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UNITED STATES SECURITIES AND
EXCHANGE COMMISSION
 WASHINGTON, D.C. 20549 FORM 10-Q (MARK ONE) x
    
    QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934.FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 2004ORo
    
    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: 0-20772 QUESTCOR PHARMACEUTICALS, INC. (Exact name of Registrant as specified in its charter)
 CALIFORNIA
    
    33-0476164(State or other jurisdiction
of incorporation or organization)
    
    (I.R.S. Employer
Identification No.)
 3260 Whipple Road
Union City, CA 94587-1217
(Address of Principal Executive Offices) REGISTRANTS TELEPHONE NUMBER, INCLUDING AREA CODE: (510) 400-0700 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 prior 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 Registrant is an accelerated filer (as
defined in Rule 12B-2 of the Act). Yes [ ] No [x] At November 1, 2004 there were 51,167,803 shares of the Registrants
common stock, no par value per share, outstanding.




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QUESTCOR PHARMACEUTICALS, INC. FORM 10-Q TABLE OF CONTENTS PART I. FINANCIAL INFORMATIONItem 1
    
    Financial Statements and Notes (Unaudited)
    
    3Condensed Consolidated Balance Sheets September 30, 2004 and December 31, 2003
    
    3Condensed Consolidated Statements of Operations  for the three months and nine months ended September 30, 2004 and 2003
    
    4Condensed Consolidated Statements of Cash Flows  for the nine months ended September 30, 2004 and 2003
    
    5Notes to Condensed Consolidated Financial Statements
    
    6Item 2
    
    Managements Discussion and Analysis of Financial Condition and Results of Operations
    
    12Item 3
    
    Quantitative and Qualitative Disclosures about MarketRisk
    
    24Item 4
    
    Controls and Procedures
    
    24PART II. OTHER INFORMATIONItem 1
    
    Legal Proceedings
    
    25Item 2
    
    Changes in Securities and Use of Proceeds
    
    25Item 3
    
    Defaults Upon Senior Securities
    
    25Item 4
    
    Submission of Matters to a Vote of Security Holders
    
    25Item 5
    
    Other Information
    
    25Item 6
    
    Exhibits and Reports on Form 8-K
    
    25Signatures
    
    
    
    26EXHIBIT 10.34EXHIBIT 31EXHIBIT 32
  2




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PART I. FINANCIAL INFORMATION 
 ITEM 1. FINANCIAL STATEMENTS
 QUESTCOR PHARMACEUTICALS, INC. 
 CONDENSED CONSOLIDATED BALANCE SHEETS
(IN THOUSANDS, EXCEPT SHARE AMOUNTS) September 30,
    
    December 31,2004
    
    2003(Unaudited)
    
    (Note 1)ASSETSCurrent assets:Cash and cash equivalents
    
    $
    7,744
    
    
    $
    3,220Short-term investments
    
    
    999
    
    
    
    Accounts receivable, net of allowances for
doubtful accounts of $25 and $60 at September
30, 2004 and December 31, 2003, respectively
    
    
    1,767
    
    
    
    2,161Inventories, net
    
    
    1,551
    
    
    
    1,050Prepaid expenses and other current assets
    
    
    619
    
    
    
    873Total current assets
    
    
    12,680
    
    
    
    7,304Property and equipment, net
    
    
    664
    
    
    
    609Purchased technology, net
    
    
    12,997
    
    
    
    13,709Goodwill and other indefinite lived intangible assets
    
    
    479
    
    
    
    479Deposits and other assets
    
    
    817
    
    
    
    828Total assets
    
    $
    27,637
    
    
    $
    22,929LIABILITIES AND SHAREHOLDERS EQUITYCurrent liabilities:Accounts payable
    
    $
    1,679
    
    
    $
    1,402Accrued compensation
    
    
    991
    
    
    
    358Other accrued liabilities
    
    
    1,503
    
    
    
    1,052Short-term
debt and capital lease obligation
    
    
    264
    
    
    
    140Convertible debentures (face amount of $4,000),
net of deemed discount of $227 at September 30, 2004
    
    
    3,773
    
    
    
    Total current liabilities
    
    
    8,210
    
    
    
    2,952Convertible debentures (face amount of $4,000), net
of deemed discount of $598 at December 31, 2003
    
    
    
    
    
    
    3,402Long-term
debt and capital lease obligation
    
    
    2,184
    
    
    
    Other non-current liabilities
    
    
    947
    
    
    
    916Commitments and contingenciesPreferred stock, no par value, 7,500,000 shares
authorized; 2,155,715 Series A shares issued and
outstanding at September 30, 2004 and December 31,
2003 (aggregate liquidation preference of $10,000 at
September 30, 2004 and December 31, 2003)
    
    
    5,081
    
    
    
    5,081Shareholders equity:Preferred stock, no par value, 8,400 and 9,100
Series B shares issued and outstanding at
September 30, 2004 and December 31, 2003,
respectively, net of issuance costs (aggregate
liquidation preference of $8,400 and $9,100 at
September 30, 2004 and December 31, 2003,
respectively)
    
    
    7,578
    
    
    
    8,278Common stock, no par value, 105,000,000 shares
authorized; 51,167,803 and 45,387,802 shares
issued and outstanding at September 30, 2004 and
December 31, 2003, respectively
    
    
    88,414
    
    
    
    85,232Deferred compensation
    
    
    (11
    )
    
    
    (17
    )Accumulated deficit
    
    
    (84,766
    )
    
    
    (82,915
    )Total shareholders equity
    
    
    11,215
    
    
    
