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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, DC 20549



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FORM 10-Q



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Mark One

|x | QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES ACT OF 1934
|- | ------------------------------------------------------------------------------



FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 2004



Or



| ̈ | TRANSITION REPORT PURSUANT TO SECTION 13 OR 15 (D) OF THE SECURITIES EXCHANGE ACT OF 1934
|- | -----------------------------------------------------------------------------------------



FOR THE TRANSITION PERIOD FROM  TO



Commission File Number: 000-31255



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ISTA PHARMACEUTICALS, INC.

(Exact name of registrant as specified in its charter)



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|                                                               |  |                                  
|-------------------------------------------------------------- |  | ---------------------------------
|DELAWARE                                                       |  | 33-0511729                       
|(State or other jurisdiction of incorporation or organization) |  | (IRS Employer Identification No.)



15295 ALTON PARKWAY,
IRVINE, CA 92618

(Address of principal executive offices)



(949) 788-6000

(Registrants telephone number, including area code)



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



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



The number of shares of the
registrants common stock, $.001 par value, outstanding as of October 22, 2004 was 19,307,234.



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##### Table of Contents

TABLE OF CONTENTS



|        |  |                                                                                                                   |  |       
|------- |  | ----------------------------------------------------------------------------------------------------------------- |  | ------
|        |  |                                                                                                                   |  | PageNo
|PART I  |  | FINANCIAL INFORMATION (Unaudited)                                                                                 |  |       
|        |  |                                                                                                                  
|Item 1  |  | Condensed Consolidated Financial Statements                                                                       |  | 3     
|        |  |                                                                                                                  
|        |  | Condensed Consolidated Balance Sheets  September 30, 2004 and December 31, 2003                                  |  | 3     
|        |  |                                                                                                                  
|        |  | Condensed Consolidated Statements of Operations - Three and Nine Month Periods Ended September 30, 2004 and 2003. |  | 4     
|        |  |                                                                                                                  
|        |  | Condensed Consolidated Statements of Cash Flows - Nine Month Periods Ended September 30, 2004 and 2003.           |  | 5     
|        |  |                                                                                                                  
|        |  | Notes to Condensed Consolidated Financial Statements                                                              |  | 6     
|        |  |                                                                                                                  
|Item 2  |  | Managements Discussion and Analysis of Financial Condition and Results of Operations                             |  | 9     
|        |  |                                                                                                                  
|Item 3  |  | Quantitative and Qualitative Disclosure about Market Risk                                                         |  | 26    
|        |  |                                                                                                                  
|Item 4  |  | Controls and Procedures                                                                                           |  | 26    
|        |  |                                                                                                                  
|PART II |  | OTHER INFORMATION                                                                                                 |  | 26    
|        |  |                                                                                                                  
|Item 1  |  | Legal Proceedings                                                                                                 |  | 26    
|        |  |                                                                                                                  
|Item 4  |  | Submission of Matters to a Vote of Security Holders                                                               |  | 27    
|        |  |                                                                                                                  
|Item 5  |  | Other Information                                                                                                 |  | 27    
|        |  |                                                                                                                  
|Item 6  |  | Exhibits                                                                                                          |  | 27    
|        |  |                                                                                                                  
|        |  | Signatures                                                                                                        |  | 27    
|        |  |                                                                                                                  
|        |  | Index to Exhibits                                                                                                 |  | 28    



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##### Table of Contents

PART I FINANCIAL INFORMATION



Item 1 Condensed Consolidated Financial Statements



ISTA Pharmaceuticals, Inc.

Condensed Consolidated Balance Sheets

(in thousands, except share data)

(Unaudited)



|                                                                                                                                                                                                                            |  |                   |          |   |                  |   |          |  
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- |  | ----------------- | -------- | - | ---------------- | - | -------- | -
|                                                                                                                                                                                                                            |  | September 30,2004 |          |   | December 31,2003 |  
|ASSETS                                                                                                                                                                                                                      |  |                   |          |   |                  |   |          |  
|Current assets:                                                                                                                                                                                                             |  |                   |          |   |                  |   |          |  
|Cash and cash equivalents                                                                                                                                                                                                   |  | $                 | 11,336   |   |                  | $ | 16,988   |  
|Short-term investments                                                                                                                                                                                                      |  |                   | 31,444   |   |                  |   | 31,475   |  
|Accounts receivable, net                                                                                                                                                                                                    |  |                   | 2,120    |   |                  |   |         |  
|Inventory, net                                                                                                                                                                                                              |  |                   | 1,715    |   |                  |   |         |  
|Other current assets                                                                                                                                                                                                        |  |                   | 944      |   |                  |   | 1,035    |  
|                                                                                                                                                                                                                            |  |                   |          |   |                  |   |          |  
|Total current assets                                                                                                                                                                                                        |  |                   | 47,559   |   |                  |   | 49,498   |  
|Property and equipment, net                                                                                                                                                                                                 |  |                   | 400      |   |                  |   | 649      |  
|Deposits and other assets                                                                                                                                                                                                   |  |                   | 309      |   |                  |   | 35       |  
|                                                                                                                                                                                                                            |  |                   |          |   |                  |   |          |  
|Total Assets                                                                                                                                                                                                                |  | $                 | 48,268   |   |                  | $ | 50,182   |  
|                                                                                                                                                                                                                            |  |                   |          |   |                  |   |          |  
|LIABILITIES AND STOCKHOLDERS EQUITY                                                                                                                                                                                        |  |                   |          |   |                  |   |          |  
|Current liabilities:                                                                                                                                                                                                        |  |                   |          |   |                  |   |          |  
|Accounts payable                                                                                                                                                                                                            |  | $                 | 2,435    |   |                  | $ | 2,072    |  
|Accrued compensation and related expenses                                                                                                                                                                                   |  |                   | 1,266    |   |                  |   | 699      |  
|Accrued expenses  clinical trials                                                                                                                                                                                          |  |                   | 308      |   |                  |   | 476      |  
|Other liabilities                                                                                                                                                                                                           |  |                   | 6,866    |   |                  |   |         |  
|Other accrued expenses                                                                                                                                                                                                      |  |                   | 4,465    |   |                  |   | 2,058    |  
|                                                                                                                                                                                                                            |  |                   |          |   |                  |   |          |  
|Total current liabilities                                                                                                                                                                                                   |  |                   | 15,340   |   |                  |   | 5,305    |  
|Deferred rent                                                                                                                                                                                                               |  |                   | 2        |   |                  |   | 9        |  
|Deferred income                                                                                                                                                                                                             |  |                   | 4,236    |   |                  |   | 4,444    |  
|Long-term liabilities                                                                                                                                                                                                       |  |                   | 3,866    |   |                  |   |         |  
|Stockholders equity:                                                                                                                                                                                                       |  |                   |          |   |                  |   |          |  
|Common stock, $.001 par value; 100,000,000 shares authorized at September 30, 2004 and December 31, 2003; 19,307,234 and 17,375,439 shares
issued and outstanding at September 30, 2004 and December 31, 2003, respectively |  |                   | 19       |   |                  |   | 17       |  
|Additional paid in capital                                                                                                                                                                                                  |  |                   | 203,523  |   |                  |   | 188,621  |  
|Deferred compensation                                                                                                                                                                                                       |  |                   | (243     | ) |                  |   | (547     | )
|Accumulated other comprehensive income                                                                                                                                                                                      |  |                   | (70      | ) |                  |   | (28      | )
|Deficit accumulated                                                                                                                                                                                                         |  |                   | (178,405 | ) |                  |   | (147,639 | )
|                                                                                                                                                                                                                            |  |                   |          |   |                  |   |          |  
|Total stockholders equity                                                                                                                                                                                                  |  |                   | 24,824   |   |                  |   | 40,424   |  
|                                                                                                                                                                                                                            |  |                   |          |   |                  |   |          |  
|Total Liabilities and Stockholders Equity                                                                                                                                                                                  |  | $                 | 48,268   |   |                  | $ | 50,182   |  
|                                                                                                                                                                                                                            |  |                   |          |   |                  |   |          |  



Note: The balance sheet at December
31, 2003 has been derived from the audited financial statements at that date, but does not include all of the information and footnotes required by accounting principles generally accepted in the United States for complete financial statements.



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ISTA Pharmaceuticals, Inc.

Condensed Consolidated Statements of Operations

(In thousands, except per share amounts)

(Unaudited)



|                                                                      |  |                                 |         |   |                                |   |        |      |  |   |         |   |  |   |         |  
|--------------------------------------------------------------------- |  | ------------------------------- | ------- | - | ------------------------------ | - | ------ | ---- |  | - | ------- | - |  | - | ------- | -
|                                                                      |  | Three Months EndedSeptember 30, |         |   | Nine Months EndedSeptember 30, |  
|                                                                      |  | 2004                            |         |   | 2003                           |   |        | 2004 |  |   | 2003    |  
|Revenue:                                                              |  |                                 |         |   |                                |   |        |      |  |   |         |   |  |   |         |  
|Product sales, net                                                    |  | $                               | 1,784   |   |                                | $ |       |      |  | $ | 1,784   |   |  | $ |        |  
|License revenue                                                       |  |                                 | 69      |   |                                |   | 69     |      |  |   | 208     |   |  |   | 208     |  
|                                                                      |  |                                 |         |   |                                |   |        |      |  |   |         |   |  |   |         |  
|Total revenue                                                         |  |                                 | 1,853   |   |                                |   | 69     |      |  |   | 1,992   |   |  |   | 208     |  
|Cost of products sold                                                 |  |                                 | 639     |   |                                |   |       |      |  |   | 639     |   |  |   |        |  
|                                                                      |  |                                 |         |   |                                |   |        |      |  |   |         |   |  |   |         |  
|Gross profit margin                                                   |  |                                 | 1,214   |   |                                |   | 69     |      |  |   | 1,353   |   |  |   | 208     |  
|Operating expenses:                                                   |  |                                 |         |   |                                |   |        |      |  |   |         |   |  |   |         |  
|Research and development                                              |  |                                 | 3,502   |   |                                |   | 4,403  |      |  |   | 12,091  |   |  |   | 11,753  |  
|Selling, general and administrative                                   |  |                                 | 15,081  |   |                                |   | 1,794  |      |  |   | 20,461  |   |  |   | 6,146   |  
|                                                                      |  |                                 |         |   |                                |   |        |      |  |   |         |   |  |   |         |  
|Total operating expenses                                              |  |                                 | 18,583  |   |                                |   | 6,197  |      |  |   | 32,552  |   |  |   | 17,899  |  
|                                                                      |  |                                 |         |   |                                |   |        |      |  |   |         |   |  |   |         |  
|Loss from operations                                                  |  |                                 | (17,369 | ) |                                |   | (6,128 | )    |  |   | (31,199 | ) |  |   | (17,691 | )
|Interest income                                                       |  |                                 | 156     |   |                                |   | 66     |      |  |   | 436     |   |  |   | 275     |  
|Interest expense                                                      |  |                                 | (1      | ) |                                |   |       |      |  |   | (3      | ) |  |   | (6      | )
|                                                                      |  |                                 |         |   |                                |   |        |      |  |   |         |   |  |   |         |  
|Net loss attributable to common stockholders                          |  | $                               | (17,214 | ) |                                | $ | (6,062 | )    |  | $ | (30,766 | ) |  | $ | (17,422 | )
|                                                                      |  |                                 |         |   |                                |   |        |      |  |   |         |   |  |   |         |  
|Net loss per common share, basic and diluted                          |  | $                               | (0.93   | ) |                                | $ | (0.46  | )    |  | $ | (1.73   | ) |  | $ | (1.31   | )
|                                                                      |  |                                 |         |   |                                |   |        |      |  |   |         |   |  |   |         |  
|Shares used in computing net loss per common share, basic and diluted |  |                                 | 18,519  |   |                                |   | 13,322 |      |  |   | 17,810  |   |  |   | 13,304  |  



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ISTA Pharmaceuticals, Inc.

