----
|Expected dividend yield         |      | 0.00%   |      | 0.00%    |     
|Expected stock price volatility |      | 68%     |      | 70%      |     
|Risk-free interest rate         |      | 4.00%   |      | 4.00%    |     
|Expected life of options        |      | 8 years |      | 10 years |     

The weighted average fair
value of the options granted in 2003, 2002, and 2001 was $6.97, $7.62, and
$9.33, respectively, as computed as described above.

11.   Shareholders Equity
On July 23, 1998 the Company issued $7.5 million of Senior Convertible
Preferred Stock (the Preferred Shares) in a private placement. The
Company realized net cash proceeds of $7.1 million from the sale of the
Preferred Shares after the payment of related offering expenses. The Preferred
Shares were initially convertible, at the option of the holders, into shares of
the Companys Common Stock at a price equal to $8.50 per share. The August
1999 financing, as discussed in the following paragraph, triggered antidilution
provisions relating to the $8.1 million of the Senior Preferred Stock held as of
August 1 (after giving effect to the semi-annual in-kind dividend
distributions), which resulted in a decrease in the conversion price of those
shares from $8.50 to $8.14 per share. The Preferred Shares have anti-dilution
protection and bear a dividend of 7.5% per annum, payable semi annually, which
during the first two years may by paid either in cash or by issuing common stock
valued at the then current market price. In the third year and thereafter, the
dividend may be paid either in cash or by issuing Common Stock valued at the
then current market price. At the Companys option upon their maturity in
July 2008, the Preferred Shares must be (a) converted into Common Stock at
the price specified in the original agreement as adjusted per the terms of the
agreements, subject to a $3.0 million conversion fee payable in cash or by
issuing additional Common Shares at the then current market price, or
(b) redeemed for cash at $1,000 per share plus accrued dividends. The
holders of the Preferred Shares are entitled to and have exercised their right
to designate an individual to serve on the Companys Board of Directors. At
this time, the Company intends to settle the conversion fee with additional
shares.

On August 2, 1999, the
Company completed a $5.0 million financing transaction in a private placement.
The funding consisted of a purchase of 2,950 shares of the Companys Series
B Convertible Preferred Stock for an aggregate purchase price of $2.95 million
and a commitment of $2.05 million of debt in the form of a line of credit. The
Company had not borrowed on this line of credit and it was eliminated as a part
of the December 2001 financing transaction. The Series B Convertible Preferred
Stock (Series B Preferred Shares) may be converted prior to August
2, 2009 into shares of the Companys Common Stock at a price of $6.50 per
share. The Series B

F-13

---

Orphan Medical, Inc.
Notes to Financial Statements (continued)
(Dollars in thousands)

11.   Shareholders Equity (continued)
Preferred Shares have anti-dilution protection and bear a dividend of 7.5%
per annum, payable semi annually, which during the first two years may by paid
either in cash or by issuing additional Series B Preferred Shares. In the
third year and thereafter, the dividend may be paid either in cash or by issuing
additional preferred stock. At the Companys option upon their maturity in
August 2009, the Series B Preferred Shares must be (a) converted into
Common Stock at the prices specified in the original agreement as adjusted per
the terms of the agreement, subject to a $1.2 million conversion fee
payable in cash or by issuing additional Common Shares at the then current
trading prices, or (b) redeemed for cash at $1,000 per share plus accrued
dividends. At this time, the Company intends to settle the conversion fees with
additional shares.

In conjunction with the
issuance of the preferred shares, the Company agreed to several restrictions and
covenants, and granted certain voting and other rights to the holders of the
preferred shares. One of these restrictions is that the Company cannot incur
additional indebtedness, except for indebtedness secured solely by our trade
receivables, until the Company has profitable operations, subject to certain
limitations. Another important restriction is that, without the approval of a
majority of the preferred stockholders, the Company cannot issue additional
equity securities unless the selling price per share exceeds the then conversion
price of the outstanding convertible preferred stock or the sale of equity is
accomplished in a public offering.

On December 6, 2001, the
Company completed the sale of 1,706,999 shares of its Common Stock at a price of
$8.25 per share. The Company received net proceeds of $13.0 million from the
transaction and registered the shares under the Securities Act of 1933, as
amended.

12.   Stock Warrants

At December 31, 2003, the Company had 20,000 warrants to purchase common
stock outstanding. During 2003, in conjunction with the line-of-credit-facility,
the Company issued warrants to purchase 15,000 shares of common stock at $8.51
per share. These warrants are currently exercisable. The value of these warrants
is $88 and is being amortized over the term of the line-of-credit-facility. For
issuances prior to 2003, the Company has warrants outstanding to purchase 5,000
shares of Common Stock at $8.50, all of which are currently exercisable.

