**UNITED STATES**

 

**SECURITIES AND EXCHANGECOMMISSION**

 

**WASHINGTON, D.C. 20549**

 

**FORM 10-Q**

 

**(MarkOne)**

 
| **ý** | **Quarterly Report pursuant to Section 13 or 15(d) of the Securities  Exchange Act of 1934 for the quarterly period ended September 30, 2004**                                                                                                                                   |
|------------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|       |                                                                                                                                                                                                                                                                             |
|       |                                                                                                                                                                                                                                                                             |
| **o**      | **Transition report pursuant to section 13 or 15(d) of the Securities  Exchange Act of 1934 for the transition period from              to            ** |

 

**Commission FileNumber:  0-24760**

 

**Orphan Medical, Inc.**

(Exact name of registrant as specified inits charter)

 
| **Delaware**                                                    | ** ** | **41-1784594**                                             |
|-----------------------------------------------------------------|------------|------------------------------------------------------------|
| (State or other jurisdiction of  incorporation or organization) |       | (I.R.S. Employer Identification Number)                    |
|                                                            |       |                                                       |
| **13911 Ridgedale Drive,  Suite 250, Minnetonka, MN 55305**     | ** ** | **(952) 513-6900**                                         |
| (Address of principal executive office  and zip code)           |       | (Registrant’s telephone number,  including area code) |

 

Indicateby check mark whether the registrant (1) has filed all reports required to befiled by Section 13 or 15(d) of the Securities Exchange Act of 1934 during thepreceding 12 months, and (2) has been subject to such filing requirements forthe past 90 days.

 
|   | Yes ý | No o |   |
|--------|------------|------|--------|

 

Indicate by check mark whether the registrant is an acceleratedfiler (as defined in Rule 12b-2 of the Exchange Act).

 
|   | Yes ý | No o |   |
|--------|------------|------|--------|

 

Indicate the number ofshares outstanding of each of the issuer’s classes of common stock, as of thelatest practical date.

 
| **Common Stock, $.01 par value** | ** ** | **11,423,211**                     |
|----------------------------------|------------|------------------------------------|
| (Class)                          | ** ** | (Outstanding  at November 1, 2004) |

 

 

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INDEX

 

**ORPHAN MEDICAL, INC. ®**

 
| **PART I. FINANCIAL INFORMATION**                                                                       | ** **                                                                                  |
|---------------------------------------------------------------------------------------------------------|---------------------------------------------------------------------------------------------|
|                                                                                                    |                                                                                        |
| **Item 1.**                                                                                             | Financial Statements (Unaudited)                                                            |   |
|                                                                                                    |                                                                                        |
| Balance  Sheets - September 30, 2004 and December 31, 2003.                                             |                                                                                        |
|                                                                                                    |                                                                                        |
| Statements of Operations –  Three and nine months ended September 30, 2004 and September 30, 2003. |                                                                                        |
|                                                                                                    |                                                                                        |
| Statements of Cash Flows -  Nine months ended September 30, 2004 and September 30, 2003.                |                                                                                        |
|                                                                                                    |                                                                                        |
| Notes to Financial Statements                                                                           |                                                                                        |
|                                                                                                    |                                                                                        |
| **Item  2.**                                                                                            | Management’s  Discussion and Analysis of Financial Condition and Results of Operations |   |
|                                                                                                    |                                                                                        |   |
| **Item  3.**                                                                                            | Quantitative and  Qualitative Disclosures about Market Risk                                 |   |
|                                                                                                    |                                                                                        |   |
| **Item  4.**                                                                                            | Controls and  Procedures                                                                    |   |
|                                                                                                    |                                                                                        |   |
| **PART  II. OTHER INFORMATION**                                                                         |                                                                                        |

 

Antizol**®**,Antizol-Vet**®**, Cystadane**®**, Xyrem**®**, MedExpandTM “The” Orphan DrugCompanyTM Orphan Medical**®**,Inc. and Dedicated to Patients with Uncommon Diseases**®** are trademarks of the Company.

 

2

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PART I -FINANCIAL INFORMATION

 

**Item 1****.  **FinancialStatements

 

**ORPHAN MEDICAL, INC.**

**BALANCE SHEETS**

**(****in thousands except shareand per share amounts****)**

 
| ** **                                                                                                                                                                | ** ** | **September 30,  2004** | ** ** | **December 31,  2003** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------|------------|------------------------|------------|
| ** **                                                                                                                                                                | ** ** | **(Unaudited)**         | ** ** | ** **             | ** ** |
| Assets                                                                                                                                                                    |       |                    |       |                   |       |
| Current assets:                                                                                                                                                           |       |                    |       |                   |       |
| Cash and cash  equivalents                                                                                                                                                |       | $                       | 14,820     |                   | $          | 23,285 |   |
| Restricted cash                                                                                                                                                           |       | 125                     |       | 128                    |       |
| Accounts receivable,  less allowance for doubtful accounts of $25 and $112, respectively                                                                                  |       | 2,816                   |       | 2,552                  |       |
| Inventories                                                                                                                                                               |       | 1,796                   |       | 1,696                  |       |
| Prepaid expenses and  other                                                                                                                                               |       | 810                     |       | 907                    |       |
| Total current assets                                                                                                                                                      |       | 20,367                  |       | 28,568                 |       |
| Office equipment and  software                                                                                                                                            |       | 562                     |       | 754                    |       |
| Total assets                                                                                                                                                              |       | $                       | 20,929     |                   | $          | 29,322 |   |
| Liabilities and  shareholders’ equity                                                                                                                                |       |                    |       |                   |       |
| Current liabilities:                                                                                                                                                      |       |                    |       |                   |       |
| Accounts payable                                                                                                                                                          |       | $                       | 1,073      |                   | $          | 2,923 |   |
| Accrued compensation                                                                                                                                                      |       | 1,314                   |       | 881                    |       |
| Deferred revenue                                                                                                                                                          |       | 1,667                   |       | 2,500                  |       |
| Accrued expenses and other                                                                                                                                                |       | 3,093                   |       | 2,460                  |       |
| Total current  liabilities                                                                                                                                                |       | 7,147                   |       | 8,764                  |       |
| Capital lease  obligation-less current maturities                                                                                                                         |       | 48                      |       | 62                     |       |
| 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; 4,106 and 3,957  shares issued and outstanding; liquidity preference of $4,106 and $3,957 |       | —                  |       | —                 |       |
| 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; 1,000 shares authorized; 0 shares issued and  outstanding                                                          |       | —                  |       | —                 |       |
| Common stock, $.01 par  value; 25,000,000 shares authorized; 11,422,791 and 10,747,656 issued and  outstanding                                                            |       | 114                     |       | 107                    |       |
| Additional paid-in  capital                                                                                                                                               |       | 80,946                  |       | 76,714                 |       |
| Accumulated deficit                                                                                                                                                       |       | (67,326                 | )          | (56,325                | )          |
| Total shareholders’  equity                                                                                                                                          |       | 13,734                  |       | 20,496                 |       |
| Total liabilities and  shareholders’ equity                                                                                                                          |       | $                       | 20,929     |                   | $          | 29,322 |   |

 

**Note:** The Balance Sheet at December 31, 2003has been derived from the audited financial statements at that date but doesnot include all of the information and footnotes required by generally acceptedaccounting principles for complete financial statements. *See Accompanying Notes.*

 

3

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**Orphan Medical, Inc.**

**Statementsof Operation****s**

**(in thousands except for per share amounts)**

 

(Unaudited)

 
| ** **                                                                     | ** ** | **For the Three Months Ended  September 30,** | ** ** | **For the Nine Months Ended  September 30,** | ** ** |
|--------------------------------------------------------------------------------|------------|-----------------------------------------------|------------|----------------------------------------------|------------|
| ** **                                                                     | ** ** | **2004**                                      | ** ** | **2003**                                     | ** ** | **2004** | ** ** | **2003** | ** ** |
| Product revenues, net                                                          |       | $                                             | 6,651      |                                         | $          | 2,982 |   | $ | 16,049 |   | $ | 11,898 |   |
| Licensing and royalty revenue                                                  |       | 437                                           |       | —                                       |       | 1,854 |   | — |   |
| Total revenue                                                                  |       | 7,088                                         |       | 2,982                                        |       | 17,903 |   | 11,898 |   |
|                                                                           |       |                                          |       |                                         |       |   |   |   |   |
| Operating expenses:                                                            |       |                                          |       |                                         |       |   |   |   |   |
| Cost of product revenues                                                       |       | 884                                           |       | 501                                          |       | 2,249 |   | 1,965 |   |
| Product development                                                            |       | 2,938                                         |       | 2,895                                        |       | 10,125 |   | 7,381 |   |
| Sales and marketing                                                            |       | 3,832                                         |       | 3,397                                        |       | 12,596 |   | 11,355 |   |
| General and administrative                                                     |       | 829                                           |       | 1,106                                        |       | 3,085 |   | 3,749 |   |
| Total operating expenses                                                       |       | 8,483                                         |       | 7,899                                        |       | 28,055 |   | 24,450 |   |
| Loss from operations                                                           |       | (1,395                                        | )          | (4,917                                       | )          | (10,152 | ) | (12,552 | ) |
|                                                                           |       |                                          |       |                                         |       |   |   |   |   |
| Interest income                                                                |       | 41                                            |       | 41                                           |       | 132 |   | 77 |   |
| Interest expense                                                               |       | —                                        |       | (35                                          | )          | (22 | ) | (84 | ) |
| Other income                                                                   |       | —                                        |       | 34                                           |       | — |   | 34 |   |
| Gain on divestment of products                                                 |       | —                                        |       | —                                       |       | — |   | 30,267 |   |
|                                                                           |       |                                          |       |                                         |       |   |   |   |   |
| Net (loss) income before taxes                                                 |       | (1,354                                        | )          | (4,877                                       | )          | (10,042 | ) | 17,742 |   |
| Income tax expense                                                             |       | —                                        |       | 251                                          |       | — |   | 509 |   |
| Net income                                                                     |       | (1,354                                        | )          | (5,128                                       | )          | (10,042 | ) | 17,233 |   |
| Less: Preferred stock dividends                                                |       | 244                                           |       | 238                                          |       | 722 |   | 704 |   |
|                                                                           |       |                                          |       |                                         |       |   |   |   |   |
| Net (loss) income attributable to common  shareholders                         |       | $                                             | (1,598     | )                                            | $          | (5,366 | ) | $ | (10,764 | ) | $ | 16,529 |   |
|                                                                           |       |                                          |       |                                         |       |   |   |   |   |
| (Loss) earnings per share                                                      |       |                                          |       |                                         |       |   |   |   |   |
| Basic                                                                          |       | $                                             | (0.14      | )                                            | $          | (0.50 | ) | $ | (0.98 | ) | $ | 1.56 |   |
| Diluted                                                                        |       | $                                             | (0.14      | )                                            | $          | (0.50 | ) | $ | (0.98 | ) | $ | 1.33 |   |
|                                                                           |       |                                          |       |                                         |       |   |   |   |   |
| Weighted average number of shares used to  calculate (loss) earnings per share |       |                                          |       |                                         |       |   |   |   |   |
| Basic                                                                          |       | 11,293                                        |       | 10,682                                       |       | 10,975 |   | 10,573 |   |
| Diluted                                                                        |       | 11,293                                        |       | 10,682                                       |       | 10,975 |   | 12,912 |   |