    10,578Total liabilities and shareholders equity
    
    $
    27,637
    
    
    $
    22,929
 See accompanying notes. 3




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QUESTCOR PHARMACEUTICALS, INC. 
 CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
(UNAUDITED) Three Months Ended
    
    Nine Months EndedSeptember 30,
    
    September 30,2004
    
    2003
    
    2004
    
    2003Revenues:Net product sales
    
    $
    3,869
    
    
    $
    3,943
    
    
    $
    13,107
    
    
    $
    9,185Technology and grant revenue
    
    
    
    
    
    
    24
    
    
    
    
    
    
    
    308Total revenues
    
    
    3,869
    
    
    
    3,967
    
    
    
    13,107
    
    
    
    9,493Operating costs and expenses:Cost of product sales
    
    
    843
    
    
    
    796
    
    
    
    2,660
    
    
    
    2,620Selling, general and administrative
    
    
    3,415
    
    
    
    2,630
    
    
    
    8,958
    
    
    
    7,950Research and development
    
    
    522
    
    
    
    590
    
    
    
    1,521
    
    
    
    1,912Depreciation and amortization
    
    
    306
    
    
    
    441
    
    
    
    905
    
    
    
    822Total operating costs and expenses
    
    
    5,086
    
    
    
    4,457
    
    
    
    14,044
    
    
    
    13,304Loss from operations
    
    
    (1,217
    )
    
    
    (490
    )
    
    
    (937
    )
    
    
    (3,811
    )Non-cash amortization of deemed discount
on convertible debentures
    
    
    (130
    )
    
    
    (130
    )
    
    
    (392
    )
    
    
    (391
    )Interest expense, net
    
    
    (94
    )
    
    
    (18
    )
    
    
    (234
    )
    
    
    (32
    )Other income (expense), net
    
    
    5
    
    
    
    5
    
    
    
    8
    
    
    
    (75
    )Rental income, net
    
    
    70
    
    
    
    57
    
    
    
    212
    
    
    
    194Net loss
    
    
    (1,366
    )
    
    
    (576
    )
    
    
    (1,343
    )
    
    
    (4,115
    )Non-cash deemed dividend related to
beneficial conversion feature of Series B Preferred Stock
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    1,394Dividends on Series B Preferred Stock
    
    
    168
    
    
    
    200
    
    
    
    508
    
    
    
    567Net loss applicable to common shareholders
    
    $
    (1,534
    )
    
    $
    (776
    )
    
    $
    (1,851
    )
    
    $
    (6,076
    )Basic and diluted net loss per share
applicable to common shareholders
    
    $
    (0.03
    )
    
    $
    (0.02
    )
    
    $
    (0.04
    )
    
    $
    (0.15
    )Shares used in computing basic and
diluted net loss per share applicable
to common shareholders
    
    
    51,111
    
    
    
    44,275
    
    
    
    50,736
    
    
    
    40,987
 See accompanying notes. 4




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QUESTCOR PHARMACEUTICALS, INC. 
 CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(IN THOUSANDS)
(UNAUDITED) Nine Months EndedSeptember 30,2004
    
    2003OPERATING ACTIVITIESNet loss
    
    $
    (1,343
    )
    
    $
    (4,115
    )Adjustments to reconcile net loss to net cash provided by (used in) operating activities:Stock-based compensation expense
    
    
    22
    
    
    
    40Amortization of deemed discount on convertible debentures
    
    
    392
    
    
    
    391Amortization of deferred compensation
    
    
    5
    
    
    
    44Depreciation and amortization
    
    
    905
    
    
    
    822Other-than-temporary loss on investment
    
    
    
    
    
    
    51Deferred rent expense
    
    
    31
    
    
    
    29Loss on the sale of investments
    
    
    
    
    
    
    14Loss on the sale of equipment, net
    
    
    
    
    
    
    9Changes in operating assets and liabilities:Accounts receivable
    
    
    394
    
    
    
    (554
    )Inventories
    
    
    (501
    )
    
    
    (631
    )Prepaid expenses and other current assets
    
    
    259
    
    
    
    366Accounts payable
    
    
    277
    
    
    
    (205
    )Accrued compensation
    
    
    633
    
    
    
    (275
    )Other accrued liabilities
    
    
    451
    
    
    
    (147
    )Other non-current liabilities
    
    
    
    
    
    
    67Net cash flows provided by (used in) operating activities
    
    
    1,525
    
    
    
    (4,094
    )INVESTING ACTIVITIESPurchase of property and equipment
    
    
    (205
    )
    
    
    (307
    )Purchase of short-term investments
    
    
    (999
    )
    
    
    (3,029
    )Proceeds from maturities and sales of short-term investments
    
    
    
    
    
    
    1,818Acquisition of purchased technology
    
    
    
    
    
    
    (12,113
    )Proceeds from sale of property and equipment
    
    
    1
    
    
    
    23(Increase) decrease in other assets
    
    
    (10
    )
    
    
    2Net cash flows used in investing activities
    
    
    (1,213
    )
    
    
    (13,606
    )FINANCING ACTIVITIESIssuance of common stock, net of issuance costs
    
    
    2,452
    
    
    
    5,058Issuance of Series B preferred stock and warrants, net of issuance costs
    
    
    
    
    
    
    9,404Short-term borrowings
    
    
    569
    
    
    
    465Long-term borrowings
    
    
    2,147
    
    
    
    Repayment of short-term and long-term debt
    
    
    (452
    )
    
    
    (532
    )Payment of Series B preferred stock dividends
    
    
    (504
    )
    
    
    (567
    )Net cash flows provided by financing activities
    
    
    4,212
    
    
    
    13,828Increase (decrease) in cash and cash equivalents
    
    
    4,524
    
    
    