In connection with the
August 1999 financing, the Company issued two seven-year warrants. One of the
warrants entitles the holder to receive, upon payment of the $2.05 million
exercise price, either 2,050 shares of Series C Convertible Preferred Stock
(which is similar to the Series B Convertible Preferred Stock and which is
convertible to shares of the Companys Series D Non-Voting Preferred Stock
at a conversion price of $6.50 per share) or 315,385 shares of Series D
Non-Voting Preferred Stock (which is equivalent to common stock except that it
has no voting rights) or a combination of Series C Convertible Preferred Stock
and Series D Non-Voting Preferred Stock, so long as the combined purchase price
for the shares does not exceed $2.05 million. The second warrant, issued in
relation to the line of credit, entitled the holder to purchase 282,353 shares
of Series D Non-Voting Preferred Stock at an exercise price of $4.25 per share.
The value of the warrants was $82 and was amortized over the term of the line of
credit to interest expense. All of these warrants are outstanding and
exercisable at December 31, 2003.

13.   Research and Development Commitments
The Company has various commitments under agreements with outside
consultants, contract drug developers and manufacturers, technical service
companies, and drug distributors. In addition, the Company has commitments under
license and research agreements. The Company does not have any joint venture
agreements nor does it have any arrangements to perform research and development
for other parties. The Company recognizes the costs associated with these
commitments as incurred based on the accrual method of accounting. Expenditures
associated with these commitments totaled approximately $6,167, $3,900, and
$3,000 for the years ended December 31, 2003,

F-14

---

Orphan Medical, Inc.
Notes to Financial Statements (continued)
(Dollars in thousands)

13.   Research and Development Commitments (continued)
2002, and 2001, respectively. The Companys commitment to incur
additional expenditures in subsequent periods for development activities totaled
approximately $14,665, $5,676, and $4,045 at December 31, 2003, 2002, and 2001,
respectively. Commitments for research and development expenditures will likely
fluctuate from year to year depending on, among other factors, the timing of new
product development, if any, and clinical trial activity.

14.   Geographic Information
The Company operates in one segment. The Company has no assets outside of the
United States. The following is a summary of net sales by geographic region for
the years ended December 31, 2003, 2002 and 2001, respectively.

|               | 2003 |  | 2002 |        | 2001
|-------------- | ---- |  | ---- | ------ | ----
|Domestic       |      |  | $    | 13,788 |     
|International  |      | 
|Japan          |      |  |      | 68     |     
|United Kingdom |      |  |      | 529    |     
|All other      |      |  |      | 1,141  |     
|               |      |  |      |        |     
|Total          |      |  | $    | 15,526 |     
|               |      |  |      |        |     

F-15

---

Orphan Medical, Inc.
Notes to Financial Statements (continued)
(Dollars in thousands)

15. Quarterly Financial Information (unaudited)
The following are unaudited quarterly results of operations for the years
ended December 31, 2003 and 2002.

|                                 | Quarter ended
|-------------------------------- | -------------
|
|Revenues                         |              
|Gross profit                     |              
|Net income (loss)                |              
|Less:  Preferred stock dividends |              
|Net (loss) income attributable   |              
|to common shareholders           |              
|(Loss) income per share          |              
|Basic                            |              
|Diluted                          |              
|                                
|
|
|Revenues                         |              
|Gross profit                     |              
|Net loss                         |              
|Less:  Preferred stock dividends |              
|Net loss attributable to common  |              
|shareholders                     |              
|Basic and diluted loss per       |              
|common share                     |              

(a) The second quarter of 2003 includes a $30.3 million gain on the divestment
of certain products discussed more fully in Note 4 to these financial
statements.

F-16

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SCHEDULE II  VALUATION AND QUALIFYING ACCOUNTS

ORPHAN MEDICAL, INC.

|                                               |  | Additions
|---------------------------------------------- |  | ---------
|
|Year Ended December 31, 2003                   |  |          
|Reserves and allowances deducted               |  |          
|from asset accounts:                           |  |          
|Allowance for doubtful accounts                |  |          
|Allowance for excess                           |  |          
|inventory                                      |  |          
|Year Ended December 31, 2002                   |  |          
|Reserves and allowances deducted               |  |          
|from asset accounts:                           |  |          
|Allowance for doubtful accounts                |  |          
|Allowance for excess                           |  |          
|inventory                                      |  |          
|Year Ended December 31, 2001                   |  |          
|Reserves and allowances deducted               |  |          
|from asset accounts:                           |  |          
|Allowance for doubtful accounts                |  |          
|Allowance for excess                           |  |          
|inventory                                      |  |          
|                                              
|(1)   Recovery of amounts previously reserved.

F-17

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