 

*SeeAccompanying Notes.*

 

4

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***Orphan Medical, Inc.***

***Statements of Cash Flows***

***(in thousands)***

*(Unaudited)*

* *
| ** **                                                                   | ** ** | **For the Nine Months Ended  September 30,** | ** ** |
|------------------------------------------------------------------------------|------------|----------------------------------------------|------------|
| ** **                                                                   | ** ** | **2004**                                     | ** ** | **2003** | ** ** |
| Operating activities                                                         |       |                                         |       |   |   |
| Net (loss) income                                                            |       | $                                            | (10,042    | ) | $ | 17,233 |   |
| Adjustments to reconcile net loss to net  cash used in operating activities: |       |                                         |       |   |   |
| Depreciation and amortization                                                |       | 363                                          |       | 394 |   |
| Gain on divestment of products                                               |       | —                                       |       | (30,267 | ) |
| Changes in operating assets and  liabilities:                                |       |                                         |       |   |   |
| Accounts receivable and prepaid expenses                                     |       | (167                                         | )          | 596 |   |
| Inventories                                                                  |       | (100                                         | )          | 787 |   |
| Accounts payable, accrued expenses and  deferred revenue                     |       | (1,619                                       | )          | (871 | ) |
| Net cash used in operating activities                                        |       | (11,565                                      | )          | (12,128 | ) |
|                                                                         |       |                                         |       |   |   |
| Investing activities                                                         |       |                                         |       |   |   |
| Purchase of office equipment                                                 |       | (150                                         | )          | (33 | ) |
| Decrease in restricted cash                                                  |       | 3                                            |       | 124 |   |
| Net proceeds from divestment of products                                     |       | —                                       |       | 30,267 |   |
| Net cash (used in) provided by investing  activities                         |       | (147                                         | )          | 30,358 |   |
|                                                                         |       |                                         |       |   |   |
| Financing activities                                                         |       |                                         |       |   |   |
| Employee stock purchase plan                                                 |       | 44                                           |       | 35 |   |
| Stock option exercise proceeds                                               |       | 3,215                                        |       | 1,507 |   |
| Principal payments on capital lease                                          |       | (12                                          | )          | (12 | ) |
| Cash dividends                                                               |       | —                                       |       | (1 | ) |
| Net cash provided by financing activities                                    |       | 3,247                                        |       | 1,529 |   |
|                                                                         |       |                                         |       |   |   |
| (Decrease)/increase in cash and cash  equivalents                            |       | (8,465                                       | )          | 19,759 |   |
| Cash and cash equivalents at beginning of  period                            |       | 23,285                                       |       | 6,921 |   |
| Cash and cash equivalents at end of period                                   |       | $                                            | 14,820     |   | $ | 26,680 |   |

 

5

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**ORPHAN MEDICAL, INC**.

 

**NOTES TO FINANCIAL S****TATEMENTS**

**(Unaudited)**

 

**1. Basis of Presentation**

***Business***

Orphan Medical acquires,develops, and markets products of high medical value intended to treat sleepdisorders, pain and other central nervous disorders that are addressed by physicianspecialists.  A drug has high medicalvalue if it offers a major improvement in the safety or efficacy of patienttreatment and has no substantially equivalent substitute.  The Company has had six pharmaceuticalproducts approved for marketing by the United States Food and DrugAdministration (FDA).  Three productswere divested in 2003 and the Company is focusing its resources on Xyrem®(sodium oxybate) oral solution, a medication approved for cataplexy, asignificant and debilitating symptom of narcolepsy.  The Company has completed clinical trials toassess Xyrem in treating excessive daytime sleepiness and fragmented nighttimesleep, the other prominent symptoms of narcolepsy.  The Company is also evaluating Xyrem in thetreatment of fibromyalgia.  A newcompound, Butamben (butyl-p-aminobenzoate) suspension for injection, is beingevaluated for development as a treatment of pain.  The Company continues to seek other approvedor development-stage products in the specialty areas it serves.

 

***Basis of Presentation***

Theaccompanying unaudited financial statements have been prepared in accordancewith generally accepted accounting principles for interim financial informationand with the instructions to Form 10-Q and Article 10 of Regulation S-X.Accordingly, these financial statements do not include all of the informationand footnotes required by generally accepted accounting principles for completefinancial statements. In the opinion of management, all adjustments (consistingof normal, recurring accruals) considered necessary for fair presentation havebeen included. Operating results for the three month and nine month periodended September 30, 2004 are not necessarily indicative of the results that maybe expected for the year ended December 31, 2004. For further information,refer to the audited financial statements and accompanying notes contained inthe Company’s Annual Report filed on Form 10-K as amended for the year endedDecember 31, 2003.

 

**2.Divestment of products**

On June10, 2003, the Company announced the divestment of Busulfex®(busulfan) Injection to ESP Pharma, Inc. for $29.3 million plus the book valueof inventory, approximately $0.2 million. The Company announced the sale of the product Sucraid®(sacrosidase) oral solution to a specialty pharmaceutical company on May 6,2003 for $1.5 million.  The Company alsodivested a third product in the second quarter of 2003, Elliotts B Solution®for proceeds that were not material.  Proceeds from these divestments will be usedfor further development and marketing of Xyrem® (sodium oxybate)oral solution and for building a stronger presence in the sleep and centralnervous system (CNS) markets.

 

**3. Use ofEstimates**

Thepreparation of financial statements in conformity with accounting principlesgenerally accepted in the United States requires management to make estimatesand assumptions that affect the amounts reported in the financial statementsand accompanying notes. Actual results could differ from those estimates.

 

6

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**4. Stock-Based Compensation**

AtSeptember 30, 2004 the Company has a stock-based employee compensationplan.  The Company accounts for its planunder the recognition and measurement principles of Accounting Principles BoardOpinion No. 25, “Accounting for Stock Issued to Employees”, and relatedinterpretations. No stock-based compensation cost is reflected in the net lossfor the three or nine month periods ended September 30, 2004 or 2003, as alloptions granted under this plan had an exercise price equal to market value ofthe underlying common stock on the date of grant.

 

Thefollowing table illustrates the effect on net income (loss) and net income(loss) per share if the Company had applied the fair value recognitionprovisions of Statement of Financial Accounting Standards No. 123, “Accountingfor Stock-Based Compensation”, to stock-based employee compensation.

 
| ** **                                                                                                       | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|------------------------------------------------------------------------------------------------------------------|------------|---------------------------------------|------------|--------------------------------------|------------|
| **(in thousands except per share data)**                                                                         | ** ** | **2004**                              | ** ** | **2003**                             | ** ** | **2004** | ** ** | **2003** | ** ** |
|                                                                                                             |       |                                  |       |                                 |       |   |   |   |   |
| Net income (loss) as  reported                                                                                   |       | $                                     | (1,598     | )                                    | $          | (5,366 | ) | $ | (10,764 | ) | $ | 16,529 |   |
|                                                                                                             |       |                                  |       |                                 |       |   |   |   |   |
| Deduct total stock-based  employee compensation expense determined under fair value-based method for  all awards |       | (935                                  | )          | (791                                 | )          | (1,907 | ) | (2,049 | ) |
| Pro forma net income  (loss)                                                                                     |       | $                                     | (2,533     | )                                    | $          | (6,157 | ) | $ | (12,671 | ) | $ | 14,480 |   |
|                                                                                                             |       |                                  |       |                                 |       |   |   |   |   |
| Earnings (loss) per  share                                                                                       |       |                                  |       |                                 |       |   |   |   |   |
| Basic - as reported                                                                                              |       | $                                     | (0.14      | )                                    | $          | (0.50 | ) | $ | (0.98 | ) | $ | 1.56 |   |
| Basic - as pro forma                                                                                             |       | $                                     | (0.22      | )                                    | $          | (0.58 | ) | $ | (1.15 | ) | $ | 1.37 |   |
|                                                                                                             |       |                                  |       |                                 |       |   |   |   |   |
| Diluted - as reported                                                                                            |       | $                                     | (0.14      | )                                    | $          | (0.50 | ) | $ | (0.98 | ) | $ | 1.33 |   |
| Diluted - as pro forma                                                                                           |       | $                                     | (0.22      | )                                    | $          | (0.58 | ) | $ | (1.15 | ) | $ | 1.24 |   |