    (3,872
    )Cash and cash equivalents at beginning of period
    
    
    3,220
    
    
    
    6,156Cash and cash equivalents at end of period
    
    $
    7,744
    
    
    $
    2,284SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION:Cash paid for interest
    
    $
    283
    
    
    $
    250Amount payable relating to product acquisition
    
    $
    
    
    
    $
    2,183NON-CASH INVESTING AND FINANCING ACTIVITIES:Common stock issued upon conversion of Series B preferred stock and accrued
dividends for Series B preferred stock
    
    $
    704
    
    
    $
    Equipment
acquired under capital lease
    
    $
    44
    
    
    $
    
 See accompanying notes. 5




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QUESTCOR PHARMACEUTICALS, INC. 
 NOTES TO CONDENSED CONSOLIDATED SEPTEMBER 30, 2004 FINANCIAL STATEMENTS (UNAUDITED) 1. BASIS OF PRESENTATION Questcor Pharmaceuticals, Inc. (the Company) is a specialty
pharmaceutical company that acquires, markets and sells brand name prescription
drugs through a U.S. direct sales force and international distributors. The
Company focuses on the treatment of gastroenterological disorders and central
nervous system (CNS) diseases which are served by a limited group of
physicians such as gastroenterologists, neurologists and bariatric surgeons.
The Companys strategy is to acquire pharmaceutical products that it believes
have sales growth potential, are promotionally responsive to a focused and
targeted sales and marketing effort, complement the Companys existing products
and can be acquired at a reasonable valuation relative to our cost of capital.
The Company currently markets five products in the U.S.: Nascobal®, the only
prescription nasal gel used for the treatment of various Vitamin B-12
deficiencies; HP Acthar® Gel (Acthar), an injectable drug that is approved
for the treatment of certain CNS disorders with an inflammatory component,
including the treatment of flares associated with multiple sclerosis (MS) and
is also commonly used in treating patients with infantile spasm; VSL#3®, a
patented probiotic marketed as a dietary supplement to promote normal
gastrointestinal function; Ethamolin®, an injectable drug used to treat
enlarged weakened blood vessels at the entrance to the stomach that have
recently bled, known as esophageal varices; and Glofil®-125, an injectable
agent that assesses how well the kidney is working by measuring glomerular
filtration rate, or kidney function. The Company acquired Nascobal, a nasal gel
formulation of Cyanocobalamin USP (Vitamin B-12), from Nastech Pharmaceutical
Company, Inc. in June 2003 and began distributing Nascobal in July 2003. The
Company markets Nascobal for patients with Crohns Disease and MS, or who have
undergone gastric bypass surgery, since these patients are at high risk of
developing severe deficiencies of Vitamin B-12 due to a compromised ability to
absorb Vitamin B-12 through the gastrointestinal system. The accompanying unaudited consolidated financial statements of the
Company have been prepared in accordance with accounting principles generally
accepted in the United States and applicable Securities and Exchange Commission
regulations for interim financial information. These financial statements do
not include all of the information and footnotes required by accounting
principles generally accepted in the United States for complete financial
statements. The unaudited financial statements should be read in conjunction
with the audited financial statements and related footnotes included in the
Companys Annual Report on Form 10-K for the year ended December 31, 2003, as
filed on March 30, 2004 with the Securities and Exchange Commission. The
accompanying balance sheet at December 31, 2003 has been derived from the
audited financial statements at that date. In the opinion of the Companys
management, all adjustments (consisting of normal recurring adjustments)
considered necessary for the fair presentation of interim financial information
have been included. Operating results for the interim periods presented are not
necessarily indicative of the results that may be expected for the year ending
December 31, 2004. The consolidated financial statements include the accounts
of the Company and its wholly owned subsidiaries. All significant intercompany
accounts and transactions have been eliminated. 2. STOCK-BASED COMPENSATION The Company generally grants stock options to its employees for a fixed
number of shares with an exercise price equal to the fair market value of the
shares on the date of grant. As allowed under Statement of Financial Accounting
Standards No. 123, Accounting for Stock-Based Compensation (SFAS 123), the
Company has elected to follow Accounting Principles Board Opinion No. 25,
Accounting for Stock Issued to Employees and related interpretations in
accounting for stock awards to employees. Accordingly, no compensation expense
is recognized in the Companys financial statements in connection with stock
options granted to employees with exercise prices not less than fair market
value. Deferred compensation for options granted to employees is determined as
the difference between the fair market value of the Companys common stock on
the date options were granted and the exercise price. For purposes of
disclosures pursuant to SFAS 123, as amended by Statement of Financial
Accounting Standards No. 148, Accounting for Stock-Based Compensation 
Transition and Disclosure, the estimated fair value of options is amortized to
expense over the options vesting periods. 6




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The following table illustrates the effect on net loss per share
applicable to common stockholders if the Company had applied the fair value
recognition provisions of SFAS 123 to stock-based employee compensation (in
thousands, except per share amounts): Three months ended
    
    Nine months endedSeptember 30,
    
    September 30,2004
    
    2003
    
    2004
    
    2003Net loss applicable to common stockholders as reported
    
    $
    (1,534
    )
    
    $
    (776
    )
    
    $
    (1,851
    )
    
    $
    (6,076
    )Add: Stock-based employee compensation expense included in reported
net loss
    
    
    1
    
    
    
    37
    
    
    
    8
    
    
    
    51Deduct: Total stock-based employee compensation expense determined
under fair value method for all awards
    
    
    (168
    )
    
    
    (343
    )
    
    
    (510
    )
    