Condensed Consolidated Statements of Cash Flows

(In thousands, unaudited)



|                                                                                                                |  |                                |         |   |      |   |         |  
|--------------------------------------------------------------------------------------------------------------- |  | ------------------------------ | ------- | - | ---- | - | ------- | -
|                                                                                                                |  | Nine Months EndedSeptember 30, |        
|                                                                                                                |  | 2004                           |         |   | 2003 |  
|Operating Activities                                                                                            |  |                                |         |   |      |   |         |  
|Net loss attributable to common stockholders                                                                    |  | $                              | (30,766 | ) |      | $ | (17,422 | )
|Adjustments to reconcile net loss attributable to common stockholders to net cash used in operating activities: |  |                                |         |   |      |   |         |  
|Amortization of Stock-based compensation                                                                        |  |                                | 623     |   |      |   | 765     |  
|Amortization of financing costs                                                                                 |  |                                | (331    | ) |      |   |        |  
|Amortization of fair value of warrant discount and related accrued interest                                     |  |                                |        |   |      |   | (9      | )
|Depreciation and amortization                                                                                   |  |                                | 181     |   |      |   | 257     |  
|Transfer of equipment for technology                                                                            |  |                                | 214     |   |      |   |        |  
|Deferred rent                                                                                                   |  |                                | (7      | ) |      |   | 1       |  
|Deferred income                                                                                                 |  |                                | (208    | ) |      |   | (208    | )
|Changes in operating assets and liabilities:                                                                    |  |                                |         |   |      |   |         |  
|Other current assets                                                                                            |  |                                | 91      |   |      |   | (138    | )
|Accounts Receivable, net                                                                                        |  |                                | (2,120  | ) |      |   |        |  
|Inventory, net                                                                                                  |  |                                | (1,715  | ) |      |   |        |  
|Accounts payable                                                                                                |  |                                | 363     |   |      |   | 1,270   |  
|Accrued compensation and related expenses                                                                       |  |                                | 567     |   |      |   | (543    | )
|Accrued expenses - clinical trials and other accrued expenses                                                   |  |                                | 2,239   |   |      |   | (482    | )
|Other liabilities                                                                                               |  |                                | 10,732  |   |      |   |        |  
|                                                                                                                |  |                                |         |   |      |   |         |  
|Net cash used in operating activities                                                                           |  |                                | (20,137 | ) |      |   | (16,509 | )
|                                                                                                                |  |                                |         |   |      |   |         |  
|Investing Activities                                                                                            |  |                                |         |   |      |   |         |  
|Purchase of marketable investment securities                                                                    |  |                                | (10,362 | ) |      |   | (10,983 | )
|Sale of marketable investment securities                                                                        |  |                                | 10,352  |   |      |   | 4,822   |  
|Purchase of equipment                                                                                           |  |                                | (146    | ) |      |   | (88     | )
|Deposits and other assets                                                                                       |  |                                | (274    | ) |      |   |        |  
|                                                                                                                |  |                                |         |   |      |   |         |  
|Net cash used in investing activities                                                                           |  |                                | (430    | ) |      |   | (6,249  | )
|                                                                                                                |  |                                |         |   |      |   |         |  
|Financing Activities                                                                                            |  |                                |         |   |      |   |         |  
|Proceeds from exercise of stock options                                                                         |  |                                | 121     |   |      |   | 172     |  
|Proceeds from issuance of common stock                                                                          |  |                                | 14,793  |   |      |   |        |  
|                                                                                                                |  |                                |         |   |      |   |         |  
|Net cash provided by financing activities                                                                       |  |                                | 14,914  |   |      |   | 172     |  
|Effect of exchange rate changes on cash                                                                         |  |                                | 1       |   |      |   | 2       |  
|                                                                                                                |  |                                |         |   |      |   |         |  
|Decrease in cash and cash equivalents                                                                           |  |                                | (5,652  | ) |      |   | (22,584 | )
|Cash and cash equivalents at beginning of period                                                                |  |                                | 16,988  |   |      |   | 32,257  |  
|                                                                                                                |  |                                |         |   |      |   |         |  
|Cash and cash equivalents at end of period                                                                      |  | $                              | 11,336  |   |      | $ | 9,673   |  
|                                                                                                                |  |                                |         |   |      |   |         |  



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ISTA Pharmaceuticals, Inc.

Notes to Unaudited Condensed Consolidated Financial Statements

September 30, 2004



1. The Company



ISTA Pharmaceuticals, Inc. (ISTA or the Company) is a specialty pharmaceutical company focused on the commercialization and
development of unique and uniquely improved products for serious conditions of the eye. ISTA recently commercially launched in the United States its first product, Istalol (0.5% timolol maleate ophthalmic solution) for the treatment of glaucoma, and is currently preparing to commercially
launch in the United States its second product, Vitrase® (hyaluronidase for injection; lyophilized ovine) for use as a spreading agent. In addition, ISTA has two New Drug Applications, or NDAs, on file with the U.S. Food and Drug Administration, or FDA, which are Vitrase for
the treatment of vitreous hemorrhage and Xibrom(0.1% bromfenac sodium ophthalmic
solution) for the treatment of ocular inflammation, eye pain and photophobia following cataract surgery.



As of September 30, 2004, ISTA had approximately $42.8 million in cash and cash equivalents and short-term investments. ISTA incurred a net loss of $30.8
million for the nine months ended September 30, 2004 and had an accumulated deficit of $178.4 million at September 30, 2004. The ability of ISTA to continue as a going concern is dependent upon its ability to obtain additional capital and achieve
profitable operations. ISTAs ability to attain profitable operations is dependent upon the successful development of its products, approval by the FDA of its products, achieving market acceptance of such approved products and achievement of
sufficient levels of revenue to support ISTAs cost structure and growth.



ISTA believes that its current cash and cash equivalents and short-term investments will be sufficient to finance its anticipated capital and operating requirements for at least the next twelve months. If ISTA engages
in acquisitions of companies, products, or technology in order to execute its business strategy, ISTA may need to raise additional capital. ISTA may be required to raise additional capital in the future through collaborative agreements, private
investment in public equity, or PIPE, financings, and various other public or private equity or debt financings. If ISTA is required to raise additional capital in the future, there can be no assurance that the additional financing will be available
on favorable terms, or at all.



The unaudited condensed
consolidated financial statements contained in this Form 10-Q do not include any adjustments to the specific amounts and classifications of assets and liabilities that might be necessary should ISTA be unable to continue as a going concern.



2. Basis of Presentation



General



The unaudited condensed consolidated financial statements included herein have been prepared by the Company pursuant to the
rules and regulations of the U.S. Securities and Exchange Commission, or SEC. Certain information and footnote disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the United
States have been condensed or omitted pursuant to such rules and regulations. In managements opinion, the accompanying financial statements have been prepared on a basis consistent with the audited financial statements and contain adjustments,
consisting of only normal, recurring accruals, necessary to present fairly the Companys financial position and results of operations. Interim financial results are not necessarily indicative of results anticipated for the full year.



The preparation of financial statements in conformity with
accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Actual results could differ from those
estimates. The Company has eliminated all intercompany accounts and transactions in consolidation.



For further information, refer to the consolidated financial statements and footnotes thereto included in the Companys annual report on Form 10-K,
for the year ended December 31, 2003.



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3. Revenue Recognition



The Company recognizes revenue consistent with the provisions of SEC Staff Accounting Bulletin No. 104, Revenue Recognition, which sets
forth guidelines in the timing of revenue recognition based upon factors such as passage of title, installation, payments and customer acceptance. Any amounts received prior to satisfying our revenue recognition criteria will be recorded as deferred
revenue in the accompanying balance sheets.



Product
Revenue.The Company recognizes revenue from product sales when there is persuasive evidence that an arrangement exists, when title has passed, the price is fixed or determinable, and the Company is reasonably assured of collecting the resulting
receivable. The Company recognizes product revenue net of estimated allowances for discounts, returns, rebates and chargebacks. The Company is obligated to accept from customers the return of pharmaceuticals that have reached their expiration date.
The Company authorizes returns for damaged products and exchanges for expired products in accordance with its return goods policy and procedures, and had established reserves for such amounts at the time of sale. To date the Company has not
experienced any returns of damaged or expired product.



License Revenue.In December 2001, the Company began a collaboration with Otsuka Pharmaceutical Co., Ltd. under which Otsuka will be responsible for all clinical development, regulatory approvals, sales and marketing activities for
Vitrase for ophthalmic uses in the posterior segment of the eye, in Japan. The Companys principal sources of revenue from this collaboration and the commercialization of Vitrase will be the license fee received in December 2001, which is being
amortized over the Companys continuing involvement with Otsuka, milestone payments and product sales received from Otsuka. To date, the Company has not earned this milestone payment from Otsuka and it cannot guarantee that it will receive this
milestone payment in the future. Under the terms of the collaboration, the Company is responsible for the manufacture of Vitrase and supplying all of Otsukas requirements for Vitrase.



4. Inventory



Inventory at September 30, 2004 consisted of $93,000 of raw materials, $1.0 million of finished goods and $622,000 of in
transit inventory. The Company had no inventory at September 30, 2003. The Company obtained FDA approval for Vitrase in May 2004 and Istalol in June 2004. Inventory relates to both Istalol, for the treatment of glaucoma and Vitrase, 6,200 USP units
multi-purpose vial, for use as a spreading agent to facilitate the absorption and dispersion of other injected drugs.



5. Comprehensive Income (Loss)



Statement of Financial Accounting Standard, or SFAS, No. 130, Reporting Comprehensive Income, requires reporting and displaying comprehensive
income (loss) and its components, which, for ISTA, includes net loss and unrealized gains and losses on investments and foreign currency translation gains and losses. Total comprehensive loss for the nine-month period ended September 30, 2004 and
2003 was $30,808,000 and $16,870,000, respectively. In accordance with SFAS No. 130, the accumulated balance of unrealized gains (losses) on investments and the accumulated balance of foreign currency translation adjustments are disclosed as
separate components of stockholders equity.



6. Stock-Based
Compensation



As permitted by SFAS No. 123,
Accounting for Stock-Based Compensation, the Company has elected to follow Accounting Principals Board, or APB, Opinion No. 25, Accounting for Stock Issued to Employees, and related interpretations in accounting for
stock-based employee compensation. Under APB 25, if the exercise price of the Companys employee and director stock options equals or exceeds the estimated fair value of the underlying stock on the date of grant, no compensation expense is
recognized.



When the exercise price of the employee or
director stock options is less than the estimated fair value of the underlying stock on the grant date, the Company records deferred compensation for the difference and amortizes this amount to expense in accordance with Financial Accounting
Standards Board, or FASB, Interpretation No. 28, Accounting for Stock Appreciation Rights and Other Variable Stock Options or Award Plans, over the vesting period of the options.



Options or stock awards issued to non-employees are recorded at their fair
value as determined in accordance with SFAS No. 123 and Emerging Issues Task Force, or EITF, No. 96-18, Accounting for Equity Instruments That Are Issued to Other Than Employees for Acquiring or in Conjunction With Selling Goods or
Services, and recognized over the related service period. Deferred charges for options granted to non-employees are periodically re-measured as the options vest.



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As required under SFAS No. 123, Accounting for Stock-Based Compensation, and SFAS No. 148,
Accounting for Stock-Based Compensation Transition and Disclosure, the pro forma effects of stock-based compensation on net loss have been estimated at the date of grant using the Black-Scholes option-pricing model. The Black-Scholes
option valuation model was developed for use in estimating the fair value of traded options that have no vesting restrictions and are fully transferable. In addition, option valuation models require the input of highly subjective assumptions
including the expected stock price volatility. Because the Companys employee stock options have characteristics significantly different from those of traded options, and because changes in the subjective input assumptions can materially affect
the fair value estimate, in managements opinion, the existing models do not necessarily provide a reliable single measure of the fair value of its employee stock options.