 

**5. Revenue Recognition**

Sales for all products except Xyrem arerecognized at the time a product is shipped to the Company’s customers and arerecorded net of reserves for discounts for prompt payment. Sales of Xyrem arerecognized at the time product is shipped from the specialty pharmacy to thepatient and are recorded net of discounts for prompt payment. Except for Xyrem,the Company is obligated to accept, for exchange, from all domestic customersproducts that have reached their expiration date, which range from three tofive years depending on the product. The Company is not obligated to acceptexchange of outdated product from its international distribution partners. TheCompany establishes a reserve for the estimated cost of the exchanges. TheCompany monitors the exchange of product and modifies its reserve as necessary.Management bases these reserves on historical experience and these estimatesare subject to change.

 

Deferred revenue represents the initialpayment received by the Company per the terms of the Company’s licenseagreement for Xyrem with Celltech Pharmaceuticals, a division of Celltech Groupplc (Celltech) which has subsequently been acquired by UCB Pharma.  Uponexpiration of the refund conditions on April 1, 2004, the Company beganrecognizing this fee over the 18 month expected regulatory review period.  The Company has recognized $0.8 million ofincome resulting from the amortization of the deferred revenue balance.

 

The Company received $1.0 million during thequarter ended March 31, 2004 as payment for the achievement of a milestone inthe license agreement. This payment is included in “Licensing and royaltyrevenue” in the Company’s Statement of Operations. Future milestone paymentsare expected to be recognized as earned.

 

7

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**6. Inventories**

Inventoriesare 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 andobsolete reserve for its products in excess of the expected demand for suchproducts.

 

| ** **                   | ** ** | **September 30, 2004** | ** ** | **December 31, 2003** | ** ** |
|------------------------------|------------|------------------------|------------|-----------------------|------------|
| Raw materials and  packaging |       | $                      | 642        |                  | $          | 690 |   |
| Finished goods               |       | 1,154                  |       | 1,006                 |       |
|                         |       | $                      | 1,796      |                  | $          | 1,696 |   |

 

**7. Earningsper Share**

Earnings per share are computed in accordancewith SFAS No. 128, “Earnings per Share”. Basic earnings (loss) per share are computed based on the weightedaverage number of common shares outstanding during the period.  Diluted earnings (loss) per share arecomputed based on the weighted average shares outstanding and the dilutiveimpact of common stock equivalents outstanding during the period.  The dilutive effect of employee stock optionsand warrants is measured using the treasury stock method.  The dilutive effect of both series ofconvertible preferred stock is computed using the “if-converted” method.  Common stock equivalents are not included inperiods where there is a loss, as they are antidilutive.  The following is a reconciliation of netincome (loss) and weighted average common shares outstanding for purposes ofcalculating basic and diluted earnings (loss) per share:

 
| ** **                                                                                         | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|----------------------------------------------------------------------------------------------------|------------|---------------------------------------|------------|--------------------------------------|------------|
| **(in thousands, except per share  data)**                                                         | ** ** | **2004**                              | ** ** | **2003**                             | ** ** | **2004** | ** ** | **2003** | ** ** |
| *Numerator*                                                                                        |       |                                  |       |                                 |       |   |   |   |   |
|                                                                                               |       |                                  |       |                                 |       |   |   |   |   |
| Numerator for basic earnings per share –  income available to common shareholders             |       | $                                     | (1,598     | )                                    | $          | (5,366 | ) | $ | (10,764 | ) | $ | 16,259 |   |
| Add back to effect assumed conversions:  Preferred stock dividends                                 |       | —                                |       | —                               |       | — |   | 704 |   |
| Numerator for diluted earnings per share                                                           |       | $                                     | (1,598     | )                                    | $          | (5,366 | ) | $ | (10,764 | ) | $ | 17,233 |   |
|                                                                                               |       |                                  |       |                                 |       |   |   |   |   |
| *Denominator*                                                                                      |       |                                  |       |                                 |       |   |   |   |   |
| Denominator for basic earnings per share –  weighted average shares                           |       | 11,293                                |       | 10,682                               |       | 10,975 |   | 10,573 |   |
|                                                                                               |       |                                  |       |                                 |       |   |   |   |   |
| Effect of dilutive securities:                                                                     |       |                                  |       |                                 |       |   |   |   |   |
| Preferred shares                                                                                   |       | —                                |       | —                               |       | — |   | 1,659 |   |
| Stock options                                                                                      |       | —                                |       | —                               |       | — |   | 423 |   |
| Warrants                                                                                           |       | —                                |       | —                               |       | — |   | 257 |   |
| Denominator for diluted earnings per share –  weighted average shares and assumed conversions |       | 11,293                                |       | 10,682                               |       | 10,975 |   | 12,912 |   |
|                                                                                               |       |                                  |       |                                 |       |   |   |   |   |
| Basic earnings per share                                                                           |       | $                                     | (0.14      | )                                    | $          | (0.50 | ) | $ | (0.98 | ) | $ | 1.56 |   |
| Diluted earnings per share                                                                         |       | $                                     | (0.14      | )                                    | $          | (0.50 | ) | $ | (0.98 | ) | $ | 1.33 |   |

 

8

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**8. Commitments**

TheCompany has various commitments under agreements with outside consultants andcontractors to provide services relating to drug development, drug acquisition,manufacturing and marketing. At September 30, 2004, the Company estimates thatit could incur approximately $6.7 million of additional expenditures insubsequent periods under existing commitments. Commitments for research anddevelopment expenditures will likely fluctuate from quarter to quarter and fromyear to year depending on, among other factors, the timing of productdevelopment and the progress of clinical development programs.

 

**9. Borrowings**

TheCompany has a line of credit facility and term loan which it amended with acommercial bank as of September 30, 2004. The line of credit facility expiresSeptember 29, 2005 and includes a borrowing base equal to 80% of eligibleaccounts receivable up to a maximum amount of $4.5 million.  The Company had the availability to borrow$1.8 million as of September 30, 2004. Certain other assets have also beenpledged as collateral for this facility. The term loan has a term of one-yearand can be used specifically for equipment purchases not to exceed $1.0million.  The interest rate for bothloans is equal to two points over the bank’s prime rate.  The Company is also subject to certain otherrequirements during the term of the agreement, including (a) minimum monthlynet tangible equity of $5.0 million plus 50 percent of the proceeds of anyequity securities or subordinated debt offering and (b) maximum monthlyoperating loss of $1.75 million for October – December 2004, $1.0 million forJanuary – June 2005, and $1.25 million for July - September 2005.  The Company was in compliance with itscovenants as of September 30, 2004. The Company had not borrowed under theseloans through September 30, 2004.

 

**10.  Reclassifications**

Aspreviously reported, the Company reclassified certain operating expenses toalign the financial statements with the Company’s current management of itsoperations.  These expenses werereclassified from General and Administrative expenses to Product Developmentand Sales and Marketing expenses.  Certainprior year balances have been reclassified in order to conform to current yearpresentation.  These reclassificationshave no impact on net loss or shareholders’ equity as previously reported.

 

9

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**Item 2****.** Management’s Discussion and Analysis of Financial Condition and Resultsof Operations

 

**Cautionary Statement**

ThisQuarterly Report on Form 10-Q contains statements that are not descriptions ofhistorical facts. The words or phrases “will likely result”, “look for”, “mayresult”, “will continue”, “is anticipated”, “expect”, “project”, or similarexpressions are intended to identify “forward-looking statements” within themeaning of the Private Securities Litigation Reform Act of 1995. Suchstatements may be forward-looking statements that are subject to risks anduncertainties. Actual results could differ materially from those currentlyanticipated due to a number of factors, including those identified in thesection of this Quarterly Report filed on Form 10-Q for the quarterly periodended September 30, 2004 titled Risk Factors.

 

**General**

Since itsinception, the activities of the Company have consisted primarily of obtainingthe rights to pharmaceutical products for developing and marketing, managingthe development of these products and preparing for and initiating thecommercial introduction of six products. The Company operates in a singlebusiness segment: pharmaceutical products. The Company has experiencedrecurring losses from operations and has generated an accumulated deficitthrough September 30, 2004 of $67.3 million. In addition, the Company expectsto incur additional losses from operations for at least for the next severalfiscal quarters.

 

**Three Months Ended September 30, 2004 vs. Three Months EndedSeptember 30, 2003**

 

Net lossapplicable to common shareholders was $1.6 million for the three months endedSeptember 30, 2004 compared to a net loss applicable to common shareholders of$5.4 million for the three months ended September 30, 2003.