    
    (1,010
    )Add: Adjustment to stock-based employee compensation
due to forfeitures of unvested options, primarily related to CEO
resignation
    
    
    359
    
    
    
    
    
    
    
    359
    
    
    
    Net loss applicable to common stockholders, pro forma
    
    $
    (1,342
    )
    
    $
    (1,082
    )
    
    $
    (1,994
    )
    
    $
    (7,035
    )Basic and diluted net loss per share applicable to common stockholders:As reported
    
    $
    (0.03
    )
    
    $
    (0.02
    )
    
    $
    (0.04
    )
    
    $
    (0.15
    )Pro forma
    
    $
    (0.03
    )
    
    $
    (0.02
    )
    
    $
    (0.04
    )
    
    $
    (0.17
    )
 Compensation expense for options granted to non-employees has been
determined in accordance with SFAS 123 and EITF 96-18, Accounting for Equity
Instruments that are Issued to Other than Employees for Acquiring, or in
conjunction with Selling Goods or Services, as the fair value of the
consideration received or the fair value of the equity instruments issued,
whichever is more reliably measured. Compensation expense for options granted
to non-employees is periodically re-measured as the underlying options vest. On March 31, 2004, the Financial Accounting Standards Board (FASB) issued
an Exposure Draft, Share-Based Payment  An Amendment of FASB Statements No.
123 and 95 (proposed FAS 123R), which currently is expected to be effective
for public companies in periods beginning after June 15, 2005. As proposed, the Company
would be required to implement the standard in the third quarter of 2005 and
the cumulative effect of adoption, if any, applied on a modified prospective
basis, would be measured and recognized on the date of implementation, July 1,
2005. The proposed FAS 123R addresses the accounting for stock options issued
to employees, and would eliminate the ability to account for employee stock
options using the intrinsic value method currently used by the Company.
Instead, the proposed FAS 123R would require that these options be accounted
for using a fair-value based method, and the Company would be required to
recognize an expense for stock options issued to employees and also for
employees participation in the Companys stock purchase plan. The FASB expects to issue
a final standard by December 31, 2004. The Company is currently evaluating option
valuation methodologies and assumptions in light of the proposed FAS 123R.
Current estimates of option values using the Black-Scholes method (as shown
above) may not be indicative of results from valuation methodologies ultimately
adopted in the final rules. 3. REVENUE RECOGNITION Revenues from product sales of Nascobal, Acthar, VSL#3, Ethamolin and
Glofil-125 are recognized based upon shipping terms, net of estimated reserves
for government chargebacks, Medicaid rebates, payment discounts, and after May
31, 2004, returns for credit. Revenue is recognized upon shipment of product,
provided title to the product has been transferred at the point of shipment. If
title to the product transfers at point of receipt by the customer, revenue is
recognized upon customer receipt of the shipment. The Company records estimated sales reserves against product revenues for
government chargebacks, Medicaid rebates, payment discounts and product returns
for credit memoranda based on historical chargebacks, rebates, discounts and
product returns, as required. The Companys policy of issuing credit memoranda
for expired product, which became effective for product lots released after May
31, 2004, allows customers to return expired product for credit within six
months beyond the expiration date. Customers who return expired product from
production lots released after May 31, 2004 will be issued credit memoranda
equal to the sales value of the product returned, and the estimated amount of
such credit memoranda is recorded as a liability with a corresponding reduction
in gross product sales. This reserve will be reduced as future credit memoranda
are issued, with an offset to accounts receivable. The Companys exchange policy, which applies to product lots released
prior to June 1, 2004, allows customers to return expired product for exchange
within six months beyond the expiration date. Returns from these product lots
are exchanged for replacement product, and estimated costs for such exchanges,
which include actual product material costs and related shipping charges, are
included in Cost of Product Sales. Returns are subject to inspection prior to
acceptance. The Company records reserves for expected product exchanges and
credit memoranda based upon historical return rates by product, analysis of
return merchandise authorizations, returns received, and other factors such as
shelf life. The Company routinely assesses the historical returns and other
experience including customers compliance with return goods policy and adjusts
its reserves as appropriate. For Glofil and VSL#3 the Company accepts no
returns for expired product. 7




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Reserves
for government chargebacks, Medicaid rebates, product exchanges
and product returns for credit memoranda were $1,091,000 and $582,000 at September 30, 2004 and
December 31, 2003, respectively, and are included in Other Accrued Liabilities.
The reserves at September 30, 2004 include $505,000 for
estimated product returns for
credit memoranda on product lots of Acthar and Nascobal released and shipped
after May 31, 2004. The Company sells product to wholesalers, who in turn sell
these products to pharmacies and hospitals. In the case of VSL#3, the Company
sells directly to consumers. The Company does not require collateral from its
customers. The Company has received government grants that support the Companys
research efforts in specific research projects. These grants provide for
reimbursement of approved costs incurred as defined in the various awards. The Company has received payments in exchange for proprietary licenses
related to technology and patents. The Company classifies these payments as
Technology Revenue. These payments are recognized as revenues upon receipt of
cash and the transfer of intellectual property, data and other rights licensed,
assuming no continuing material obligations exist. 4. CASH AND CASH
EQUIVALENTS AND SHORT-TERM INVESTMENTS The Company considers highly liquid investments with maturities from the
date of purchase of three months or less to be cash equivalents. The Company
had cash, cash equivalents and short-term investments of $8,743,000 and
$3,220,000 at September 30, 2004 and December 31, 2003, respectively. All cash
equivalents are in money market funds and commercial paper. All
short-term investments are in commercial paper. The fair value of the funds approximated
cost. In 2003, the Company recognized an other-than-temporary loss of $51,000
and a realized loss of $14,000 related to its equity investment in Rigel
Pharmaceuticals, Inc. (Rigel). These amounts are included in Other Income
(Expense) in the accompanying Consolidated Statement of Operations. The Company
liquidated its investment in Rigel common stock in the second quarter of fiscal
year 2003. 5. INVENTORIES Inventories are stated at the lower of cost (first-in, first-out method)
or market and consist of the following (in thousands): September 30,
    