In December 2002, the FASB issued SFAS No. 148, Accounting for Stock-Based CompensationTransition and
Disclosure. SFAS No. 148 is an amendment to SFAS No. 123 providing alternative methods of transition for a voluntary change to the fair value based method of accounting for stock-based employee compensation and also provides additional
disclosures about the method of accounting for stock-based employee compensation. Amendments are effective for financial statements for the Company beginning January 1, 2003. The Company has currently chosen to not adopt the voluntary change to the
fair value based method of accounting for stock-based employee compensation. If the Company should choose to adopt such a method, its implementation pursuant to SFAS No. 148 could have a material effect on the Companys consolidated financial
position and results of operations.



The fair value of these
options was estimated at the date of grant using the minimum value pricing model for grants prior to the initial public offering and the Black Scholes method for grants after the initial public offering with the following weighted average
assumptions: risk-free interest rate of 3.0%, zero dividend yield, volatility of 73%; and a weighted-average life of the option of four years.



For purposes of adjusted pro forma disclosures, the estimated fair value of the options is amortized to expense over the options vesting period. The
effect of applying SFAS No. 123 for purposes of providing pro forma disclosures is not likely to be representative of the effects on the Companys operating results for future years because changes in the subjective input assumptions can
materially affect future value estimates. Pro forma information is as follows:



|                                                                                                                |  |                   |         |   |                   |   |         |  
|--------------------------------------------------------------------------------------------------------------- |  | ----------------- | ------- | - | ----------------- | - | ------- | -
|                                                                                                                |  | Nine Months Ended |        
|                                                                                                                |  | September 30,2004 |         |   | September 30,2003 |  
|Net loss attributable to common stockholders, as reported                                                       |  | $                 | (30,766 | ) |                   | $ | (17,422 | )
|Add: Stock-based employee compensation expense included in net loss attributable to common shareholders         |  |                   | 358     |   |                   |   | 765     |  
|Deduct: Total stock-based employee compensation expense determined under fair value based method for all awards |  |                   | (1,632  | ) |                   |   | (1,053  | )
|                                                                                                                |  |                   |         |   |                   |   |         |  
|Pro forma net loss                                                                                              |  | $                 | (32,040 | ) |                   | $ | (17,710 | )
|                                                                                                                |  |                   |         |   |                   |   |         |  
|Net loss per share, basic and diluted, as reported                                                              |  | $                 | (1.73   | ) |                   | $ | (1.31   | )
|                                                                                                                |  |                   |         |   |                   |   |         |  
|Pro forma net loss per share, basic and diluted                                                                 |  | $                 | (1.80   | ) |                   | $ | (1.33   | )
|                                                                                                                |  |                   |         |   |                   |   |         |  



7. Net Loss Per Share



In accordance with SFAS No. 128, Earnings Per
Share, and SEC Staff Accounting Bulletin, or SAB, No. 98, basic net loss per common share is computed by dividing the net loss for the period by the weighted average number of common shares outstanding during the period. Under SFAS No. 128,
diluted net income (loss) per share is computed by dividing the net income (loss) for the period by the weighted average number of common and common equivalent shares, such as stock options, outstanding during the period. Such common equivalent
shares have not been included in the Companys computation of net loss per share as their effect would be anti-dilutive.



Under the provisions of SAB No. 98, common shares issued for nominal consideration, if any, would be included in the per share calculations as if they
were outstanding for all periods presented. No common shares have been issued for nominal consideration.



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8. Commitments and Contingencies



The Company is subject to routine claims and litigation incidental to its business. In the opinion of management, the
resolution of such claims is not expected to have a material adverse effect on the operating results or financial position of the Company.



Visionex



Visionex was established in 1997, under the laws of Singapore, to engage in clinical, regulatory and marketing activities. During 1997, Visionex obtained
from the Company the exclusive rights to register, import, market, sell and distribute Vitrase®and a product called Keraform®in East Asian markets, excluding Japan and
Korea, for which Visionex paid the Company $5.0 million. Prior to the Companys acquisition of Visionex (discussed below), investors who owned 66% of ISTA shares controlled 100% of Visionex shares.



On March 8, 2000, the Company acquired Visionex by entering into an agreement
with Visionex shareholders whereby the Company issued 3,319,363 shares of its Series C preferred stock, convertible into 245,879 shares of its common stock, to acquire all of the outstanding capital stock of Visionex. The Company assigned a fair
value of $11.70 per share to the 3,319,363 shares of Series C preferred stock issued to effect the acquisition, at which time the Company recorded a deemed dividend of $19.2 million to recognize the excess of the value of the shares issued over the
net assets acquired.



Under Singapore tax law, Visionex was
subject to a 15% withholding tax on a $5.0 million license that it paid to the Company in connection with a license to market, sell and distribute Vitrase®and its other corneaplasty products in certain countries in Southeast Asia. This withholding tax was waived by the Economic
Development Board, or EDB, of Singapore subject to various conditions, including a commitment that Visionex would implement a proposed project to expand its business activities in Singapore to the benefit of the local economy. The Company
substantially wound down Visionex operations in July 2002, and the proposed project was never implemented. Based upon a letter the Company received from the EDB and the Companys assessment of its obligations with the EDB, management does not
believe that the Company will be required to pay any withholding tax or related obligations in connection with the license fee. However, if the Company is required to pay this withholding tax, the Company does not believe such payment would have a
material adverse effect on the Companys business.



Item 2 Managements Discussion and Analysis of Financial Condition and Results of Operations



This Interim Report on Form 10-Q contains forward-looking statements that have been made pursuant to the provisions of the Securities Litigation Act of
1995 and concern matters that involve risks and uncertainties that could cause actual results to differ materially from those projected in the forward-looking statements. Discussions containing forward-looking statements may be found in the material
set forth under Managements Discussion and Analysis of Financial Condition and Results of Operations and in other sections of this Form 10-Q. Words such as may, will, should, could,
expect, plan, anticipate, believe, estimate, predict, potential or continue or similar words are intended to identify forward-looking statements,
although not all forward-looking statements contain these words. Although we believe that our opinions and expectations reflected in the forward-looking statements are reasonable as of the date of this Report, we cannot guarantee future results,
levels of activity, performance or achievements, and our actual results may differ materially from the views and expectations set forth in this Report. We expressly disclaim any intent or obligation to update any forward-looking statements after the
date hereof to conform such statements to actual results or to changes in our opinions or expectations.



Readers are urged to carefully review and consider the various disclosures made by us which attempt to advise interested parties of the factors which
affect our business, including without limitation Factors That May Affect Results of Operations and Financial Condition set forth in this Form 10-Q, and the audited financial statements and the notes thereto and disclosures made under
the captions, Management Discussion and Analysis of Financial Condition and Results of Operations, Risk Factors, Consolidated Financial Statements and Notes to Consolidated Financial Statements,
included in the Companys annual report on Form 10-K for the year ended December 31, 2003.



Overview



We are a
specialty pharmaceutical company focused on the commercialization and development of unique and uniquely improved products for serious conditions of the eye. We recently commercially launched in the United States our



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first product, Istalol for the treatment of glaucoma, and are currently preparing to commercially launch in the United
States our second product, Vitrase for use as a spreading agent. In addition, we have two NDAs on file with the FDA, which are for Vitrase for the treatment of vitreous hemorrhage and Xibrom for the treatment of ocular inflammation, eye pain and
photophobia following cataract surgery.



We continue to build
our commercial capabilities, including a targeted salesforce, to distribute and market our currently approved products. We estimate that approximately 10,000 ophthalmologists write the majority of the prescriptions for serious conditions of the eye,
and we believe that a targeted salesforce of 50 to 100 representatives can successfully reach this physician population. We hired four regional sales managers, and entered into a multi-year service agreement with Ventiv Health, Inc. under which they
have provide us with a dedicated nationwide specialty salesforce, which has promoted our products exclusively. Under the terms of our agreement, Ventiv Health will provide full-time sales representatives selected by and reporting to our senior sales
and marketing management team. Ventiv Health has granted us the right to hire these sales representatives for a nominal fee. We intend to leverage our commercial capabilities for our other late-stage product candidates and additional products we may
develop or acquire in the future.



We believe that the
prescription market in the United States for ophthalmic pharmaceutical products represents a significant and growing market. According to industry sources, this market had annual sales in 2003 of approximately $2.8 billion and a historic growth rate
of over 12% per year.



Our Products and Pipeline



Istalol



Istalolis a once-a-day, eye drop solution of timolol, a beta-blocking agent for the treatment of glaucoma. We received FDA approval of Istalol in June 2004 and launched Istalol in the United States during
the third quarter of 2004. In October 2004, the FDA determined that Istalol is not therapeutically equivalent (bioequivalent) to other commercially available timolol maleate solutions and granted Istalol a BT rating, which
means that prescriptions for Istalol cannot be substituted legally at pharmacies with generic timolol maleate products. Our ability to secure the benefit of the Istalol BT rating depends on a variety of factors, some of which are beyond
our control, including, among others, the timing, content and outcome of actions and decisions by the FDA and other regulatory authorities regarding Istalols BT rating and its affect on third party products.



Beta-blockers are a large group of approved medications that block specific
receptors in the central nervous system and are used in the treatment of a number of diseases including glaucoma. Timolol maleate, which is currently available from several manufacturers, is the leading beta-blocker to treat glaucoma in the United
States. In clinical trials, Istalol, given once-a-day, has shown efficacy and safety comparable to a timolol maleate solution, given twice-a-day. In addition to this dosing advantage, Istalol is formulated as an eye drop solution versus commonly
available once-a-day gel formulations of timolol, which have been known to cause blurring of patients vision. We acquired U.S. marketing rights for Istalol under a license agreement with Senju Pharmaceuticals Co., Ltd.



According to data compiled by NDC Health, we estimate the U.S. glaucoma
pharmaceutical market is approximately $1.1 billion annually. Of this market, the ophthalmic beta-blocker segment represents approximately $170 million per year, primarily at generic prices, with over 4.4 million prescriptions written annually.



Vitrase



Vitrase® is a highly purified, proprietary formulation of ovine hyaluronidase. In May 2004, the FDA approved our NDA for Vitrase, in a 6,200 USP units
multi-purpose vial, for use as a spreading agent to facilitate the absorption and dispersion of other injected drugs. During the third quarter of 2004, we filed a supplemental NDA for Vitrase for use as a spreading agent in a smaller vial size. We
believe the smaller vial size will be more convenient and cost effective for use as a spreading agent.



In October 2004, the FDA informed us that Vitrase (hyaluronidase for injection; lyophilized, ovine) for use as a spreading agent to facilitate the
dispersion and absorption of other drugs was entitled to five-year new chemical entity market exclusivity pursuant to the Federal Food, Drug and Cosmetic Act. The FDA indicated that Vitrases new chemical entity exclusivity would bar submission
to FDA of certain third party 505(b)(2) NDAs and Abbreviated New Drug Applications, or



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ANDAs, for drugs containing the same active moiety as Vitrase. The submission bar would be for five years from
Vitrases approval date (i.e., May 5, 2004) or for four years in the case of patent challenges. The FDA also said that Vitrases new chemical entity exclusivity is not a prohibition on FDAs review and approval of any 505(b)(2) NDA or
ANDA that was submitted to the agency before Vitrase was granted five-year exclusivity. Our ability to secure the benefit of the Vitrase market exclusivity depends on a variety of factors, some of which are beyond our control, including, among
others, the timing, content and outcome of actions and decisions by the FDA and other regulatory authorities regarding third party products and the impact and scope of the Vitrase market exclusivity and its affect on third party products.