 

Operatingexpenses increased over the prior year primarily due to the sales and marketingsupport of Xyrem and the ongoing development activities for Xyrem.  The following is a summary of operatingexpenses for the three months ended September 30, 2004 compared to the threemonths ended September 30, 2003:

 

| ** **         | ** ** | **Three Months Ended  September 30,** | ** ** | **Variance** | ** ** |
|--------------------|------------|---------------------------------------|------------|--------------|------------|
| **(in thousands)** | ** ** | **2004**                              | ** ** | **2003**     | ** ** | **$** | ** ** | **%** | ** ** |
| Antizol            |       | $                                     | 3,236      |         | $          | 1,582 |   | $ | 1,654 |   | 105 | % |
| Antizol-Vet        |       | 74                                    |       | 71           |       | 3 |   | 4 |   |
| Cystadane          |       | 286                                   |       | 338          |       | (52 | ) | (15 | ) |
| Xyrem              |       | 3,055                                 |       | 1,109        |       | 1,946 |   | 175 |   |
| Busulfex (1),(2)   |       | —                                |       | (111         | )          | 111 |   | (100 | ) |
| Elliotts B (1)     |       | —                                |       | —       |       | — |   | — |   |
| Sucraid (1)        |       | —                                |       | (7           | )          | 7 |   | (100 | ) |
| **Total**          |       | $                                     | 6,651      |         | $          | 2,982 |   | $ | 3,669 |   | 123 | % |

 

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*(1)**      **These products were divested during the second quarter of2003.*

*(2)**      **Foreign currency adjustment for Canadian sales prior todivestment of product.*

 

Netproduct revenues increased 123% to $6.7 million for the three months endedSeptember 30, 2004 compared to $3.0 million for the same period in the prioryear.  Sales of Xyrem were approximately$1.1 million for the quarter ended September 30, 2003 and $3.1 million for thequarter ended September 30, 2004.  Revenue from Xyrem, Antizol,and Cystadane during the three months ended September 30, 2004 increased 115percent compared to the same products in the corresponding 2003 period.

 

As ofSeptember 30, 2004 more than 1,900 physicians had written prescriptions forXyrem.  The Company continues to expectsteady growth for this product.  Thenumber of filled prescriptions in the third quarter of 2004 increased 28percent over the previous quarter.  TheCompany’s market research indicates that overall satisfaction of both patientsand physicians continues to be strong and third party reimbursement remainshigh.

 

Sales ofAntizol® (fomepizole) Injection increased approximately 105% comparedto the prior year as more hospitals with emergency rooms stock the product.  It is currently being used to treat more than two-thirds of the reportedethylene glycol and methanol poisonings in the United States.

 

Licensing and royalty revenue for the threemonths ended September 30, 2004 was $0.4 million of the amortized portion ofthe upfront payment related to the Xyrem European agreement.  The upfront payment is being amortized on astraight line basis over an 18 month period which began April 2004.

 

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Due toproduct mix, gross profit margins increased to 87% for the quarter endedSeptember 30, 2004 compared to 83% for the same period the prior year.  Cost of product revenues was $0.9 million forthe three months ended September 30, 2004 compared to $0.5 million for the sameperiod in 2003.  Cost of product revenuesas a percentage of net product revenues will fluctuate from quarter to quarterand from year to year depending on, among other factors, demand for the Company’sproducts, new product introductions and the mix of approved products shipped.

 

Productdevelopment expense was $2.9 million for both of the three month periods endedSeptember 30, 2004 and 2003.  Themajority of the spending was associated with two Xyrem Phase III(b) trials inexcessive daytime sleepiness (EDS) in narcolepsy.  The Company also announced that it has begun patientenrollment in a clinical trial designed to evaluate Xyrem in the treatment ofFibromyalgia Syndrome. The Company expects that initial data from this 150patient placebo controlled trial will be available in the second half of 2005.Trial sites are located throughout the United States and Canada withapproximately twenty participating centers. Clinical spending for trials isdependent on a number of factors, including among others, the number of humansubjects screened and enrolled in the trial, and the number of active clinicalsites.

 

Sales andmarketing expense increased 13% to $3.8 million for the three months endedSeptember 30, 2004 from $3.4 million for the three months ended September 30,2003. This increase results from the implementation of various sales andmarketing programs related to Xyrem.

 

Generaland administrative expense decreased 25% to $0.8 million for the period endedSeptember 30, 2004 compared to $1.1 million for the three months endedSeptember 30, 2003. The decrease is the result of staffing expense reductionsrelated to the product divestments in 2003.

 

Becausethe Company recorded a loss for the three months ended September 30, 2004, noincome tax expense was recorded.  Duringthe three months ended September 30, 2003, the Company recorded $0.3 million ofincome tax expense related to the gain on divestment of products.  Since the Company expects to be unprofitablefor at least the next several quarters, the Company continues to provide avaluation allowance for the entire amount of its deferred tax assets.

 

**Nine Months Ended September 30, 2004 vs. Nine Months EndedSeptember 30, 2003**

 

Net lossapplicable to common shareholders was $10.8 million for the nine months endedSeptember 30, 2004 compared to a net income applicable to common shareholdersof $16.5 million for the nine months ended September 30, 2003.  The Company divested three products in thesecond quarter of 2003 resulting in a net gain of $30.3 million.  Operating expenses increased over the prioryear primarily due to the commercialization efforts for Xyrem and the ongoingdevelopment activities for Xyrem and completion of the trials in excessivedaytime sleepiness.

 

**Product Revenue Summary**

The following is a summaryof product revenue for the nine months ended September 30, 2004 compared to thenine months ended September 30, 2003: 

 

| ** **         | ** ** | **Nine Months Ended  September 30,** | ** ** | **Variance** | ** ** |
|--------------------|------------|--------------------------------------|------------|--------------|------------|
| **(in thousands)** | ** ** | **2004**                             | ** ** | **2003**     | ** ** | **$** | ** ** | **%** | ** ** |
| Antizol            |       | $                                    | 7,748      |         | $          | 4,717 |   | $ | 3,031 |   | 64 | % |
| Antizol-Vet        |       | 198                                  |       | 190          |       | 8 |   | 4 |   |
| Cystadane          |       | 1,071                                |       | 1,003        |       | 68 |   | 7 |   |
| Xyrem              |       | 7,032                                |       | 2,466        |       | 4,566 |   | 185 |   |
| Busulfex (1)       |       | —                               |       | 3,322        |       | (3,322 | ) | (100 | ) |
| Elliotts B (1)     |       | —                               |       | 15           |       | (15 | ) | (100 | ) |
| Sucraid (1)        |       | —                               |       | 185          |       | (185 | ) | (100 | ) |
| **Total**          |       | $                                    | 16,049     |         | $          | 11,898 |   | $ | 4,151 |   | 35 | % |

 

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*(1) These products were divested during the second quarterof 2003.*

 

Revenue from Xyrem, Antizol, Antizol-Vet, andCystadane during the nine months ended September 30, 2004 increased 92 percentcompared to the same products in the corresponding 2003 period. Total reportedproduct revenues were $16.0 million, an increase of $4.2 million or 35 percentcompared to reported product revenues in the same period of 2003. Reportedproduct revenues for the nine months ended September 30, 2003 included $3.5million from products divested in 2003. Antizol increased from the prior yearas a result of increased stocking and continued

 

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penetration of the market for treatment ofpoisonings or suspected poisonings. Xyrem increased over the prior year as a result of continued growth inprescriptions and refills from the existing patient base.

 

Licensing and royalty revenue for the ninemonths ended September 30, 2004 was $1.9 million which includes a milestonepayment related to the European licensing of Xyrem and an amortized portion ofthe upfront payment for the same agreement. The upfront payment is being amortized on a straight line basis over an18 month period which commenced April 2004.

 

Grossprofit margins increased to 86% for the nine months ended September 30, 2004compared to 83% for the same period the prior year due to product mix.  Cost of product revenues increased to $2.2million for the nine months ended September 30, 2004 compared to $2.0 millionfor the same period in 2003.  Cost ofproduct revenues as a percentage of net product revenues will fluctuate fromquarter to quarter and from year to year depending on, among other factors,demand for the Company’s products, new product introductions and the mix ofapproved products shipped.

 

Productdevelopment expense increased 37% to $10.1 million in the nine months endedSeptember 30, 2004 compared to $7.4 million for nine months ended September 30,2003. The increase results from the recently completed Xyrem Phase III(b)trials.  The Company also recently announced that it has begunpatient enrollment in a clinical trial designed to evaluate Xyrem in the treatmentof Fibromyalgia Syndrome. The Company expects that initial data from this 150patient placebo controlled trial will be available in the second half of 2005.Trial sites are located throughout the United States and Canada withapproximately twenty participating centers. The Company expects developmentexpense to increase slightly in the fourth quarter given the clinical trialexpense related to Xyrem in fibromyalgia. Clinical spending for trials is dependent on a number of factors,including among others, the number of human subjects screened and enrolled inthe trial, and the number of active clinical sites.

 

Sales andmarketing expense increased 11% to $12.6 million for the nine months endedSeptember 30, 2004 from $11.4 million for the nine months ended September 30,2003. This increase results from the implementation of various selling andmarketing programs.  The Company expectssales and marketing spending for 2004 to be approximately 5% higher than theexpense in 2003 due to medical education and other programs related to EDS inNarcolepsy.

 

Generaland administrative expense decreased 18% to $3.1 million for the nine monthsended September 30, 2004 compared to $3.7 million for the nine months endedSeptember 30, 2003. Thedecrease from the prior year in general and administrative expenses was theresult of staff reductions resulting from the product divestments in the secondquarter of 2003.  General andadministrative expenses in the second half of 2004 are expected to be similarto the first half of 2004 levels.