    December 31,2004
    
    2003Raw materials
    
    $
    390
    
    
    $
    534Work in process
    
    
    782
    
    
    
    197Finished goods
    
    
    560
    
    
    
    660Less allowance for excess and obsolete inventories
    
    
    (181
    )
    
    
    (341
    )$
    1,551
    
    
    $
    1,050
 6. PURCHASED TECHNOLOGY AND INTANGIBLE ASSETS Goodwill and assembled workforce no longer subject to amortization
amounted to $479,000 at September 30, 2004 and December 31, 2003. The Company
performed an impairment test of goodwill and assembled workforce as of December
31, 2003, which did not result in an impairment charge. The Company will
continue to monitor the carrying value of goodwill and assembled workforce
through the annual impairment tests or more frequently if indicators of
potential impairment exist. As of September 30, 2004, no indicators of
potential impairment existed. No such impairment losses have been recorded to
date. Purchased technology at September 30, 2004 includes $14.2 million related
to the Nascobal acquisition. The Nascobal purchased technology is being
amortized over its estimated life of 15 years. Accumulated amortization for the
Nascobal purchased technology is $1,226,000 as of September 30, 2004. 7. SECURED PROMISSORY NOTE On July 31, 2004, the Company issued a $2.2 million secured promissory
note to Defiante Farmaceutica LdA, a Portuguese corporation and a wholly-owned
subsidiary of Sigma-Tau Finanziaria SpA (Sigma-Tau). Sigma-Tau beneficially
owned approximately 28% of the Companys outstanding stock as of September 30,
2004. The interest rate on the note is 9.83% per annum. 8




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Repayment of the note consists of interest only for the first twelve
months, with monthly principal and interest payments thereafter through August
2008. The Company intends to use a majority of the proceeds from the note to fund the
$2 million milestone payment to be made to Nastech Pharmaceutical Company, Inc.
upon approval of the New Drug Application (NDA) for the spray formulation of
Nascobal. The NDA for the spray formulation was submitted in December 2003. We
are aware that the FDA issued an approvable letter to Nastech for the nasal
spray NDA on October 28, 2004. There were no FDA requirements for Nastech to
conduct additional work related to manufacturing, preclinical or clinical
studies. Remaining items to be completed for product approval include an FDA
inspection of the Vitamin B-12 raw material manufacturing facility (scheduled
for November 15, 2004) and finalization of the product labeling. Hence the NDA
could be approved by the end of the fourth quarter of 2004. The note will be
secured by the Nascobal intellectual property including the NDA for the spray
formulation when it is approved. The Company purchased the world-wide rights to
Nascobal, including the rights to the spray formulation from Nastech
Pharmaceutical Company in June 2003. 8. COMMITMENTS, INDEMNIFICATIONS AND CONTINGENCIES The Company, as permitted under California law and in accordance with its
Bylaws, indemnifies its officers and directors for certain events or
occurrences while the officer or director is or was serving at the Companys
request in such capacity. The potential future indemnification limit is to the
fullest extent permissible under California law; however, the Company has a
director and officer insurance policy that limits its exposure and may enable
it to recover a portion of any future amounts paid. The Company believes the
fair value of these indemnification agreements is minimal. Accordingly, the
Company has no liabilities recorded for these agreements as of September 30,
2004. From time to time, the Company may become involved in claims and other
legal matters arising in the ordinary course of business. Management is not
currently aware of any such matters that will have a material adverse affect on
the financial position, results of operations or cash flows of the Company. 9. NET LOSS PER SHARE APPLICABLE TO COMMON SHAREHOLDERS Basic and diluted net loss per share applicable to common shareholders is
based on net loss applicable to common shareholders for the relevant period,
divided by the weighted average number of common shares outstanding during the
period. Diluted earnings per share applicable to common shareholders gives
effect to all potentially dilutive common shares outstanding during the period
such as options, warrants, convertible preferred stock, and contingently
issuable shares. Diluted net loss per share applicable to common shareholders
has not been presented separately as, due to the Companys net loss position,
it is anti-dilutive. Had the Company been at a net income position at September
30, 2004, shares used in calculating diluted earnings per share applicable to
common shareholders would have included, if dilutive, the effect of the
outstanding 7,980,519 stock options to purchase common shares, 11,080,492
convertible preferred shares, 2,531,644 common shares issuable upon conversion
of debentures, placement unit options for 127,679 common shares and 4,539,407
warrants to purchase common shares. 10. EQUITY TRANSACTIONS In January 2004 the Company entered into agreements with some of its
existing investors and issued 4,878,201 shares of common stock in exchange for
$2,399,050 in cash and the surrender of outstanding warrants to purchase
3,878,201 shares of common stock. The Companys offer to issue common stock for
cash and the surrender of warrants was made to all warrant holders. The
warrants retired represented approximately 46% of the Companys warrants
outstanding as of December 31, 2003. The warrants surrendered were included as
consideration at their aggregate fair value of $743,000 which was determined
using a Black-Scholes valuation method. The purchase price of the common stock,
which was payable in cash and surrender of outstanding warrants, was $0.644 per
share, which was the volume weighted average price of the Companys common
stock in December 2003 for the five trading days prior to the agreement to the
terms of the transaction. Sigma-Tau, a related party, participated in the
transaction, purchasing 759,493 shares of common stock for aggregate
consideration of $489,000 in cash and the surrender of 759,493 warrants with a
fair value of $53,000 to purchase common stock. In January 2004, shares of the Companys Series B Preferred Stock with a
stated value of $600,000 plus accrued dividends of $2,000 were converted into
640,147 shares of common stock. In March 2004, shares of the Companys Series B Preferred Stock with a
stated value of $100,000 plus accrued dividends of $1,600 were converted into
107,995 shares of common stock. 9