We are also developing Vitrase for the treatment of vitreous
hemorrhage and diabetic retinopathy. In October 2002, we submitted a NDA for Vitrase for the treatment of vitreous hemorrhage by injection into the posterior region of the eye. On April 3, 2003, the FDA issued an approvable letter citing issues
primarily related to the sufficiency of the efficacy data submitted with this NDA. The FDA requested additional analysis of the existing data and an additional confirmatory clinical study based upon that analysis. We have submitted information to
the FDA in response to its comments contained in the approvable letter. We believe that all non-clinical issues have been resolved with the FDA, and we are continuing to assess and discuss with the FDA the clinical issues raised in the approvable
letter. Based upon these discussions, we will determine the next appropriate steps in the approval process of Vitrase for the treatment of vitreous hemorrhage. The continued development of Vitrase for the treatment of diabetic retinopathy will be
dependent upon the FDAs evaluation of the Vitrase NDA for the treatment of vitreous hemorrhage, among other factors.



Based on published reports, we believe the potential annual market opportunity for Vitrase as a spreading agent consists of the 3,000,000 ophthalmic
surgeries performed in the United States each year, of which 2,600,000 are cataract surgeries. In addition, based on data compiled for us by The Wilkerson Group, we believe that the potential annual market opportunity in the United States for
Vitrase for the treatment of vitreous hemorrhage is approximately 225,000 cases. We intend to seek a higher reimbursement price for Vitrase for the treatment of vitreous hemorrhage, and therefore we believe that this market represents a larger
market opportunity than for use as a spreading agent.



Xibrom



Xibromis a topical non-steroidal anti-inflammatory formulation of bromfenac for the treatment of ocular inflammation, eye pain and
photophobia following cataract surgery. Senju launched this product in Japan in 2000. We acquired U.S. marketing rights for Xibrom under a license agreement with Senju. We completed two pivotal Phase III clinical studies of Xibrom in the United
States and submitted a NDA in May 2004, which was accepted by the FDA in July 2004. The FDA has granted a Prescription Drug User Fee Act, or PDUFA, action date in late March 2005. In these studies, a statistically significant proportion of patients
treated with Xibrom achieved treatment success, defined as the complete absence of ocular inflammation, compared to those patients who received placebo.



Based on data compiled by NDC Health, we estimate that over 5.4 million prescriptions are written annually for topical ophthalmic anti-inflammatory agents
in the United States.



Caprogel



Caprogel®, a topical gel formulation of aminocaproic acid for treatment of hyphema, has received an orphan drug designation from the FDA. In
May 2002, we acquired worldwide marketing rights for Caprogel under a license agreement with the Eastern Virginia Medical School. We are currently conducting feasibility studies for Caprogels reformulation and commercialization. Once
completed, and if these studies yield promising results, we intend to pursue the remaining Phase III clinical development.



Based on data compiled for us by Milliman U.S.A., we believe that hyphema affects an estimated 50,000 patients per year in the United States.



Company Information



We incorporated in California in February 1992 as Advanced Corneal Systems, Inc. In March 2000, we changed our name to ISTA
Pharmaceuticals, Inc., and we reincorporated in Delaware in August 2000. Our corporate headquarters are located at 15295 Alton Parkway, Irvine, CA 92618, and our telephone number is (949) 788-6000.



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We have incurred losses since inception and had an accumulated deficit of $178.4 million through
September 30, 2004. Our losses have resulted primarily from research and development activities, including clinical trials, general and administrative expenses and a deemed dividend to our preferred shareholders. We expect to continue to incur
operating losses for the foreseeable future as we continue to conduct research, development and clinical testing activities, to seek regulatory approval for our product candidates, and to launch our approved products.



Critical Accounting Policies and Estimates



Managements discussion and analysis of financial condition and results
of operations, as well as disclosures included elsewhere in this Report are based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. Our significant
accounting policies are described in the accompanying Notes to Consolidated Financial Statements. Included within these policies are our critical accounting policies. Critical accounting policies are those policies that are most
important to the preparation of our consolidated financial statements and require managements most subjective and complex judgment due to the need to make estimates about matters that are inherently uncertain. Although we believe that our
estimates and assumptions are reasonable, actual results may differ significantly from these estimates. Changes in estimates and assumptions based upon actual results may have a material impact on our results of operations and/or financial
condition.



We believe that the critical accounting policies
that most impact the consolidated financial statements are as described below.



Revenue Recognition



Product Revenue.We recognize revenue from product sales when there is persuasive evidence that an arrangement exists, when title has passed, the price is fixed or determinable, and we are reasonably assured of collecting the
resulting receivable. We recognize product revenue net of estimated allowances for discounts, returns, rebates and chargebacks. If actual future payments for allowances for discounts, returns, rebates and chargebacks exceed the estimates we made at
the time of sale, our financial position, results of operations and cash flows would be negatively impacted. We are obligated to accept from customers the return of pharmaceuticals that have reached their expiration date. We authorize returns for
damaged products and exchanges for expired products in accordance with our return goods policy and procedures, and have established reserves for such amounts at the time of sale. Although we only recently launched our first marketed product in July
2004, to date we have not experienced any returns of damaged or expired product.



License Revenue.We recognize revenue consistent with the provisions of the Securities and Exchange Commissions Staff Accounting Bulletin No. 104 (SAB 104), Revenue Recognition, which sets
forth guidelines in the timing of revenue recognition based upon factors such as passage of title, installation, payments and customer acceptance. Amounts received for product and technology license fees under multiple-element arrangements are
deferred and recognized over the period of such services or performance if such arrangements require on-going services or performance. Amounts received for milestones are recognized upon achievement of the milestone, unless the amounts received are
creditable against royalties or we have ongoing performance obligations. Royalty revenue will be recognized upon sale of the related products, provided the royalty amounts are fixed and determinable and collection of the related receivable is
probable. Any amounts received prior to satisfying our revenue recognition criteria will be recorded as deferred revenue in the accompanying balance sheets.



Inventories



Inventory at September 30, 2004 consisted of $93,000 of raw materials, $1.0 million of finished goods and $622,000 of in transit inventory. The Company
had no inventory at September 30, 2003. We obtained FDA approval for Vitrase in May 2004 and Istalol in June 2004. Inventory relates to both Istalol, for the treatment of glaucoma and Vitrase, 6,200 USP units multi-purpose vial, for use as a
spreading agent to facilitate the absorption and dispersion of other injected drugs. Inventories are recorded at standard cost.



Income Taxes



We record a valuation allowance to reduce our deferred tax assets to the amount that is more likely than not to be realized. While we have considered
future taxable income and ongoing prudent and feasible tax planning strategies in assessing the need for the valuation allowance, in the event we were to determine that we would be able to realize our deferred tax assets in the future in excess of
its net recorded amount, an adjustment to the deferred tax asset would increase income in the period such determination was made.



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Results of Operations



The following discussion of our results of operations generally reflects our transition to a commercial-stage company with a primary focus on
ophthalmology.



Three Months Ended September 30, 2004 and 2003



Revenue & Cost of Sales.During July 2004, we
launched our first commercial product, Istalol, a once-a-day, eye drop solution of timolol, a beta-blocking agent for the treatment of glaucoma. Sales of Istalol generated net product sales of $1.8 million for the three months ended September 30,
2004. Cost of sales were $639,000 with a gross profit margin of 64% for the three months ended September 30, 2004. There were no product sales during 2003. We recognize product sales upon receipt by the customer and record reserves based upon an
estimate of returns and allowances. As a result of the launch of Istalol in July 2004, fixed distribution expenses accounted for a higher proportion of net sales in the third quarter of 2004 than we would anticipate for the product over a twelve
month period from launch. During the first eight weeks of the launch of Istalol, we made more than 8,000 sales calls and left over 100,000 free samples. We believe the significant number of free samples left during the launch of Istalol limited
Istalol prescription activity during the third quarter of 2004. We expect Istalol prescription activity to increase during future periods as physicians continue to distribute launch samples and exhaust outstanding sample supplies. In addition to
product sales, we reported other revenue of $69,000 for both the third quarter of 2004 and the third quarter of 2003, which is attributable to the recognition of the license fee payment received from Otsuka Pharmaceutical Co., Ltd. in December 2001
in connection with the license for Vitrase in Japan.



Research and development expenses.Research and development expenses for the three months ended September 30, 2004 were $3.5 million compared to $4.4 million for the three months ended September 30, 2003. Our research and development
expenses have consisted primarily of costs associated with the clinical trials of our product candidates, compensation and other expenses for research and development personnel, costs for consultants and contract research organizations and costs
related to the development of commercial manufacturing capabilities for Vitrase, Istalol and Xibrom. Research and development expenses decreased by $900,000 during the three months ended September 30, 2004 as compared to the third quarter of 2003.
This decrease is attributable to a $1.9 million reduction in research and development expenses (primarily as a result of obtaining FDA approval for Vitrase and Istalol, which resulted in the capitalization of various amounts into commercial
inventory and the completion of the Xibrom Phase III clinical study) for the third quarter of 2004 as compared to the prior period, offset by a $1.0 million milestone payment to Senju recorded in the third quarter of 2004 upon first
commercialization of Istalol. The milestone payment is payable to Senju during the fourth quarter of 2004.



Selling, general and administrative expenses.Selling, general and administrative expenses were $15.1 million for the three months ended September
30, 2004 compared to $1.8 million for the three months ended September 30, 2003. Selling, general and administrative expenses increased by $13.3 million in the third quarter of 2004 as compared to the third quarter of 2003. Of this $13.3 million
increase, $1.9 million relates to sales and marketing expenses associated with the commercial launch of our approved products, $1.4 million is due to increases in headcount, consultant costs, bonus accruals and other general corporate expenses
principally related to Board fees and compensation accruals and the remainder is attributable to a one-time $10.0 million payment to Allergan, Inc. During the third quarter of 2004, a one-time payment of $10.0 million was recorded upon entering an
agreement with Allergan pursuant to which we have reacquired all rights to market and sell Vitrase for all uses in the United States and many other markets worldwide. Allergan retains an option to commercialize Vitrase for the posterior segment of
the eye in Europe. With respect to the $10.0 million payment, we have paid Allergan $6.5 million and the remainder is payable subject to our completion of qualified financing.



Interest income.Interest income was $156,000 for the three months ended September 30, 2004 compared to $66,000 for
the three months ended September 30, 2003. The increase in interest income was primarily attributable to higher cash balances following our equity financing of $14.5 million in net proceeds completed during the third quarter of 2004.



Interest expense. Interest expense was $1,000 for the three months
ended September 30, 2004. There was no interest expense recorded for the three months ended September 30, 2003. Interest expense for the three month period ended September 30, 2004 was attributable to the interest paid on the financing of our
directors and officers insurance premiums.



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Nine Months Ended September 30, 2004 and 2003



Revenue & Cost of Sales.During July 2004, we launched our first commercial product, Istalol, a once-a-day, eye
drop solution of timolol, a beta-blocking agent for the treatment of glaucoma. Sales of Istalol generated net product sales of $1.8 million for the nine months ended September 30, 2004. Cost of sales were $639,000 with a gross profit margin of 64%
for the nine months ended September 30, 2004. There were no product sales during 2003. We recognize product sales upon receipt by customer and record reserves based upon an estimate of returns and allowances. As a result of the launch of Istalol in
July 2004, fixed distribution expenses accounted for a higher proportion of net sales in the third quarter of 2004 than we would anticipate for the product over a twelve month period from launch. During the launch of Istalol, we made more than 8,000
sales calls and left over 100,000 free samples. We believe the significant number of free samples left during the launch of Istalol limited Istalol prescription activity during the third quarter of 2004. We expect Istalol prescription activity to
increase during future periods as physicians continue to distribute launch samples and exhaust outstanding supplies. In addition to product sales, we reported other revenue of $208,000 for both the nine months ended September 30, 2004 and the nine
months ended September 30, 2003, which is attributable to the recognition of the license fee payment received from Otsuka Pharmaceutical Co., Ltd. in December 2001 in connection with the license for Vitrase in Japan.