 

Becausethe Company recorded a loss for the nine months ended September 30, 2004, noincome tax expense was recorded.  Duringthe nine months ended September 30, 2003, the Company recorded $0.5 million ofincome tax expense related to the gain on divestment of products.  Since the Company expects to be unprofitablefor at least the next several quarters, the Company continues to provide avaluation allowance for the entire amount of its deferred tax assets.

 

**Liquidity and Capital Resources**

SinceJuly 2, 1994, the effective date it was spun-off from Chronimed, Inc., theCompany has financed its operations principally from net proceeds of $90.8million from several public and private financings, interest income and productsales, including $30.3 million of net proceeds from the divestiture of productsduring the quarter ended June 30, 2003.

 

The primary sources ofcapital for the nine months ended September 30, 2004 were from productrevenues, a milestone payment from a licensing partner, and existing balancesof cash and cash equivalents.  TheCompany also had proceeds from the exercise of existing stock options of $3.2million for the nine months ended September 30, 2004.

 

In October 2003, the Company announced thatit had licensed European sales and marketing rights for Xyrem to CelltechPharmaceuticals, a division of Celltech Group plc. Celltech was subsequentlyacquired by UCB Pharma and UCB has indicated that it intends to proceed withthe licensing and marketing of Xyrem according to the previously signedagreement.  Under the terms of theagreement, UCB will be responsible for the registration, sales and marketing ofXyrem in Europe. The ten-year licensing agreement includes the use of Xyrem innarcolepsy and provides UCB with rights to negotiate in regard to otherpotential future indications including fibromyalgia syndrome. The term of thisagreement is for 10 years from the date of approval in Europe with automaticextension until UCB provides 12 month notice to Orphan Medical. The agreementmay be terminated under certain conditions including material breach ofcontract provisions prior to the ten year initial term.  Celltech made an initial payment of $2.5million to Orphan Medical in October 2003 and may make further payments up to $6million tied to product development milestones and up to $7 million tied tosales-related milestones should these milestones be met. According to the termsof the

 

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agreement, milestone payments are due within30 days of achieving the milestone.  Inaddition to the milestone payments, UCB will also pay the Company a royalty onsales of the product which is expected to begin no earlier than 2005. Duringthe first quarter of 2004, the Company received a milestone payment of $1.0million from Celltech based on the filing of the Xyrem application with theEuropean authorities, an achievement of a product development milestone.  A $1.0 million milestone payment may becomedue in the fourth quarter of 2004 or first quarter of 2005 if certainconditions are met.  The Company does notexpect another milestone payment until mid-2005 assuming the requiredconditions are met.

 

The Company used morecapital than its operations generated for the nine months ended September 30,2004. The Company expects to incur a loss from operations in 2004 and 2005,which will continue to decrease its capital reserves. The Company continues toinvest its capital in product development activities that may provideopportunities to enhance the commercial opportunities for Xyrem. The Companyhas committed $6.7 million to future product development and marketingactivities. In addition, the Company also continues to use capital to developand enhance the commercial programs for Xyrem. The Company expects that theseefforts may result in increased Xyrem revenues. The Company expects that itscurrent cash balances, cash flow from product revenues and any milestonepayments received in accordance with the terms of the Celltech agreement will besufficient to fund operations at least into the second half of 2005; however,the Company may seek additional capital in order to fund operations or shouldit decide to expand its product development programs or acquire additionalproducts.

 

On April 14, 2004, theCompany filed a “shelf” registration statement with the U.S. Securities andExchange Commission (SEC) for the registration of 4,000,000 shares of commonstock. Although we believe we have sufficient cash available for currentlyanticipated clinical trials, proceeds of any stock sales might be used foroperations, clinical trials related to products that we may acquire or developin the future or for trials related to new indications of existingproducts.  This statement was madeeffective by the SEC on September 7, 2004.

 

TheCompany has a credit facility and term loan which it amended with a commercialbank as of September 30, 2004. The credit facility expires September 29, 2005and includes a borrowing base equal to 80% of eligible accounts receivable upto a maximum amount of $4.5 million.  TheCompany had the availability to borrow $1.8 million as of September 30,2004.  Certain other assets have alsobeen pledged as collateral for this facility. The term loan has a term ofone-year and can be used specifically for equipment purchases not to exceed$1.0 million.  The interest rate for bothloans is equal to two points over the bank’s prime rate.  The Company is also subject to certain otherrequirements during the term of the agreement, including (a) minimum monthlynet tangible equity of $5.0 million plus 50 percent of the proceeds of anyequity securities or subordinated debt offering and (b) maximum monthlyoperating loss of $1.75 million for October to December 2004, $1.0 million forJanuary to June 2005, and $1.25 million for July to September 2005.  The Company was in compliance with itscovenants as of September 30, 2004. The Company had not borrowed under theseloans through September 30, 2004.

 

The Company’s commitments for outside productdevelopment and marketing spending decreased to approximately $6.7 millionat September 30, 2004 from $14.7 million at December 31, 2003. Thesecommitments are generally made for periods shorter than one year.  The decrease is principally attributable to thecompletion of the Phase III(b) clinical trials assessing Xyrem for thetreatment of EDS in narcolepsy.  This wasoffset by costs and commitments associated with the initiation of theFibromyalgia trial, which began patient enrollment in the second quarter of2004. The Company expects quarterly product development spending in the secondhalf of 2004 to be in the $3.5 million to $4.0 million range depending onpatient accession in the Fibromyalgia trial. In addition, the Company continues to assess opportunities relating tocurrent products and to new product opportunities, which, if pursued, willincrease development spending.  Due tothe dependence of this estimate on the results of the studies and othervariable components, actual results may be different than the Company’sestimates.

 

As ofSeptember 30, 2004, the Company received approximately $3.2 million from theexercise of stock options during 2004. Management believes the Company’s current cash availability, includingthe $3.2 million received to date, anticipated operating cash flows fromproduct revenues and anticipated milestone payments from Celltech will besufficient to fund its operations at least into the second half of 2005.

 

Forcontinued listing on the NASDAQ National Market, a company must satisfy anumber of requirements, which in the Company’s case include either: (1) netequity in excess of $10.0 million or (2) a market capitalization of at least$50.0 million. The Company met both the thresholds at September 30, 2004. TheCompany’s market capitalization was approximately $120.9 million as ofSeptember 30, 2004 (based on the last sale price of $10.58 and 11.4 millionshares outstanding). Althoughthe Company does not expect to be profitable in 2004 or 2005, the Companynevertheless expects to continue to meet the listing requirements for listingon the Nasdaq National Market. However, there can be no assurance that theCompany will continue to meet these requirements in the future.

 

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Inconnection with the 1998 and 1999 private placements of convertible preferredstock, the Company agreed to certain restrictions and covenants, which couldlimit its ability to obtain additional financing. Even without theserestrictions, the Company can make no assurances that additional financingopportunities will be available or, if available, on acceptable terms.

 

**Geographic Sales Information**

TheCompany tracks sales in two geographic regions, domestic and international. TheCompany has no assets outside of the United States. The following is a summaryof net product revenues by geographic region for the three month and nine monthperiods ended September 30, 2004 and 2003, respectively.

 
| ** **         | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|--------------------|------------|---------------------------------------|------------|--------------------------------------|------------|
| **(in thousands)** | ** ** | **2004**                              | ** ** | **2003**                             | ** ** | **2004** | ** ** | **2003** | ** ** |
|               |       |                                  |       |                                 |       |   |   |   |   |
| Domestic           |       | $                                     | 6,607      |                                 | $          | 2,880 |   | $ | 15,506 |   | $ | 10,643 |   |
| International      |       | 44                                    |       | 102                                  |       | 543 |   | 1,255 |   |
| Total              |       | $                                     | 6,651      |                                 | $          | 2,982 |   | $ | 16,049 |   | $ | 11,898 |   |

 

**Off-Balance Sheet Arrangements**

We do not participate intransactions or have relationships or other arrangement with an unconsolidatedentity, which include special purpose and similar entities or other off-balancesheet arrangements.

 

**RISKFACTORS**

An investment in our common stock involves anumber of risks, including among others, risks associated with companies thatoperate in the pharmaceutical industry. These risks are substantial andinherent in our operations and industry. Any investor or potential investorshould carefully consider the following information about these risks beforebuying shares of common stock.

 

**We have ahistory of losses, which we expect to continue.**

 

We have been unprofitable since our inceptionin January 1993, with the exception of 2003 due to the divestment of threeproducts. We expect operating losses at least through 2004 because anticipatedgross profits from product revenues will not offset our operating expenses andadditional spending to continue drug development activities. The amount ofthese losses may vary significantly from year-to-year and quarter-to-quarter.Our actual losses will depend on, among other factors, the timing of productdevelopment, regulatory approval, and market demand for our Food and DrugAdministration approved products. We cannot assure you that we will evergenerate sufficient product revenues to achieve profitability.

 

**We cannotbe sure that future capital will be available to meet our expected capitalrequirements.**

 

Although we believe that we have sufficientcapital to meet out current business objectives, we may need additional capitalif we expand our business plans, if business conditions change or results ofoperations are not as expected. Adequate funds for our operations, continueddevelopment, and expansion of our business plans, whether from financialmarkets or from other sources, may not be available when needed on acceptableterms, or at all. If we issue additional securities your ownership may bediluted.