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11. 2004 DIRECTORS STOCK OPTION PLAN In May 2004, shareholders approved the 2004 Non-Employee Directors Equity
Incentive Plan (the 2004 Plan) at the Companys 2004 Annual Meeting of
Shareholders. Under the terms of the 2004 Plan, 1,250,000 shares of the
Companys common stock were authorized for grants of non-qualified stock
options to non-employee directors of the Company. The 2004 Plan provides for
the granting of 25,000 options to purchase common stock upon appointment as a
non-employee director and an additional 15,000 options each January thereafter
upon reappointment. Such option grants vest over four years. As originally
approved by shareholders, such option grants had an exercise price of the
options equal to 85% of the fair market value on the date of grant. However, in
May 2004, the Companys Board of Directors approved an amendment to the 2004
Plan to provide that all option grants under the 2004 Plan be made at an
exercise price equal to 100% of the fair market value of the Companys common
stock on the date of grant. Additionally, the 2004 Plan provides for the annual
granting of 10,000 options to members of one or more committees of the Board of
Directors and an additional 7,500 options to chairmen of one or more
committees. Such option grants will have an exercise price equal to 100% of the
fair market value of the Companys common stock on the date of the grant and
will become fully vested at the time of grant. The maximum term of the options
granted under the 2004 Plan is ten years. 12. SERIES B CONVERTIBLE PREFERRED STOCK In January 2003, the Company completed a private placement of Series B
Convertible Preferred Stock and warrants to purchase common stock to various
investors. Gross proceeds to the Company from the private placement were $10
million. Net of issuance costs, the proceeds to the Company were $9.4 million.
Of the original $10 million stated value, Series B Convertible Preferred Stock
having a stated value of $1.6 million has been converted into common stock
through September 30, 2004. The holders of the Series B Convertible Preferred Stock have the right,
upon the occurrence of certain designated optional redemption events, to
require the Company to redeem the Series B Preferred Stock at 100% of its
stated value ($8.4 million as of September 30, 2004), together with all accrued
and unpaid dividends and interest. The redemption events are all within the
control of the Company. Therefore, in accordance with EITF Topic D-98, the
Company has classified the Series B Preferred Stock in permanent equity. In
addition, the Company initially recorded the Series B Preferred Stock at its
fair value on the date of issuance. The Company has elected not to adjust the
carrying value of the Series B Preferred Stock to the redemption value of such
shares, since it is uncertain whether or when the redemption events will occur.
Subsequent adjustments to increase the carrying value to the redemption value
will be made when it becomes probable that such redemption will occur. The purchasers of the Series B Preferred Stock also received for no
additional consideration warrants exercisable for an aggregate of 3,399,911
shares of Common Stock at an exercise price of $1.0824 per share, subject to
certain anti-dilution adjustments. The warrants expire in January 2007. The
warrants issued to the Series B holders were assigned a value of $1,527,000
which decreased the carrying value of the preferred stock. The warrants were
valued using the Black-Scholes method with the following assumptions: a risk
free interest rate of 3%; an expiration date of January 15, 2007; volatility of
82% and a dividend yield of 0%. In connection with the issuance of the Series B
Preferred Stock and warrants, the Company recorded $1,301,000 related to the
beneficial conversion feature on the Series B Preferred Stock as a deemed
dividend, which increased the carrying value of the preferred stock. A
beneficial conversion feature is present because the effective conversion price
of the Series B Preferred Stock was less than the fair value of the Common
Stock on the commitment date. For the nine months ended September 30, 2003, the
deemed dividend increased the loss applicable to common shareholders in the
calculation of basic and diluted net loss per common share. 13. RELATED PARTY TRANSACTIONS In December 2001, the Company entered into a promotion agreement with VSL
Pharmaceuticals Inc. (VSL), a private company owned in part by the major
shareholders of Sigma-Tau. The promotion agreement expires in January 2005. In
June 2002, the Company signed an amendment to the promotion agreement.
Effective January 1, 2004, the promotion agreement and all amendments were
assigned by VSL to Sigma-Tau Pharmaceuticals, Inc. Under these agreements, the
Company has agreed to purchase VSL#3 from Sigma-Tau Pharmaceuticals at a stated
price, and has also agreed to promote, sell, warehouse and distribute the VSL#3
product direct to customers at its cost and expense, subject to certain expense
reimbursements. Revenues from sales of VSL#3 are recognized when product is
shipped to the customer. The Company does not accept returns of VSL#3. VSL#3
revenue for the quarter ending September 30, 2004 was $372,000 and is included
in Net Product Sales. Included in Accounts Payable is $202,000 for amounts owed
to Sigma- 10