Research and development expenses.Research and development expenses
for the nine months ended September 30, 2004 were $12.1 million compared to $11.8 million for the nine months ended September 30, 2003. Our research and development expenses have consisted primarily of costs associated with the clinical trials of
our product candidates, compensation and other expenses for research and development personnel, costs for consultants and contract research organizations and costs related to the development of commercial manufacturing capabilities for Vitrase,
Istalol and Xibrom. Research and development expenses increased by $300,000 during the nine months ended September 30, 2004 as compared to the nine months ended September 30, 2003. This increase is attributable to a $700,000 reduction in research
and development expenses (primarily as a result of obtaining FDA approval for Vitrase and Istalol, which resulted in the capitalization of various amounts into commercial inventory and the completion of the Xibrom Phase III clinical study) for the
nine months ended September 30, 2004 as compared to the prior period, offset by a $1.0 million milestone payment to Senju recorded in the third quarter of 2004 upon first commercialization of Istalol. The milestone payment is payable to Senju during
the fourth quarter of 2004.



Selling, general and
administrative expenses.Selling, general and administrative expenses were $20.5 million for the nine months ended September 30, 2004 compared to $6.1 million for the nine months ended September 30, 2003. Selling, general and administrative
expenses increased by $14.4 million during the nine months ended September 30, 2004 as compared to the nine months ended September 30, 2004. Of this $14.4 million increase, $1.9 million relates to sales and marketing expenses associated with the
commercial launch of our approved products, $2.5 million is due to increases in headcount, consultant costs, bonus accruals and other general corporate expenses principally related to Board fees and compensation accruals and the remainder is
attributable to a one-time $10.0 million payment to Allergan. During the third quarter of 2004, a one-time payment of $10.0 million was recorded upon entering an agreement with Allergan, Inc. pursuant to which we have reacquired all rights to market
and sell Vitrase for all uses in the United States and many other markets worldwide. Allergan retains an option to commercialize Vitrase for the posterior segment of the eye in Europe. With respect to the $10.0 million payment, we have paid Allergan
$6.5 million and the remainder is payable subject to our completion of qualified financing.



Interest income.Interest income was $436,000 for the nine months ended September 30, 2004 compared to $275,000 for the nine months ended September 30, 2003. The increase in interest income was primarily
attributable to higher cash balances following our equity financing of $14.5 million in net proceeds completed during the third quarter of 2004.



Interest expense.Interest expense was $3,000 for the nine months ended September 30, 2004 compared to $6,000 for the nine months ended September
30, 2003. The interest expense was primarily attributable to the financing of our directors and officers insurance premiums during both the nine months ended September 30, 2004 and 2003.



Liquidity and Capital Resources



As of September 30, 2004, we had approximately $42.8 million in cash and
equivalents and short-term investments and working capital of $32.2 million.



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We have financed our operations since inception primarily through private equity sales and the sale of
our common stock in our initial and follow-on public offerings. We received net proceeds of $10.0 million from the private sale of preferred stock in March 2000, $31.7 million from our initial public offering in August 2000, $4.0 million from the
private sale of common stock in December 2001, $5.0 million from a license fee payment in December 2001, $4.0 million from the issuance of promissory notes in September 2002, $37.3 million from our PIPE transaction in November 2002 and $35.7 million
from our follow-on public offering in November 2003. The PIPE transaction in November 2002 consisted of a private placement of 10,526,306 shares of our common stock for the aggregate purchase price of approximately $40.0 million, or $3.80 per share,
and warrants to purchase up to 1,578,946 shares of our common stock for an exercise price of $3.80 per share. The follow-on public offering in November 2003 consisted of the sale of 4,000,000 shares of our common stock for the aggregate purchase
price of $38.0 million, or $9.50 per share. On April 23, 2004, we filed a universal shelf registration statement on Form S-3 with the SEC providing for the offering from time to time of up to $75,000,000 of our securities, which may consist of
common stock, preferred stock, warrants, or debt securities. On August 6, 2004 we filed a Supplemental Prospectus under Rule 424(b)(2) for the issuance of up to 2,500,000 shares of our common stock, of which we sold 1,570,000 shares for the
aggregate purchase price of $13.3 million, or $8.50 per share, before placement agency fees and other offering expenses. On August 10, 2004 we filed an additional Supplemental Prospectus under Rule 424(b)(2) for the issuance of up to 250,000 shares
of our common stock, which we sold for an aggregate purchase price of $2.1 million, or $8.50 per share, before offering expenses.



For the nine months ended September 30, 2004, we used $20.1 million of cash for operations principally as a result of the net loss of $30.8 million
partially offset by non-cash compensation expense of $623,000, the transfer of equipment for technology of $214,000 and the change in other liabilities of $10.7 million, relative to the $10.0 million liability incurred as a result of the buy back of
U.S. marketing rights for Vitrase from Allergan. We used approximately $16.5 million of cash for operations in the nine months ended September 30, 2003.



For the nine months ended September 30, 2004, we used $430,000 of cash from investing activities, primarily due to the purchase of our short-term
investment securities. For the nine months ended September 30, 2003, we used $6.2 million of cash from investing activities, primarily due to the purchase of our short-term investment securities.



For the nine months ended September 30, 2004, we received $14.9 million from
financing activities, primarily from the issuance of 1,820,000 shares of our common stock in two separate offerings, for an aggregate purchase price of $15.5 million, or $8.50 per share, net of offering expenses. For the nine months ended September
30, 2003, we received $172,000 from financing activities, primarily from the exercise of stock options.



We may be required to raise additional capital in the future through collaborative agreements, PIPE related financings, and various other public or
private equity or debt financings. If we are required to raise additional capital in the future, there can be no assurance that the additional financing will be available on favorable terms, or at all.



We continually evaluate new opportunities for late-stage or currently
marketed complementary product candidates and, if and when appropriate, intend to pursue such opportunities through the acquisitions of companies, products, or technology and our own research and development activities. Our ability to execute on
such opportunities in some circumstances will be dependent, in part, upon our ability to raise additional capital on commercially reasonable terms. There can be no assurance that funds from these sources will be available when needed or, if
available, will be on terms favorable to us or to our stockholders. If additional funds are raised by issuing equity securities, the percentage ownership of our stockholders will be reduced, stockholders may experience additional dilution or such
equity securities may provide for rights, preferences or privileges senior to those of the holders of our common stock.



Our actual future capital requirements will depend on many factors, including the following:



| |  | activities and payments in connection with obtaining licenses for or acquisition of products including;
| | - | -------------------------------------------------------------------------------------------------------



| |  | sales and marketing activities related to our approved products and product candidates;
| | - | ---------------------------------------------------------------------------------------



| |  | the rate of progress of our research and development programs;
| | - | --------------------------------------------------------------



| |  | the results of our clinical trials and requirements to conduct additional clinical trials;
| | - | ------------------------------------------------------------------------------------------



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| |  | the time and expense necessary to obtain regulatory approvals;
| | - | --------------------------------------------------------------



| |  | our ability to establish and maintain collaborative relationships;
| | - | ------------------------------------------------------------------



| |  | competitive, technological, market and other developments; and
| | - | --------------------------------------------------------------



| |  | the success of the commercialization of our products.
| | - | -----------------------------------------------------



CAUTIONARY NOTE REGARDING FORWARD-LOOKING STATEMENTS



This Quarterly Report on Form 10-Q contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of
the Securities Exchange Act of 1934 that involve risks and uncertainties. In some cases, you can identify forward-looking statements by words like may, will, should, could, believes,
intends, expects, anticipates, plans, estimates, predicts, potential, continue and similar expressions. You should not rely on these forward-looking
statements. These forward-looking statements are subject to substantial risks, uncertainties and assumptions. Some of the factors that could cause actual results to differ materially from the forward-looking statements are described under Risk
Factors in this Report. These factors include, but are not limited to:



| |  | our ability to successfully develop, obtain regulatory approvals for and market our products;
| | - | ---------------------------------------------------------------------------------------------



| |  | our ability to generate and maintain sufficient cash resources to increase investment in our business;
| | - | ------------------------------------------------------------------------------------------------------



| |  | the contribution to our results of new product launches;
| | - | --------------------------------------------------------



| |  | the timing or results of pending or future clinical trials;
| | - | -----------------------------------------------------------



| |  | actions by the FDA and other regulatory agencies;
| | - | -------------------------------------------------



| |  | demand and market acceptance for our approved products; and
| | - | -----------------------------------------------------------



| |  | the effect of changing economic conditions.
| | - | -------------------------------------------



If one or more of these risks or uncertainties materialize, or if any underlying assumptions proves incorrect, our actual results, performance or
achievements may vary materially from future results, performance or achievements expressed or implied by these forward-looking statements. All forward-looking statements attributable to us or persons acting on our behalf are expressly qualified in
their entirety by the cautionary statements in this section. We undertake no obligation to update or revise any forward-looking statements to reflect future events or developments.



Factors that May Affect Results of Operations and Financial Condition.



Risks Related to Our Business



If we do not receive and maintain regulatory approvals for our product candidates, we, or our marketing partners, will not be able to commercialize our products,
which would substantially impair our ability to generate revenues and materially harm our business and financial condition.



Only two of our product candidates have received regulatory approval from the FDA. In May 2004, the FDA approved our NDA for Vitrase for use as a
spreading agent. In June 2004, we received FDA approval of the NDA for Istalol for the treatment of glaucoma. Approval from the FDA is necessary to manufacture and market pharmaceutical products in the United States. Many other countries including
major European countries and Japan have similar requirements.



The regulatory approval process is extensive, time-consuming and costly, and there is no guarantee that the FDA will approve additional NDAs for our product candidates, or that the timing of any such approval will be appropriate for our
product launch schedule and other business priorities, which are subject to change. We have submitted two NDAs which are currently pending before the FDA, one for Vitrase for the treatment of vitreous hemorrhage and one for Xibrom for the treatment
of ocular inflammation, eye pain and photophobia.



Although we
have received an approvable letter from the FDA with respect to our NDA for Vitrase for the treatment of vitreous hemorrhage, the FDA has requested additional analysis of the existing data and an additional confirmatory clinical study based upon
that analysis. There can be no assurances that the FDA will approve this NDA for Vitrase, even if we decide to and are successfully able to undertake the further analysis and clinical testing requested by the FDA.



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We have received FDA approval of Vitrase, in a 6,200 USP units multi purpose vial, for use as a spreading
agent, to facilitate the absorption and dispersion of other injected drugs. We have filed a supplemental NDA during the third quarter of 2004 for a smaller vial size that we believe is optimal for this use. There can be no assurances that the FDA
will approve this supplemental NDA or that the timing of any such approval will be consistent with our preparation for product launch. Failure to obtain approval of this supplemental NDA could adversely impact the commercial potential of Vitrase for
use as a spreading agent.



Clinical testing of pharmaceutical
products is also a long, expensive and uncertain process. Even if initial results of preclinical studies or clinical trial results are positive, we may obtain different results in later stages of drug development, including failure to show desired
safety and efficacy.



The clinical trials of any of our product
candidates could be unsuccessful, which would prevent us from obtaining regulatory approval and commercializing the product.