 

In addition there are restrictions on ourability to raise additional capital that are part of the terms of the sales ofour preferred stock. On July 23, 1998, we completed the private sale to UBSCapital 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 ofSeries B Convertible Preferred Stock. In conjunction with the issuance of thepreferred shares, we agreed to several restrictions and covenants, and grantedcertain voting and other rights to the holders of the preferred shares. One of themost important of these restrictions is that we cannot incur additionalindebtedness, except for indebtedness secured solely by our trade receivables,until we have profitable operations, subject to certain limitations. Anotherimportant restriction is that, without the approval of a majority of thepreferred stockholders, we cannot issue additional equity securities unless theselling price per share exceeds the then conversion price of the outstandingconvertible preferred stock or the sale of equity is accomplished in a publicoffering. The present conversion price is $8.14 per share for the SeniorConvertible Preferred Stock and $6.50 for the Series B Convertible PreferredStock. These restrictions could

 

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make it more difficult and more costly for usto obtain additional capital. We cannot assure you that additional sources ofcapital will be available to us or, if available, on terms acceptable to us.

 

**PossiblePrice Volatility and Limited Liquidity of Common Stock.**

 

There is generally significant volatility inthe market prices and limited liquidity of securities of early stage companies,and particularly of early stage pharmaceutical companies. Contributing to thisvolatility are various factors and events that can affect our stock price in apositive or negative manner. These factors and events include, but are notlimited to:

•                  general national and international economicand political developments;

•                  governmental approvals, refusals to approve,regulations or actions;

•                  developments or disputes relating to patentsor proprietary rights;

•                  public concern over the safety of therapies;

•                  financial performance;

•                  fluctuations in financial performance fromperiod to period; and

•                  small float or number of shares of our stockavailable for sale and trade.

 

There is also a risk that the market valueand the liquidity of the public float for our common stock could be adverselyaffected in the event we no longer meet the Nasdaq’s requirements for continuedlisting on the National Market. For continued listing on the Nasdaq NationalMarket, a company must satisfy a number of requirements, which in our caseincludes either: (1) minimum net equity in excess of $10.0 million as reportedon Form 10-Q or Form 10-K or (2) a market capitalization of at least $50.0million. Market capitalization is defined as total outstanding sharesmultiplied by the last sales price quoted by Nasdaq. We met both criteria as ofDecember 31, 2003, however, we cannot assure you that the market capitalizationthreshold will continue to be met or that we will be able to generate adequatecapital to meet the net tangible asset requirement.

 

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

 

**There is alimited market for our products.**

 

Most orphan drugs have a potential UnitedStates market of less than $25 million annually and many address annual marketsof less than $1 million. Although we expect combined revenue from the sales ofAntizol, Cystadane, and Antizol-Vet in 2004 to be approximately $10.0 million,we believe that the total market opportunity for these three products is notlikely to exceed the $10.0 - $11.0 million range in the foreseeable future.

 

We expect revenue from Xyrem in 2004 to beapproximately $10.5 million to $11.0 million. Xyrem is indicated for thetreatment of cataplexy in narcolepsy, and, if our clinical trials in ourproduct development programs that are underway produce positive data, these datamay result in increased market opportunity for Xyrem. We cannot assure you,however, that sales of our products will be adequate to make us profitable evenif the products are accepted by medical specialists and used by patients.

 

**Wecurrently rely on the limited protection of the Orphan Drug Act for certainproducts.**

 

Since our inception, all of our products,with the exception of Antizol-Vet, have been granted orphan drug status by theFDA. 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 wecan obtain appropriate proprietary protection through patents or otherwise.Currently two of our products have orphan drug status: Xyrem with an expirationdate of July 17, 2009 and Antizol, with an expiration date of December 8, 2007for the methanol indication.

 

We are not aware of any company intending tomarket a competitive product when the orphan drug protection for Antizolexpires.

 

**UnitedStates**

Under the Orphan Drug Act, the FDA may grantorphan drug designation to drugs intended to treat a “rare disease orcondition.” 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 ourproducts.

 

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The first step in obtaining the limitedprotection under the Orphan Drug Act is acquiring the FDA’s approval of “orphandrug designation,” which must be requested before submitting a New DrugApplication (“NDA”). After the FDA grants orphan drug designation, it publishesthe generic identity of the therapeutic agent and the potential orphan usespecified in the request. Orphan drug designation does not constitute FDAapproval. In addition, orphan drug designation does not convey any advantagein, or shorten the duration of, the regulatory approval process.

 

The second step in obtaining the limitedprotection under the Orphan Drug Act is acquiring the FDA’s recognition of “orphandrug status.” The Orphan Drug Act confers orphan drug status upon the firstcompany to receive FDA approval to market a drug with “orphan drug designation”for a specific designated indication. Orphan drug status does not protectagainst another formulation or drug of materially different composition frombeing approved, with or without orphan drug status, for the same indication.FDA approval also results in United States marketing exclusivity for a periodof seven years, subject to certain limitations. Although obtaining FDA approvalto market a product with orphan drug status can be advantageous, we cannotassure you that the scope of protection or the level of marketing exclusivitywill remain in effect in the future. In addition, United States orphan drugstatus does not provide any marketing exclusivity in foreign markets. Althoughcertain foreign countries provide development and marketing benefits to orphandrugs, 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 forXyrem, Antizol, and Cystadane. Upon expiration of orphan drug status, ourproducts might be subject to competition from other pharmaceutical companies,with the exception of Xyrem which has some patent protection.

 

Even if the FDA approves an NDA for a drugwith orphan drug designation, the FDA may still approve the same drug for adifferent indication, or a molecular variation of the same drug for the sameindication. In addition, the FDA does not restrict doctors from prescribing anapproved drug for uses not approved by the FDA for that drug. Thus, a doctorcould prescribe another company’s drug for indications for which our producthas received FDA approval and orphan drug status. Significant “off label” use,that is, prescribing approved drugs for unapproved uses, could adversely affectthe marketing potential of any of our products that have received orphan drugstatus and NDA approval by FDA.

 

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

 

**Europe**

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

 

**Patents andother proprietary rights are important factors in our business.**

 

The pharmaceutical industry and theinvestment community place considerable importance and value on obtainingpatent, proprietary, and trade secret protection for new technologies, productsand processes. The patent position of pharmaceutical firms is often highlyuncertain and generally involves complex legal, technical and factualquestions. Our success depends on several issues, including, but not limited toour ability:

•                  to obtain, and enforce proprietary protectionfor our products under United States and foreign patent laws and otherintellectual property laws;

•                  to preserve the confidentiality of our tradesecrets; and

•                  to operate without infringing the proprietaryrights of third parties.

 

We evaluate the desirability of seekingpatent or other forms of protection for our products in foreign markets basedon the expected costs and relative benefits of attaining such protection. Wecannot assure you that any patents will be issued from any applications or thatany 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 haveobtained or may obtain United States or foreign patents or possess or maypossess

 

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proprietary rights relating to our products.We cannot assure you that patents now in existence or later issued to otherswill not adversely affect the development or commercialization of our products.

 

We believe that the active ingredients orcompounds in our FDA-approved products, Cystadane, Antizol, Antizol-Vet, andXyrem, are in the public domain and presently are not subject to patentprotection in the United States. We have a patent with respect to ourformulation of Xyrem oral solution and other patents pending or issued.

 

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

 

We seek to protect our proprietaryinformation and technology, in part, through confidentiality agreements andinventors’ rights agreements with our employees. We cannot assure you that theseagreements will not be breached, that we will have adequate remedies for anybreach, or that our trade secrets will not otherwise be disclosed to ordiscovered by our competitors. We also cannot assure you that our plannedactivities will not infringe patents owned by others. We could incursubstantial costs in defending infringement suits brought against us. We alsocould incur substantial costs in connection with any suits relating to mattersfor which we have agreed to indemnify our licensors or distributors. An adverseoutcome in any such litigation could have a material adverse effect on ourbusiness and prospects. In addition, we often must obtain licenses underpatents or other proprietary rights of third parties. We cannot assure you thatwe can obtain any such licenses on acceptable terms, if at all. If we cannotobtain required licenses on acceptable terms, we could encounter substantialdifficulties in developing, manufacturing or marketing one or more of ourproducts.

 

**The FDAmust agree with investigational new drug applications, including any suchapplications with respect to butamben, prior to the initiation of clinicaldevelopment programs.**

 

 Priorto the initiation of a clinical development program, companies submit aninvestigational new drug application (IND) to the FDA. If the FDA notifies thesubmitting sponsor that the IND requires additional information or is notapprovable, the potential development program may be significantly delayed orterminated. We cannot assure you that IND applications submitted by us to theFDA, including with respect to butamben if we decide to initiate a developmentprogram for this product, will proceed in a timely manner. Further, it ispossible that FDA action may result in the termination of the potentialdevelopment program. Although we do not expect to derive any revenues frombutamben prior to 2008, we cannot assure you that a termination of anypotential development program will not adversely affect the prospects of ourbusiness.

 

The Company is in the process of determininga production and manufacturing process for preclinical and clinical trialactivities that can be validated and then support commercial activities postapproval. This manufacturing process is different from the process used to manufacturebutamben injection which was on file with FDA for the previous IND. Because themanufacturing process for the product in Orphan Medical’s development programis different from the original manufacturing process in the IND, the Companywill file this data in an IND application with the FDA prior to the initiationof the clinical development program.