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Tau Pharmaceuticals at September 30, 2004. An access fee to Sigma-Tau
Pharmaceuticals is calculated quarterly, which varies based upon sales and
costs incurred by the Company subject to reimbursement under certain
circumstances. For the quarter ended September 30, 2004, the amount of the
access fee was $72,000 and is included in Selling, general and administrative
expense in the accompanying Condensed Consolidated Statements of Operations. During the
nine months ended September 30, 2004 and 2003, the Company paid
$672,000 and $358,000, respectively, to Sigma-Tau
Pharmaceuticals for the purchase of VSL#3 product and access fees. Upon the hiring of Reinhard Koenig, MD, PhD, as Vice President, Medical
Affairs in February 2004, the Company issued to Dr. Koenig a Promissory Note
for $40,000 at an interest rate of prime plus 1% per annum. The principal and
interest will be forgiven on February 8, 2005 provided that Dr. Koenig
continues as a full-time employee through that date. In May 2004, Dr. Koenig
was appointed an officer of the Company. For accounting purposes, the loan is
being amortized over the one year service period. 14. COMPREHENSIVE LOSS Comprehensive loss is comprised of net loss and the change in unrealized
holding gains and losses on available-for-sale securities. Three Months Ended
    
    Nine Months EndedSeptember 30,
    
    September 30,2004
    
    2003
    
    2004
    
    2003($000s)
    
    ($000s)Net loss
    
    $
    (1,366
    )
    
    $
    (576
    )
    
    $
    (1,343
    )
    
    $
    (4,115
    )Change in unrealized gains on available-for-sale securities
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    42Comprehensive loss
    
    $
    (1,366
    )
    
    $
    (576
    )
    
    $
    (1,343
    )
    
    $
    (4,073
    )
 15. CHIEF EXECUTIVE OFFICER RESIGNATION On August 5, 2004, Mr. Charles J. Casamento resigned as Chairman,
President and CEO of the Company. Under the separation agreement entered into
by the Company and Mr. Casamento, and consistent with certain terms of his
employment agreement, the Company (i) will continue to pay Mr. Casamento his
regular monthly base salary of $38,208 for 18 months, (ii) paid the prorated
portion of his 2004 annual bonus potential in the amount of $136,294 in August
2004, and (iii) extended the exercise period for 18 months of 129,251 stock
options with an exercise price of $1.25 per share. All other stock options held
by Mr. Casamento expired on November 3, 2004. Although certain payments will be
paid on a monthly basis over the 18 months, Mr. Casamento will not be
performing further services for the Company, other than part-time consulting
services. A charge of approximately $920,000 was recorded in the third quarter
of 2004 to recognize the cost of the separation arrangement, including the
payroll and bonus, and other associated costs and is included in Selling,
general and administrative in the Condensed Consolidated Statements of
Operations. The stock compensation expense related to the extension
of the option exercise period will be insignificant. 11




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ITEM 2. MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Except for the historical information contained herein, the following
discussion contains forward-looking statements that involve risks and
uncertainties, including statements regarding the period of time during which
our existing capital resources and income from various sources will be adequate
to satisfy our capital requirements. Our actual results could differ materially
from those discussed herein. Factors that could cause or contribute to such
differences include, but are not limited to, those discussed in this section,
as well as those discussed in our annual report on Form 10-K for the fiscal
year ended December 31, 2003, including Item 1 Business of Questcor, Risk
Factors, as well as factors discussed in any documents incorporated by
reference herein or therein. Whenever used in this Quarterly Report, the terms
Questcor, Company, we, our, ours, and us refer to Questcor
Pharmaceuticals, Inc. and its consolidated subsidiaries. Overview We are a specialty pharmaceutical company that acquires, markets and sells
brand name prescription drugs through our U.S. direct sales force and
international distributors. We focus on the treatment of gastroenterological
disorders and central nervous system (CNS) diseases which are served by a
limited group of physicians such as gastroenterologists, neurologists and
bariatric surgeons. Our strategy is to acquire pharmaceutical products that we
believe have sales growth potential, are promotionally responsive to a focused
and targeted sales and marketing effort, complement our existing products and
can be acquired at a reasonable valuation relative to our cost of capital. We
currently market five products in the United States:  
    
    Nascobal®, the only prescription nasal gel used for the treatment of
various Vitamin B-12 deficiencies including Vitamin B-12 deficiencies
associated with Crohns disease, gastric bypass surgery and multiple
sclerosis (MS);  
    
    HP Acthar® Gel (Acthar), an injectable drug that is approved for
the treatment of certain CNS disorders with an inflammatory component
including the treatment of flares associated with MS and is also
commonly used in treating patients with infantile spasm;  
    
    VSL#3®, a patented probiotic marketed as a dietary supplement to
promote normal gastrointestinal function;  
    
    Ethamolin®, an injectable drug used to treat enlarged weakened blood
vessels at the entrance to the stomach that have recently bled, known as
esophageal varices; and  
    