FDA approval can be delayed, limited or not granted for many reasons, including, among others:



| |  | FDA officials may not find a product candidate safe or effective to merit an approval;
| | - | --------------------------------------------------------------------------------------



| |  | FDA officials may not find that the data from preclinical testing and clinical trials justifies approval, or they may require additional studies that would make it commercially
unattractive to continue pursuit of approval;
| | - | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | the FDA might not approve the processes or facilities of our contract manufacturers or raw material suppliers or our manufacturing processes or facilities;
| | - | -----------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | the FDA may change its approval policies or adopt new regulations; and
| | - | ----------------------------------------------------------------------



| |  | the FDA may approve a product candidate for indications that are narrow or under conditions that place our product at a competitive disadvantage, which may limit our sales and
marketing activities or otherwise adversely impact the commercial potential of a product.
| | - | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



If the FDA does not approve our product candidates in a timely fashion on commercially viable terms or we terminate development of any of our product
candidates due to difficulties or delays encountered in the regulatory approval process, it will have a material adverse impact on our business and we will be dependent on the development of our other product candidates and/or our ability to
successfully acquire other products and technologies.



In
addition, we intend to market certain of our products, and perhaps have certain of our products manufactured, in foreign countries. The process of obtaining approvals in foreign countries is subject to delay and failure for similar reasons.



If our product candidates are approved by the FDA but do not gain market
acceptance, our business will suffer because we might not be able to fund future operations.



A number of factors may affect the market acceptance of our products or any other products we develop or acquire, including, among others:



| |  | the price of our products relative to other therapies for the same or similar treatments;
| | - | -----------------------------------------------------------------------------------------



| |  | the perception by patients, physicians and other members of the health care community of the effectiveness and safety of our products for their prescribed treatments;
| | - | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | our ability to fund our sales and marketing efforts; and
| | - | --------------------------------------------------------



| |  | the effectiveness of our sales and marketing efforts.
| | - | -----------------------------------------------------



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In addition, our ability to market and promote our products will be restricted to the labels approved by
the FDA. If the approved labels are restrictive, our sales and marketing efforts and market acceptance and the commercial potential of our products may be negatively affected. For example, should the market not widely accept Vitrase for usage based
on the label of the approved NDA, we may have to await approval of additional indications in order to reach the full market potential for this drug.



If our products do not gain market acceptance, we may not be able to fund future operations, including the development or acquisition of new product
candidates and/or our sales and marketing efforts for our approved products, which would cause our business to suffer.



If we are unable to sufficiently develop our sales, marketing and distribution capabilities and/or enter into agreements with third parties to perform these functions,
we will not be able to commercialize products.



We are
continuing to develop and enhance our sales, marketing and distribution capabilities. Although we have recently expanded our capabilities, our current resources in these areas are limited. In order to commercialize any products successfully, we must
continue to develop and expand substantial sales, marketing and distribution capabilities, and/or maintain our arrangements with Ventiv Health or establish other collaborations or other arrangements with third parties to perform these services. We
do not have extensive experience in these areas, and we may not be able to establish adequate in-house sales, marketing and distribution capabilities or engage and effectively manage relationships with third parties to perform any or all of such
services. To the extent that we enter into co-promotion, licensing or other third party arrangements, our product revenues and returns are likely to be lower than if we directly marketed and sold our products, and any revenues we receive will depend
upon the efforts of third parties, whose efforts may not be successful.



If
we fail to properly manage our anticipated growth, our business could suffer.



Rapid growth of our business is likely to place a significant strain on our managerial, operational and financial resources and systems. We have increased our full-time employee count from 42 as of January 1, 2004 to
61 as of September 30, 2004. To execute our anticipated growth successfully, we must attract and retain qualified personnel and manage and train them effectively. We will be dependent on our personnel and third parties to effectively manufacture,
market, sell and distribute our products. We will also depend on our personnel and third parties to successfully develop and acquire new products. Further, our anticipated growth will place additional strain on our suppliers and manufacturers,
resulting in increased need for us to carefully manage these relationships and monitor for quality assurance. Although we cannot assure you that we will, in fact, grow as we expect, if we fail to manage our growth effectively or to develop and
expand a successful commercial infrastructure to support marketing and sales of our products, our business and financial results will be materially harmed.



We have not generated any significant revenue from product sales to date, we have a history of net losses and negative cash flow, and we may need to raise additional
working capital.



In July 2004, we commenced the U.S.
commercial launch of Istalol, our first marketed product. We have not generated any significant revenue from product sales to date, and we may never generate significant revenues from product sales in the future. We have never been profitable, and
we might never become profitable. As of September 30, 2004, our accumulated deficit was $178.4 million, including a net loss of approximately $25.2 million for the year ended December 31, 2003 and a net loss of $30.8 million for the nine months
ended September 30, 2004. As of September 30, 2004, we had approximately $42.8 million in cash and cash equivalents and short-term investments and working capital of $32.2 million. We believe our current cash and cash equivalents and short-term
investments on hand will be sufficient to finance anticipated capital and operating requirements for at least the next twelve months. We anticipate, however, that our operating expenses will substantially increase from historical levels as we expand
our commercial infrastructure to launch our approved products. If we are unable to generate sufficient product revenues, we may be required to raise additional capital in the future through collaborative agreements, private investment in public
equity financings, and various other public or private equity or debt financings. If we are required to raise additional capital in the future there can be no assurance that the additional financing will be available on favorable terms, or at all.
If we fail to obtain additional capital as and when required could have a material adverse impact on our operating plan and business.



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We may be unable to execute our strategic plan to transition to a commercial-stage company, which could have a
material adverse impact on our business and financial condition.



Our strategy to transition to a commercial-stage company will be dependent upon our ability to gain additional regulatory approvals for our product candidates and market acceptance for our approved products, build a commercial
infrastructure to support multiple product launches, conduct business development efforts to further expand our late-stage product pipeline, and pursue opportunistic acquisitions of or licenses for marketed products.



We have limited sales, marketing and distribution capabilities to support the
marketing of any products, and we do not have experience in managing third-party manufacturers of any products in commercial quantities. In addition, if we acquire or obtain licenses for late-stage development products, our ability to successfully
commercialize such products will also be dependent on our ability to successfully complete development of such products, including obtaining the necessary regulatory approvals. For example, we have obtained a license for U.S. marketing rights to
Xibrom from Senju, and we have obtained a license for worldwide rights to Caprogel from the Eastern Virginia Medical School. We are also responsible for the development of both Xibrom and Caprogel.



We may not be able to identify any product acquisition opportunities or be
successful in negotiating favorable terms for any such product acquisitions. Should we be successful in acquiring or licensing any products, we will need to enhance our sales, marketing, distribution and manufacturing capabilities, each of which
will require substantial financial and management resources. Our failure to establish effective sales, marketing, distribution and manufacturing capabilities on a timely basis would adversely affect our ability to commercialize our products,
including any acquired products. If we are unable to execute our strategic plan to transition to a commercial-stage company on a timely basis, our ability to generate revenues would be substantially impaired which would materially harm our business
and financial condition.



If we have problems with our contract
manufacturers, our product development and commercialization efforts could be delayed or stopped.



We entered into a master services agreement with R.P. Scherer West, Inc., which was subsequently acquired by Cardinal Health, Inc., for the manufacture of
commercial quantities of Vitrase. We also intend to use a contract manufacturer to assist us in the development and manufacture of the new package configuration of Vitrase. We also have entered into a manufacturing services agreement with Bausch
& Lomb Incorporated for the manufacture of commercial quantities of Istalol and, if approved, Xibrom. To date, we have needed these products only in amounts sufficient for clinical trials. Before any contract manufacturer can produce commercial
quantities of a product, we must demonstrate to the FDAs satisfaction that the product source for commercial quantities is substantially equivalent to the supply of the product used in our clinical trials. Such demonstration may include the
requirement to conduct additional clinical trials. In addition, the manufacturing facilities of all of our contract manufacturers must comply with current Good Manufacturing Practice regulations, which the FDA strictly enforces. Moreover, the
facilities of the contract manufacturer must undergo and pass pre-approval inspections by the FDA before any of our products can be approved for commercial manufacture and, once approved, such facilities must maintain their compliance and good
standing with regulatory authorities. We cannot assure you that R.P. Scherer West, Bausch & Lomb, or any other manufacturer we may contract with in the future will be able, as applicable, to develop processes necessary to produce substantially
equivalent product that regulatory authorities will approve them as a manufacturer or that such facilities, once approved, will maintain their compliance and good standing with regulatory authorities. Failure to achieve or maintain any of the
foregoing could delay or stop our efforts to develop our product candidates and commercialize our products.



Our marketing partners may terminate, or fail to perform their duties under, our agreements, in which case our ability to commercialize our products may be significantly impaired.



We have entered into collaborations with Senju relating to Istalol and
Xibrom, and Allergan and Otsuka relating to Vitrase for ophthalmic uses for the posterior region of the eye. In September 2004, we entered into a new agreement with Allergan, replacing our previous Vitrase collaboration, under which we reacquired
all rights to market and sell Vitrase for all uses in the United States and many other markets worldwide. Allergan retains an option to commercialize Vitrase for the posterior segment of the eye in Europe. If Allergan exercises its option, we will
be dependent upon Allergan for the commercialization of Vitrase for such approved uses in Europe. If Allergan does not exercise its option, then such European rights will revert to ISTA, and Allergan will be paid a royalty on ISTAs European
sales of Vitrase for use in the posterior segment of the eye. We depend on Otsuka for obtaining regulatory approval of Vitrase for ophthalmic uses for the posterior



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region of the eye in Japan, and if such approval is obtained, we will be dependent upon Otsuka for the commercialization
of Vitrase for such approved uses in Japan. The amount and timing of resources that our partners dedicate to our collaborations is not within our control. Accordingly, any breach or termination of our agreements by, or disagreements with, these
collaborators could delay or stop the development and/or commercialization of our product candidates, or adversely impact our receipt of milestone payments, profit splits, royalties, and other consideration from these collaborations. Our
collaborative partners may change their strategic focus, terminate our agreements or choose not to exercise their options, on relatively short notice, or pursue alternative technologies. Our agreements with Otsuka and Senju contain reciprocal terms
providing that neither we nor they may develop products that directly compete in the same form with the products involved in the collaboration. Nonetheless, there can be no assurances that our collaborators will not develop competing products in
different forms or products that compete indirectly with our products. Accordingly, unfavorable developments relating to our strategic partners could have a significant adverse effect on us and our financial condition.



If we have problems with our sole source suppliers, our product development and
commercialization efforts for our product candidates could be delayed or stopped.



Some materials used in our products are currently obtained from a single source. Biozyme Laboratories, Ltd. is currently our only source for highly purified ovine hyaluronidase, which is the active ingredient in
Vitrase. Our supply agreement with Biozyme ends in August 2007, after which any further supply of hyaluronidase by Biozyme to us would be subject to Biozymes agreement. Commercial quantities of Vitrase will be supplied by R.P. Scherer West as
the sole source manufacturer. Both Istalol and, if approved, Xibrom will be supplied by other third party contract manufacturers.



We have not established and may not be able to establish arrangements with additional suppliers for these ingredients or products. Difficulties in our
relationship with our suppliers or delays or interruptions in such suppliers supply of our requirements could limit or stop our ability to provide sufficient quantities of our products, on a timely basis, for clinical trials and, if our
products are approved, could limit or stop commercial sales, which would have a material adverse effect on our business and financial condition. While we are currently pursuing additional sources for these products and materials, our success in
establishing such additional supply arrangements cannot be assured.



We
depend on our Chief Executive Officer, Vicente Anido, Jr., Ph.D., and other key personnel, to execute our strategic plan to transition to a commercial-stage company.



Our success largely depends on the skills, experience and efforts of our key personnel, including Chief Executive Officer,
Vicente Anido, Jr., Ph.D. We have entered into a written employment agreement with Dr. Anido that can be terminated at any time by us or by Dr. Anido. In the event Dr. Anidos employment is terminated, other than for cause or voluntarily by Dr.
Anido, Dr. Anido will receive nine months of salary as severance compensation. In the event Dr. Anidos employment is terminated after a change of control, other than for cause or voluntarily by Dr. Anido, then Dr. Anidos stock options
will immediately vest and become exercisable in full, and Dr. Anido will receive twenty-four months of salary as severance compensation. We do not maintain key person life insurance policies covering Dr. Anido. The loss of Dr. Anido, or
our failure to retain other key personnel, would jeopardize our ability to execute our strategic plan and materially harm our business.