 

**Approvalfrom the FDA and foreign regulatory authorities must occur before any newproducts or a new indication for an existing product we may develop can becommercially sold, including butamben.**

 

Government regulation in the United Statesand abroad is a significant factor in the testing, production and marketing ofour current and future products. Each product must undergo an extensiveregulatory review process conducted by the United States Food and DrugAdministration and by comparable agencies in other countries. Appropriateapprovals must be obtained before we are able to market or promote a product.We must also receive regulatory approval for each new indication for a productprior to marketing for that indication. We cannot market any medicine we maydevelop or license as a prescription product in any jurisdiction, includingforeign countries, in which the product does not receive regulatory approval.The approval process can take many years and requires the expenditure ofadditional resources.

 

We depend on external laboratories andmedical institutions to conduct our pre-clinical and clinical analyticaltesting in compliance with good clinical and laboratory practices establishedby the FDA. The data obtained from pre-clinical and clinical testing is subjectto varying interpretations that could delay, limit or prevent regulatoryapproval. In addition, changes in FDA policy for drug approval during theperiod of development and in the requirements for regulatory review of eachsubmitted NDA could result in additional delays or outright rejection.

 

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We cannot assure you that the FDA or anyforeign regulatory authority will approve a regulatory marketing application ina timely manner, if at all, with respect to any products we develop. Generally,the FDA and foreign regulatory authorities approve only a very small percentageof newly discovered pharmaceutical compounds that enter pre-clinicaldevelopment. Moreover, even if the FDA approves a product, it may placecommercially unacceptable limitations on the uses, or “indications,” for whicha product may be marketed. This would result in additional cost and delay tothe extent that further studies are required to provide additional data onsafety or effectiveness.

 

**FDAapproval does not guarantee financial success.**

 

Four of our currently marketed products havebeen approved for marketing by regulatory authorities in the United States andelsewhere. We cannot assure you that any of our products will be commerciallysuccessful or achieve the expected financial results as a result of limitedmarkets for our products as discussed in the risk factor entitled, “There is alimited market for our products”. We may encounter unanticipated problemsrelating to the development, manufacturing, distribution and marketing of ourproducts. Some of these problems may be beyond our financial and technicalcapacity to solve. The failure to adequately address any such problems couldhave a material adverse effect on our business and our prospects. In addition,the efforts of government entities and third party payors to contain or reducethe costs of health care may adversely affect our sales and limit thecommercial success of our products.

 

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

 

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

 

**Significantgovernment regulation continues once a product is approved for sale.**

 

After a reviewing division of the FDAapproves a drug, the FDA’s Division of Drug Marketing, Advertising and Communicationmust accept such drug’s marketing claims, which are the basis for the drug’slabeling, advertising and promotion. We cannot be sure that the Division ofDrug Marketing, Advertising and Communication will accept marketing claims wepropose to the agency. The failure of the Division of Drug Marketing,Advertising and Communication to accept our proposed marketing claims couldhave a material adverse effect on our business and prospects.

 

The FDA can require that a company conduct “post-marketingadverse event surveillance programs” to monitor any side effects that occurafter the company’s drug is approved for marketing. If the surveillance programindicates unsafe side effects, the FDA may recall the product, and suspend orterminate a company’s authorization to market the product. The FDA alsoregulates the manufacturing process for an approved drug. The FDA may imposerestrictions or sanctions upon the subsequent discovery of previously unknownproblems with a product or manufacturer. One possible sanction is requiring therecall of such product from the market. The FDA must approve any change inmanufacturer as well as most changes in the manufacturing process prior toimplementation. Obtaining the FDA’s approval for a change in manufacturingprocedures or change in manufacturers is a lengthy process and could causeproduction delays and loss of sales, which would have a material adverse effecton our business and our prospects.

 

Certain foreign countries regulate the salesprice of a product after marketing approval is granted. We cannot be sure thatwe can sell our products at satisfactory prices in foreign markets even ifforeign regulatory authorities grant marketing approval.

 

**We rely onothers for product development opportunities.**

 

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

 

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pharmaceutical products, or our failure topromote and market any products successfully within an existing therapeuticarea, could have a material adverse effect on our business and our prospects.

 

We have contractual development rights tocertain compounds through various license agreements. Generally, the licensorcan unilaterally terminate these agreements for several reasons, including, butnot limited to the following reasons:

•                  for cause if we breach the contract;

•                  if we become insolvent or bankrupt;

•                  if we do not apply specified minimumresources and efforts to develop the compound under license; or

•                  if we do not achieve certain minimum royaltypayments, or in some cases, minimum sales levels.

 

We cannot assure you that we can meet allspecified requirements and avoid termination of any license agreements. Wecannot assure you that if any agreement is terminated, we will be able to enterinto similar agreements on terms as favorable as those contained in ourexisting license agreements.

 

We have invested most of our capital in thedevelopment of products already licensed to or under the control of theCompany, therefore this risk has not had a material impact on our business inthe past. As we look for additional opportunities to expand our productportfolio, this risk factor may have an adverse effect on our business.

 

**A failureby our manufacturers or suppliers to deliver product timely could adverselyaffect sales revenue.**

 

We do not have and do not currently intend toestablish any manufacturing capability for drug products. Instead, we engagethird parties to manufacture our products. Failure by parties with whom wecontract to adequately perform their responsibilities may delay the submissionof products for regulatory approval, impair our ability to deliver our productson a timely basis or otherwise adversely affect our business and our prospects.

 

The loss of either a bulk drug supplier ordrug product manufacturer would require us to obtain regulatory clearance inthe form of a “pre-approval submission” and incur validation and other costsassociated with the transfer of the bulk drug or drug product manufacturingprocess. We believe that it could take as long as two years for the FDA toapprove such a submission. Because our products are targeted to relativelysmall markets and our manufacturing production runs are small by industrystandards, we have not incurred the added costs to certify and maintainsecondary sources of supply for bulk drug substance or backup drug productmanufacturers for some products. Should we lose either a bulk drug supplier ora drug product manufacturer, we could run out of marketable product to meetmarket demands or investigational product for use in clinical trials, while wewait for the FDA approval of a new bulk drug supplier or drug productmanufacturer.

 

During the course of negotiations in theordinary course of business to renew or extend an agreement with amanufacturing vendor, on occasion, the Company’s vendors have indicated that ifprice increases cannot be successfully negotiated, their agreement may need tobe terminated. If this were to occur, we believe that there are alternatemanufacturing and supply sources that would be available both on acceptableterms and on a timely basis for our products. In addition, our agreementsgenerally require the manufacturer or supplier to continue to perform theirobligations under these agreements for at least one year, and in some cases,two years, following formal notice of termination, during which period we wouldseek to implement new manufacturing and supply relationships. However, wecannot assure you that the change of a bulk drug supplier or drug productmanufacturer and the transfer of the processes to another third party will beapproved by the FDA, and if approved, in a timely manner. Therefore, we mayexperience additional costs and delay with switching providers, which in turncould adversely affect sales revenue.

 

***Bulk Drug Supply***

 

Bulk drug substance is the active chemicalcompound used in the manufacture of our drug products. We currently have asingle supplier for the supply of bulk drug substance used in Cystadane,Antizol and Antizol-Vet. If we were to lose this company as a supplier, wewould be required to identify a new supplier for the bulk drug substance. Wealso currently use a single supplier for the supply of bulk drug substance usedin Xyrem, which is expected to account for approximately 50% of our revenue in2004. If we were to lose this company as a supplier, we would be required toidentify a new supplier.

 

***Drug Product Manufacture***

 

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

 

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manufacturer, we would be required toidentify a new manufacturer. We cannot assure you that our drug productmanufacturing arrangements with either or both of these suppliers will notchange.

 

**We cannotcontrol our contractors’ compliance with applicable regulations.**

 

The FDA defines and regulates goodmanufacturing practices to which bulk drug suppliers and drug productmanufacturers are subject. The Drug Enforcement Agency (DEA) defines andregulates the handling and reporting requirements for certain drugs which haveabuse potential, known as “scheduled drugs.” Foreign regulatory authoritiesprescribe similar rules and regulations. Our supply and manufacturingcontractors must comply with these regulatory requirements. Failure by ourcontractors to comply with FDA or DEA requirements or applicable foreignrequirements could result in significant time delays or in our inability to commercializeor continue to market a product. Either result could have a material adverseeffect on our business and prospects. Failure to comply with good manufacturingpractices or other applicable legal requirements can lead to federal seizure ofviolative products, injunctive actions brought by the federal government, orpotential criminal and civil liability for Orphan Medical, our officers, or ouremployees. This risk has not impacted us in the past and we are not aware ofany instances of noncompliance with applicable regulations that may materiallyimpact our business. We cannot assure you that we will be able to maintainrelationships either domestically or abroad with contractors whose facilitiesand procedures comply or will continue to comply with FDA or DEA requirementsor applicable foreign requirements.

 

**We have asingle distributor for three of our products: Antizol, Antizol-Vet andCystadane.**

 

We have an agreement with a singledistribution contractor to provide integrated distribution and operationsservices to support transactions between us and our wholesalers, specialtydistributors, and direct customers. The contractor currently distributesAntizol, Antizol-Vet and Cystadane. The contractor may also distribute futureproducts should those products receive marketing clearance from the FDA. Afailure by this distributor to fulfill its responsibilities might have anadverse affect on our ability to meet customer demand in a timely manner.