We may have difficulty implementing in a timely manner the internal controls over financial reporting necessary to allow our management to report on the effectiveness
of our internal controls internal controls over financial reporting, and we may incur substantial costs in order to comply with the requirements of the Sarbanes-Oxley Act of 2002.



Pursuant to Section 404 of Sarbanes-Oxley, we will be required to furnish a report of managements assessment of the
effectiveness of our internal controls over financial reporting as part of our Annual Report on Form 10-K for the fiscal year ended December 31, 2004. Our registered public accountant will then be required to attest to, and report on, our
assessment. In order to issue our report, our management must document both the design for our internal controls over financial reporting and the testing processes that support managements evaluation and conclusion. There can be no assurance
that we will be able to complete the work necessary for our management to issue its management report in a timely manner, or that management will be able to report that our internal controls over financial reporting are effective.



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Risks Related to Our Industry



Compliance with the extensive government regulations to which we are subject is expensive and time consuming, and may result in the delay
or cancellation of product sales, introductions or modifications.



Extensive industry regulation has had, and will continue to have, a significant impact on our business. All pharmaceutical companies, including us, are subject to extensive, complex, costly and evolving regulation by the federal government,
principally the FDA and to a lesser extent by the U.S. Drug Enforcement Administration, or DEA, and foreign and state government agencies. The Federal Food, Drug and Cosmetic Act, the Controlled Substances Act and other domestic and foreign statutes
and regulations govern or influence the testing, manufacturing, packing, labeling, storing, record keeping, safety, approval, advertising, promotion, sale and distribution of our products. Under certain of these regulations, we and our contract
suppliers and manufacturers are subject to periodic inspection of our or their respective facilities, procedures and operations and/or the testing of our products by the FDA, the DEA and other authorities, which conduct periodic inspections to
confirm that we and our contract suppliers and manufacturers are in compliance with all applicable regulations. The FDA also conducts pre-approval and post-approval reviews and plant inspections to determine whether our systems, or our contract
suppliers and manufacturers processes, are in compliance with cGMP and other FDA regulations.



In addition, the FDA imposes a number of complex regulatory requirements on entities that advertise and promote pharmaceuticals, including, but not
limited to, standards and regulations for direct-to-consumer advertising, off-label promotion, industry sponsored scientific and educational activities, and promotional activities involving the Internet.



We are dependent on receiving FDA and other governmental approvals prior to
manufacturing, marketing and shipping our products. Consequently, there is always a risk that the FDA or other applicable governmental authorities will not approve our products, or will take post-approval action limiting, modifying or revoking our
ability to sell our products, or that the rate, timing and cost of such approvals will adversely affect our product introduction plans or results of operations.



Our suppliers and manufacturers are subject to regulation by the FDA and other agencies, and if they do not meet their commitments, we would have to find substitute
suppliers or manufacturers, which could delay or prevent the supply of our products to market.



Regulatory requirements applicable to pharmaceutical products make the substitution of suppliers and manufacturers costly and time consuming. We have no
internal manufacturing capabilities and are, and expect to be in the future, entirely dependent on contract manufacturers and suppliers for the manufacture of our products and for their active and other ingredients. The disqualification of these
suppliers through their failure to comply with regulatory requirements could negatively impact our business because the delays and costs in obtaining and qualifying alternate suppliers (if such alternative suppliers are available, which we cannot
assure) could delay clinical trials or otherwise inhibit our ability to bring approved products to market or could result in a delay or disruption in the manufacture, marketing or sales of our products, which would have a material adverse affect on
our business and financial condition.



We may be required to initiate or
defend against legal proceedings related to intellectual property rights, which may result in substantial expense, delay and/or cessation of our development and commercialization of our products.



We rely on patents to protect our intellectual property rights. The strength
of this protection, however, is uncertain. For example, it is not certain that:



| |  | our patents and pending patent applications cover products and/or technology that we invented first;
| | - | ----------------------------------------------------------------------------------------------------



| |  | we were the first to file patent applications for these inventions;
| | - | -------------------------------------------------------------------



| |  | others will not independently develop similar or alternative technologies or duplicate our technologies;
| | - | --------------------------------------------------------------------------------------------------------



| |  | any of our pending patent applications will result in issued patents; and
| | - | -------------------------------------------------------------------------



| |  | any of our issued patents, or pending patent applications that result in issued patents, will be held valid and infringed in the event the patents are asserted against others.
| | - | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



We currently own or license 33 U.S. and foreign
patents and 44 U.S. and foreign pending patent applications. There can be no assurance that our existing patents, or any patents issued to us as a result of such applications, will provide a basis for commercially viable products, will provide us
with any competitive advantages, or will not face third-party challenges or be the subject of further proceedings limiting their scope or enforceability. We may become involved in interference proceedings in the U.S. Patent and Trademark Office to
determine the priority of our inventions. In addition, costly litigation could be necessary to protect our patent position. We license patents held by the Eastern Virginia Medical School for



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Caprogel and Senju for Istalol and Xibrom. Some of these license agreements do not permit us to control the prosecution,
maintenance, protection and defense of such patents. If the licensor chooses not to protect its own patent rights, we may not be able to take actions to secure our related product marketing rights. In addition, if such patent licenses are terminated
before the expiration of the licensed patents, we may no longer be able to continue to manufacture and sell such products as may be covered by the patents.



We also rely on trademarks to protect the names of our products. These trademarks may be challenged by others. If we enforce our trademarks against third
parties, such enforcement proceedings may be expensive. We have exclusively licensed the trademark Vitrase to Allergan under our collaboration agreement. Some of our other trademarks, including Caprogel and Xibrom, are owned by or assignable to our
licensors Eastern Virginia Medical School and Senju, and upon expiration or termination of the license agreements, we may no longer be able to use these trademarks.



We also rely on trade secrets, unpatented proprietary know-how and continuing technological innovation that we seek to
protect with confidentiality agreements with employees, consultants and others with whom we discuss our business. Disputes may arise concerning the ownership of intellectual property or the applicability or enforceability of these agreements, and we
might not be able to resolve these disputes in our favor.



In
addition to protecting our own intellectual property rights, third parties may assert patent, trademark or copyright infringement or other intellectual property claims against us based on what they believe are their own intellectual property rights.
We may be required to pay substantial damages, including but not limited to treble damages, for past infringement if it is ultimately determined that our products infringe a third partys intellectual property rights. Even if infringement
claims against us are without merit, defending a lawsuit takes significant time, may be expensive and may divert managements attention from other business concerns. Further, we may be stopped from developing, manufacturing or selling our
products until we obtain a license from the owner of the relevant technology or other intellectual property rights. If such a license is available at all, it may require us to pay substantial royalties or other fees.



If third-party reimbursement is not available, our products may not be accepted in the
market.



Our ability to earn sufficient returns on our
products will depend in part on the extent to which reimbursement for our products and related treatments will be available from government health administration authorities, private health insurers, managed care organizations and other healthcare
providers.



Third-party payers are increasingly attempting to
limit both the coverage and the level of reimbursement of new drug products to contain costs. Consequently, significant uncertainty exists as to the reimbursement status of newly approved healthcare products. Third-party payers may not establish
adequate levels of reimbursement for any of our approved products or products we develop or acquire in the future, which could limit their market acceptance and result in a material adverse effect on our financial condition.



The rising cost of healthcare and related pharmaceutical product pricing has lead to
cost-containment pressures that could cause us to sell our products at lower prices, resulting in less revenue to us.



Any of our products that have been or in the future are approved by the FDA may be purchased or reimbursed by state and federal government authorities,
private health insurers and other organizations, such as health maintenance organizations and managed care organizations. Third party payors increasingly challenge pharmaceutical product pricing. The trend toward managed healthcare in the United
States, the growth of such organizations, and various legislative proposals and enactments to reform healthcare and government insurance programs, including the Medicare Prescription Drug Modernization Act of 2003, could significantly influence the
manner in which pharmaceutical products are prescribed and purchased, resulting in lower prices and/or a reduction in demand. Such cost containment measures and healthcare reforms could adversely affect our ability to sell our products. Furthermore,
individual states have become increasingly aggressive in passing legislation and implementing regulations designed to control pharmaceutical product pricing, including price or patient reimbursement constraints, discounts, restrictions on certain
product access, importation from other countries and bulk purchasing. Legally mandated price controls on payment amounts by third party payors or other restrictions could negatively and materially impact our revenues and financial condition. We
anticipate that we will encounter similar regulatory and legislative issues in most other countries outside the United States.



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We face intense competition and rapid technological change that could result in the development of products by others
that are superior to the products we are developing.



We
have numerous competitors in the United States and abroad, including, among others, major pharmaceutical and specialized biotechnology firms, universities and other research institutions that may be developing competing products. Such competitors
may include Allergan, Alcon Laboratories, Inc., Bausch & Lomb, Novartis AG, Pfizer, Inc. and Eli Lilly and Company. These competitors may develop technologies and products that are more effective or less costly than our current or future
products or product candidates or that could render our technologies, products and product candidates obsolete or noncompetitive. Many of these competitors have substantially more resources and product development, manufacturing and marketing
experience and capabilities than we do. Many of our competitors also have more resources committed to and expertise in effectively commercializing, marketing, and promoting products approved by the FDA, including communicating the effectiveness,
safety and value of the products to actual and prospective customers and medical professionals. In addition, many of our competitors have significantly greater experience than we do in undertaking preclinical testing and clinical trials of
pharmaceutical product candidates and obtaining FDA and other regulatory approvals of products and therapies for use in healthcare.



We are exposed to product liability claims, and insurance against these claims may not be available to us on reasonable terms or at all.



The design, development, manufacture and sale of our products involve an
inherent risk of product liability claims by consumers and other third parties. As a commercial company, we have begun to market, and promote our approved products, like Vitrase for use as a spreading agent and Istalol, and we may be subject to
various product liability claims. In addition, we may in the future recall or issue field corrections related to our products due to manufacturing deficiencies, labeling errors or other safety or regulatory reasons. We cannot assure you that we will
not experience material losses due to product liability claims, product recalls or corrections. These events, among others, could result in additional regulatory controls, such as the performance of costly post-approval clinical studies or revisions
to our approved labeling that could limit the indications or patient population for our products or could even lead to the withdrawal of a product from the market. Furthermore, any adverse publicity associated with such an event could cause
consumers to seek alternatives to our products, which may cause our sales to decline, even if our products are ultimately determined not to have been the primary cause of the event.



We currently maintain sold products and clinical trial liability insurance with per occurrence and aggregate coverage limits
of $10 million. The coverage limits of our insurance policies may be inadequate to protect us from any liabilities we might incur in connection with clinical trials or the sale of our products. Product liability insurance is expensive and in the
future may not be available on commercially acceptable terms, or at all. A successful claim or claims brought against us in excess of our insurance coverage could materially harm our business and financial condition.



Risks Related to Our Stock



Our stock price is subject to significant volatility.



Since 2001 until the present, the daily closing price per share of our
common stock has ranged from a high of $133.75 per share to a low of $2.60 per share, as adjusted for the 1-for-10 reverse stock split effected November 2002. Our stock price has been and may continue to be subject to significant volatility. The
following factors, in addition to other risks and uncertainties described in this section may cause the market price of our common stock to fall:



| |  | the scope, outcome and timeliness of any governmental, court or other regulatory action that may involve us, including, without limitation, the scope, outcome or timeliness of any
inspection or other action of the FDA;
| | - | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | market acceptance and demand for our approved products;
| | - | -------------------------------------------------------



| |  | the availability to us, on commercially reasonable terms or at all, of third-party sourced products and materials;
| | - | ------------------------------------------------------------------------------------------------------------------



| |  | timely and successful implementation of our strategic initiatives, including the expansion of our commercial infrastructure to support the marketing and sale of our products;
| | - | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



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| |  | developments concerning proprietary rights, including the ability of third parties to assert patents or other intellectual property rights against us which, among other things,
could cause a delay or disruption in the development, manufacture, marketing or sale of our products;
| | - | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | competitors publicity regarding actual or potential products under development or new commercial products, and the impact of competitive products and pricing;
| | - | ---------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | period-to-period fluctuations in our financial results;
| | - | -------------------------------------------------------



| |  | public concern as to the safety of new technologies;
| | - | ----------------------------------------------------



| |  | future sales of debt or equity securities by us;
| | - | ------------------------------------------------



| |  | sales of our securities by our directors, officers or significant shareholders;
| | - | -------------------------------------------------------------------------------



| |  | comments made by securities analysts; or
| | - | ----------------------------------------



| |  | economic and other external factors, including disasters and other crises.
| | - | --------------------------------------------------------------------------



We participate in a highly dynamic industry, which often results in significant volatility in the market price of our common stock irrespective of company
performance. Fluctuations in the price of our common stock may be exacerbated by conditions in the healthcare and technology industry segments or conditions in the financial markets generally.



Trading in our stock over the last 12 months has been limited, so investors may not be
able to sell as much stock as they want at prevailing prices.



The average daily trading volume in our common stock for the twelve-month period ended September 30, 2004 was approximately 65,942 shares and the average daily number of transactions was approximately 175 for the same period. If limited
trading in our stock continues, it may be difficult for investors to sell their shares in the public market at any given time at prevailing prices.



Future sales of shares of our common stock may negatively affect our stock price.



As a result of our bridge financing in September 2002, our PIPE financing transaction in November 2002, and our follow-on
public offering in November 2003, we issued approximately 15.6 million shares of our common stock. The shares of common stock issued in connection with these transactions represent approximately 89% of our common stock outstanding as of September
30, 2004. In connection with our bridge financing and our PIPE financing transaction, we also issued warrants exercisable for the purchase of up to an aggregate of 1,842,104 shares of our common stock based upon a purchase price of $3.80 per share.
We filed a registration statement on Form S-3 (Registration No. 333-103820), which was declared effective on June 6, 2003, to cover sales of the shares issued to the PIPE investors and issuable to the PIPE and bridge investors upon conversion of the
warrants. The exercise of these warrants could result in significant dilution to our shareholders at the time of exercise. We also filed a registration statement on Form S-2 (Registration No. 333-109576) in connection with our follow-on public
offering, which was declared effective on November 12, 2003, in which we issued and sold 4,000,000 shares of our common stock. On April 23, 2004, we filed a universal shelf registration statement on Form S-3 with the SEC providing for the offering
from time to time of up to $75,000,000 of our securities, which may consist of common stock, preferred stock, warrants, or debt securities. On August 6, 2004 we filed a Supplemental Prospectus under Rule 424(b)(2) for the issuance of up to 2,500,000
shares of our common stock, of which we sold 1,570,000 shares for the aggregate purchase price of $13.3 million, or $8.50 per share, before placement agency fees and other offering expenses. On August 10, 2004, we filed an additional Supplemental
Prospectus under Rule 424(b)(2) for the issuance of up to 250,000 shares of our common stock, which we sold for the aggregate purchase price of $2.1 million, or $8.50 per share, before offering expenses.



In the future, we may issue additional shares of common stock or other equity
securities, including but not limited to options, warrants or other derivative securities convertible into our common stock, which could result in significant dilution to our shareholders.



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Concentration of ownership and contractual board rights could delay or prevent a change in control or otherwise
influence or control most matters submitted to our stockholders and could enable certain shareholders to exert control over us and our significant corporate decisions.



Our directors, officers, and principal stockholders together control approximately 60.1% of our voting securities, a
concentration of ownership that could delay or prevent a change in control. Our executive officers and directors beneficially own approximately 5.7% of our voting securities and our 5% or greater stockholders beneficially own approximately 54.4% of
our voting securities. We are obligated to include a representative of each of Investor Growth Capital as a nominee for election to the Board of Directors and Sprout Capital has the right to designate two such nominees. These stockholders, if acting
together, would be able to influence and possibly control most matters submitted for approval by our stockholders, including the election of directors, delaying or preventing a change of control, and the consideration of transactions in which
stockholders might otherwise receive a premium for their shares over then-current market prices.



Our shareholder rights plan, provisions in our charter documents, and Delaware law may inhibit a takeover of us, which could limit the price investors might be willing to pay in the future for our common stock, and
could entrench management.



We have a shareholder rights
plan that may have the effect of discouraging unsolicited takeover proposals, thereby entrenching current management and possibly depressing the market price of our common stock. The rights issued under the shareholder rights plan would cause
substantial dilution to a person or group that attempts to acquire us on terms not approved in advance by our board of directors. In addition, our charter and bylaws contain provisions that may discourage unsolicited takeover proposals that
stockholders may consider to be in their best interests. These provisions include:



| |  | a classified board of directors;
| | - | --------------------------------



| |  | the ability of the board of directors to designate the terms of and issue new series of preferred stock;
| | - | --------------------------------------------------------------------------------------------------------



| |  | advance notice requirements for nominations for election to the board of directors; and
| | - | ---------------------------------------------------------------------------------------



| |  | special voting requirements for the amendment of our charter and bylaws.
| | - | ------------------------------------------------------------------------



We are also subject to anti-takeover provisions under Delaware law, each of which could delay or prevent a change of control. Together these provisions
and the shareholder rights plan may make more difficult the removal of management and may discourage transactions that otherwise could involve payment of a premium over prevailing market prices for common stock.



We do not anticipate declaring any cash dividends on our common stock.



We have never declared or paid cash dividends on our common stock and do not
plan to pay any cash dividends in the near future. Our current policy is to retain all funds and any earnings for use in the operation and expansion of our business.



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Item 3 Quantitative and Qualitative Disclosures about Market Risk



The primary objective of our investment activities is to preserve principal while at the same time maximizing the income we receive from our investments without significantly increasing risk. Some of the securities
that we invest in may have market risk. This means that a change in prevailing interest rates may cause the principal amount of the investment to fluctuate. For example, if we hold a security that was issued with a fixed interest rate at the
then-prevailing rate and the prevailing interest rate later rises, the principal amount of our investment will probably decline. To minimize this risk in the future, we intend to maintain our portfolio of cash equivalents and short-term investments
in a variety of securities, including commercial paper, money market funds, government and non-government debt securities. The average duration of all of our investments in 2003 and for the nine months of 2004 was less than one year. Due to the
short-term nature of these investments, we believe we have no material exposure to interest rate risk arising from our investments. A hypothetical 100 basis point adverse move in interest rates along the entire interest rate yield curve would not
materially affect the fair market value of our interest sensitive financial investments. Declines in interest rates over time will, however, reduce our investment income, while increases in interest rates over time will increase our interest
expense. Historically, and as of September 30, 2004, we have not used derivative instruments or engaged in hedging activities.



We have operated primarily in the United States and have had no sales to date. Accordingly, we have not had any significant exposure to foreign currency
rate fluctuations. Visionexs functional currency is the Singapore dollar and a portion of Visionexs business was conducted in currencies other than the Singapore dollar prior to the wind down of operations in July 2002. As a result,
currency fluctuations between the Singapore dollar and the currencies in which Visionex had done business will cause foreign currency translation gains and losses. We do not expect our foreign currency translation gains or losses to be material. We
do not currently engage in foreign exchange hedging transactions to manage our foreign currency exposure.



Item 4 Disclosure Controls and Procedures



Evaluation of Disclosure Controls and Procedures.Based on our evaluation during the most recent quarter, the Companys principal executive officer and principal financial officer have concluded that the Companys
disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (the Exchange Act)) are effective to ensure that information required to be disclosed by the Company in
reports that it files or submits under the Exchange Act is recorded, processes, summarized and reported within the time period specified in SEC rules and forms.



Changes in Internal Controls. During the current fiscal year the Company upgraded its accounting system to Oracle e-Business Suite. There have
been no significant changes in the Companys internal controls or in other factors that could significantly affect the Companys disclosure controls and procedures subsequent to the date of the previously mentioned evaluation.



Sarbanes-Oxley 404 Compliance. We have begun a detailed assessment
of our internal controls as called for by the Sarbanes-Oxley Act of 2002. We are still in the evaluation of design phase where we have identified what may be control deficiencies in our system of internal controls. As we move to the testing phase of
our project, we expect to validate these potential control deficiencies and to assess whether or not they rise to the level of significant deficiencies or material weaknesses. In the meantime, we have established a series of remediation teams to
investigate these potential control deficiencies, and, where appropriate, to remediate them. To ensure that we address these issues thoroughly, effectively, and timely, we have supplemented our internal project team with the services of several
outside specialists. Although we have made this project a top priority for the Company, there can be no assurances that all control deficiencies identified and validated will be remediated before the end of the Companys fiscal year or that the
remaining unresolved control deficiencies will not rise to the level of significant deficiencies or material weaknesses.



PART II OTHER INFORMATION



Item 1 Legal Proceedings



From
time to time, we may be involved in litigation relating to claims arising out of our operations in the normal course of business. We currently are not a party to any legal proceedings, the adverse outcome of which, in managements opinion,
individually or in the aggregate, would have a material adverse effect on our results of operations or financial position.



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Item 4 Submission of Matters to a Vote of Security Holders



No matters were voted upon during the third quarter of 2004.



Item 5 Other Information



Item 6 Exhibits and Reports on Form 8-K



(a)
Exhibits



See Exhibit Index



Signatures



Pursuant to the
requirements of the Securities Exchange Act of 1934, ISTA Pharmaceuticals, Inc. has duly caused this 10-Q report to be signed on its behalf by the undersigned, thereunto duly authorized, in the City of Irvine, County of Orange, State of California,
on this 12th day of November 2004.



ISTA PHARMACEUTICALS, INC.(Registrant)/s/ Vicente Anido, Jr., Ph.D.Vicente Anido, Jr., Ph.D.President and Chief Executive Officer/s/ Lauren P. SilvernailLauren P. SilvernailChief Financial Officer,Chief Accounting Officer andVice President, Corporate Development




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INDEX TO EXHIBITS



|              |  |                                                                                                                                                                          
|------------- |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|ExhibitNumber |  | Description                                                                                                                                                              
|4.1           |  | 2004 Performance Incentive Plan*                                                                                                                                         
|              | 
|4.2           |  | Form of Stock Option Agreement*                                                                                                                                          
|              | 
|4.3           |  | Form of Restricted Stock Purchase Agreement*                                                                                                                             
|              | 
|10.1          |  | Vitrase Agreement, dated September 27, 2004, by and between the Registrant and Allergan Sales, LLC, a Delaware Limited Liability                                         
|              | 
|31.1          |  | President and Chief Executive Officers Certification, as required by Section 302 of the Sarbanes-Oxley Act of 2002                                                      
|              | 
|31.2          |  | Chief Financial Officer, Chief Accounting Officer and Vice President, Corporate Developments Certification, as required by Section 302 of the Sarbanes-Oxley Act of 2002
|              | 
|32.1          |  | President and Chief Executive Officers Certification, as required by Section 906 of the Sarbanes-Oxley Act of 2002                                                      
|              | 
|32.2          |  | Chief Financial Officer, Chief Accounting Officer and Vice President, Corporate Developments Certification, as required by Section 906 of the Sarbanes-Oxley Act of 2002

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|* | Incorporated by reference from the Registrants registration statement on Form S-8 filed with the Commission on October 22, 2004.
|- | ---------------------------------------------------------------------------------------------------------------------------------



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