 

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

 

**Xyrem isclassified as a Schedule III controlled substance.**

 

We have an agreement with a specialtypharmacy to distribute Xyrem. Xyrem is classified as a Schedule III controlledsubstance and approved under Subpart H of the FDA’s review process, anddistribution is strictly controlled. The specialty pharmacy is the only sourcethrough which Xyrem can be obtained. Distribution is governed by the FDA’sSubpart H regulations and complies with the risk-management controls jointlydeveloped by Orphan Medical, the FDA, the Drug Enforcement Agency and lawenforcement agencies. Every shipment of Xyrem is subject to stringentsafeguards to ensure it reaches only individuals for whom it has beenlegitimately prescribed. Our contractor for this product also providesreimbursement management, patient assistance and information hotline servicesand specialty distribution and marketing services to physician practices withrespect to our products.

 

Our purchases of sodium oxybate, the activeingredient in Xyrem, for use in the production of Xyrem are subject to quotasthat are published and approved by the U.S. Drug Enforcement Administration.Supply disruption could result from delays in obtaining DEA approvals or thereceipt of approvals for quantities of sodium oxybate that are insufficient tomeet current or projected product demand. The quota system also limits ourability to build inventories as a method of insuring against possible supplydisruptions.

 

**We rely onforeign marketing alliances and have no assurance of foreign licensees.**

 

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

 

•      *Europe.* We have licensed the marketing anddistribution rights for Xyrem and Cystadane in Europe. If our licensees areunsuccessful in their registration and distribution efforts, we may find itdifficult to contract with other distributors for these products within Europe.Distribution of all products except Antizol is limited to “named patient” or “emergencyuse” basis until full regulatory approval is obtained. Antizol has beenapproved for use in the United Kingdom but is limited to “named patient” basisin other parts of Europe. This distribution of the Company’s products isexpected to result in a limited contribution to the Company’s revenues.

 

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•      *Australia and New Zealand.* We have licensed marketing anddistribution rights for Cystadane in Australia and New Zealand, but sales ofthese products have not been material. We do not expect sales to increase inthe near future to the point that they become material.

 

•      *Israel.* We have licensed marketing anddistribution rights for Antizol and Cystadane in Israel. Full regulatoryapproval for Cystadane was obtained in Israel in February 2000. We do not expectsuch distribution to result in material revenues.

 

•      *Canada.* We have licensed marketing anddistribution rights for Antizol in Canada. For Cystadane we have only licensedthe distribution rights in Canada. We do not expect such distribution to resultin material revenues.

 

We depend on our foreign licensees for theregulatory registration of our products in foreign countries. We cannot be surethat our licensees can obtain such registration. In addition, we cannot be surethat we will be able to negotiate commercially acceptable license agreementsfor our other products or in additional foreign countries. Furthermore, wecannot assure you that these companies will be successful in negotiatingacceptable pricing or in marketing and selling our products in their respectiveterritories.

 

**Ourproducts might be recalled.**

 

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

 

**We facelimits on price flexibility and third-party reimbursement.**

 

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

 

In the United States, we expect continuingfederal and state proposals to implement greater government control of thepricing and profitability of prescription pharmaceuticals. Cost controls, ifmandated by a government agency, could decrease, or limit, the price we receivefor our products or products we may develop in the future. We may not be ableto recover our development costs, which could be substantial. We may not beable to realize an appropriate profit margin. This could have a materialadverse effect on our business. Furthermore, federal and state regulationsgovern or influence reimbursement of health care providers for medical treatmentof certain patients. We cannot assure you that action taken by federal and/orstate governments, if any, with regard to health care reform will not have amaterial adverse effect on our business and prospects.

 

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

 

**We faceintense competition in our industry.**

 

Competition in the pharmaceutical industry isintense. Potential competitors in the United States are numerous and includepharmaceutical, chemical and biotechnology companies. Many of these companieshave substantially greater capital resources, marketing experience, researchand development staffs and facilities than we do. We seek to limit potentialsources of competition by developing products that are eligible for orphan drugstatus upon NDA approval or other forms of protection. We cannot assure you,however, that our competitors will not succeed in developing similartechnologies and products more rapidly than we can. Similarly, we cannot assureyou that these competing technologies and products will not be more effectivethan any of those that we have developed or are currently developing.

 

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**We expectrapid technological and other change to be constant in our industry.**

 

The pharmaceutical industry has experiencedrapid and significant technological change as well as structural changes, suchas those brought about by changes in heath care delivery or in productdistribution. We expect that pharmaceutical technology will continue to developand change rapidly, and our future success will depend, in large part, on ourability to develop and maintain a competitive position. Technological developmentby others may result in our products becoming obsolete before they are marketedor before we recover a significant portion of the development andcommercialization expenses incurred with respect to such products. In addition,alternative therapies, new medical treatments, or changes in the manner inwhich health care is delivered or products provided could alter existingtreatment regimes or health care practices, and thereby reduce the need for oneor more of our products, which would adversely affect our business and ourprospects.

 

**We facesubstantial product liability and insurance risks.**

 

Testing and selling health care productsentails the inherent risk of product liability claims. The cost of productliability insurance coverage has increased and is likely to continue toincrease in the future. Substantial increases in insurance premium costs inmany cases have rendered coverage economically impractical. We currently carryproduct liability coverage in the aggregate amount of $30 million for allclaims made in any policy year. Although to date we have not been the subjectof any product liability or other claims, we cannot assure you that we will beable to maintain product liability insurance on acceptable terms or that ourinsurance will provide adequate coverage against potential claims. A successfuluninsured product liability or other claim against us could have a materialadverse effect on our business and prospects.

 

**Item 3.**Quantitative and Qualitative Disclosures about Market Risk

 

There have been no material changes to the Company’s market risksince the filing of the Company’s Annual Report on Form 10-K as amended.

 

**Item 4.**Controls and Procedures

 

*Evaluation of Disclosure Controls and Procedures. *Under the supervision and with theparticipation of our management, including our Chief Executive Officer andChief Financial Officer, we evaluated the effectiveness of the design andoperation of our disclosure controls and procedures (as defined in Rule13a-15(e) under the Securities Exchange Act of 1934, as amended (the “ExchangeAct”)) as of the end of the period covered by this report.  Based upon that evaluation, the ChiefExecutive Officer and Chief Financial Officer concluded that, as of the end ofthe period covered by this report, our disclosure controls and procedures areadequately designed to ensure that information required to be disclosed by usin the reports that we file or submits under the Exchange Act is recorded,processed, summarized and reported, within the time periods specified inapplicable rules and forms.

 

*Changes in Internal Controls over Financial Reporting*.  During our third fiscal quarter, there wereno significant changes made in our internal control over financial reporting(as defined in Rule 13(a)-15(f) under the Exchange Act) that have materiallyaffected, or are reasonably likely to materially affect, our internal controlover financial reporting.

 

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**PART II****- OTHER INFORMATION**

 

**Item 1.**  Legal Proceedings

 

Not Applicable

 

**Item 2.**  Unregistered Sales ofEquity Securities and Use of Proceeds

 

Not Applicable

 

**Item 3.**  Defaults Upon SeniorSecurities

 

Not Applicable

 

**Item 4.**  Submission of Matters to aVote of Security Holders

 

Not Applicable

 

**Item 5.**  Other Information

 

Not Applicable

 

**Item 6.**   Exhibits

 
| **Exhibit  Number** | ** ** | **Description**                                                                                     |
|---------------------|------------|-----------------------------------------------------------------------------------------------------|
|                |       |                                                                                                |
| 31.1                |       | Certification of Chief Executive Officer pursuant to Section 302  of the Sarbanes-Oxley Act of 2002 |
|                |       |                                                                                                |
| 31.2                |       | Certification of Chief Financial Officer pursuant to Section 302  of the Sarbanes-Oxley Act of 2002 |
|                |       |                                                                                                |
| 32.1                |       | Certification of Chief Executive Officer pursuant to Section 906  of the Sarbanes-Oxley Act of 2002 |
|                |       |                                                                                                |
| 32.2                |       | Certification of Chief Financial Officer pursuant to Section 906  of the Sarbanes-Oxley Act of 2002 |

 

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**SIGNATURE**

 

Pursuant to the requirements of the Securities Exchange Act of1934, as amended, the Registrant has duly caused this report to be signed onits behalf by the undersigned, thereunto duly authorized.

 
|        |             | Orphan Medical, Inc.                   |   |
|-------------|------------------|----------------------------------------|--------|
|        |             | Registrant                             |   |
|        |             |                                   |   |
| Date   | November 9, 2004 |                                   | By     | /s/ Timothy G. McGrath |   |
|        |             |                                   |   |
|        |             | Timothy G McGrath                      |   |
|        |             | Chief Financial Officer                |   |
|        |             | (duly authorized officer and principal |   |
|        |             | financial officer)                     |   |
|        |             |                                   |   |
|             |                  |                                        |        |  |  |

 

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**INDEX TO EXHIBITS**

 
| **Exhibit** | ** ** |                                                                                                |   |
|-------------|------------|-----------------------------------------------------------------------------------------------------|--------|
|        |       |                                                                                                |   |
| 31.1        |       | Certification of Chief Executive Officer pursuant to Section 302  of the Sarbanes-Oxley Act of 2002 |   |
|        |       |                                                                                                |   |
| 31.2        |       | Certification of Chief Financial Officer pursuant to Section 302  of the Sarbanes-Oxley Act of 2002 |   |
|        |       |                                                                                                |   |
| 32.1        |       | Certification of Chief Executive Officer pursuant to Section 906  of the Sarbanes-Oxley Act of 2002 |   |
|        |       |                                                                                                |   |
| 32.2        |       | Certification of Chief Financial Officer pursuant to Section 906  of the Sarbanes-Oxley Act of 2002 |   |

 

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