    Glofil®-125, an injectable agent that assesses how well the kidney is
working by measuring glomerular filtration rate, or kidney function. In June 2003 we acquired Nascobal, an FDA approved nasal gel formulation
of Cyanocobalamin USP (Vitamin B-12), from Nastech Pharmaceutical Company, Inc.
(Nastech) for $14.2 million. We also agreed to acquire the rights to Nascobal
nasal spray, an alternative dosage form, for which there will be two contingent
payments to Nastech of $2 million each. Upon approval by the FDA of an NDA
filed by Nastech for Nascobal nasal spray, Nastech is obligated to transfer the
NDA to us, and we are obligated to pay $2 million to Nastech. On July 31, 2004,
we issued a $2.2 million secured promissory note to Defiante Farmaceutica LdA,
a wholly-owned subsidiary of Sigma-Tau. We intend to use a majority of the
proceeds from the note to make the $2 million payment to Nastech upon the
approval and subsequent transfer of the NDA covering the spray formulation
which may be as early as the fourth quarter of 2004. We are aware that the FDA
issued an approvable letter to Nastech for the nasal spray NDA on October 28,
2004. There were no FDA requirements for Nastech to conduct additional work
related to manufacturing, preclinical or clinical studies. Remaining items to
be completed for product approval include an FDA inspection of the Vitamin B-12
raw material manufacturing facility (scheduled for November 15, 2004) and
finalization of the product labeling. Upon subsequent issuance of a patent for
the nasal spray, we are obligated to pay an additional $2 million to Nastech.
We began distributing Nascobal in July 2003. We are marketing Nascobal for
patients with Crohns Disease and MS, and patients who are at high risk of
developing severe deficiencies of Vitamin B-12 due to a compromised ability to
absorb Vitamin B-12 through the gastrointestinal system. We are also marketing
Nascobal for patients who have undergone gastric bypass surgery, have
inflammatory bowel disease, or other conditions that lead to a malabsorbtive
state. Consistent with our focus on sales and marketing, our spending on research
and development activities is minimal. Expenses incurred for the Acthar
manufacturing site transfer and medical and regulatory affairs are classified
as Research and Development Expenses in the accompanying unaudited Condensed
Consolidated Statements of Operations. We have entered into agreements with
pharmaceutical and biotechnology companies to further the development of
certain acquired technology. In June 2002, we signed a definitive License
Agreement with Fabre Kramer Pharmaceuticals, Inc. (Fabre Kramer), whereby we
granted Fabre Kramer exclusive worldwide rights to develop and commercialize
HypnostatTM (intranasal triazolam for the treatment of insomnia) and 12




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PanistatTM (intranasal alprazolam for the treatment of panic disorders).
We have granted rights to Rigel Pharmaceuticals, Inc. of South San Francisco,
California for our antiviral drug discovery program, and granted rights to
Dainippon Pharmaceuticals Co., Ltd. of Osaka, Japan for our antibacterial
program. We have incurred an accumulated deficit of $84.8 million at September 30,
2004. At September 30, 2004, we had $8.7 million in cash, cash equivalents and
short-term investments. Results of operations may vary significantly from
quarter to quarter depending on, among other factors, the results of our sales
efforts, demand for our products by patients and consumers, inventory levels of
our products at wholesalers, timing of expiration of our products and the
resulting shipment of replacement product under our exchange policy, future
credit memoranda to be issued under our credit memoranda policy, the
availability of finished goods from our sole-source manufacturers, the timing
of certain expenses including the Acthar site transfer costs and various market
research and marketing planning expenses, the acquisition of marketed products,
the establishment of strategic alliances and corporate partnering arrangements
and the receipt of milestone payments. Critical Accounting Policies Our managements discussion and analysis of our financial condition and
results of operations is based upon our consolidated financial statements,
which have been prepared in accordance with accounting principles generally
accepted in the United States. The preparation of these financial statements
requires us to make estimates and judgments that affect the reported amounts of
assets, liabilities, revenues and expenses, and related disclosures. On an
on-going basis, we evaluate our estimates, including those related to product
returns, sales reserves, bad debts, inventories and intangible
assets. We base our estimates on historical experience and on various other
assumptions that we believe are reasonable under the circumstances, the results
of which form the basis for making judgments about the carrying values of
assets and liabilities that are not readily apparent from other sources. Actual
results may differ from these estimates under different assumptions or
conditions. We believe the following critical accounting policies affect our more
significant judgments and estimates used in the preparation of our consolidated
financial statements. Product Returns, Rebates and Sales Reserves We have estimated reserves for product returns from wholesalers, hospitals
and pharmacies, government chargebacks for goods purchased by certain Federal
government organizations including the Veterans Administration, Medicaid
rebates to all states for goods purchased by patients covered by Medicaid, and
cash discounts for prompt payment. We estimate our reserves by utilizing
historical information for existing products and data obtained from external
sources. For new products, we estimate our reserves for product returns,
government chargebacks and rebates on specific terms for product returns,
chargebacks and rebates, and our experience with similar products. We have an exchange policy which allows customers to return expired
product within six months beyond the expiration date in exchange for
replacement product. The estimated costs for such potential exchanges, which
include actual product costs and related shipping charges, are included in Cost
of Product Sales. In estimating returns for each product, we analyze (i)
historical returns and sales patterns, (ii) current inventory on hand at
wholesalers and the remaining shelf life of that inventory (ranging from 18
months to 3 years for all products except Glofil and VSL#3, which are not
subject to our returned goods policy), and (iii) changes in demand measured by
prescriptions or other data as provided by an independent third party source
and our internal estimates. For Glofil and VSL#3, we accept no returns for
expired product. We routinely assess our historical experience including
customers compliance with our exchange policy, and we adjust our allowances as
appropriate. Our exchange policy is not commonplace in the pharmaceutical industry. The
standard policy in the industry is to issue credit memoranda in exchange for
expired product that is returned. In response to dissatisfaction with our
exchange policy expressed by our three largest customers, we implemented a plan
applicable to all customers during the second quarter of 2004 to transition
from the exchange policy to a credit memoranda policy for the return of expired
product within six months beyond the expiration date. Expired product returned
from production lots released prior to June 1, 2004 continues to be subject to
the product exchange policy. Expired product returned from lots released after
May 31, 2004 are subject to a credit memoranda policy in which a credit
memoranda will be issued for the original purchase price of the returned
product. We commenced shipping a new lot of Acthar in June 2004 and a new lot of
Nascobal in July 2004, which are subject to the credit memoranda policy. A
reserve for the sales value of estimated returns on shipments of Acthar and
Nascobal product lots released and shipped after May 31, 2004 has been recorded
as a liability in the amount of $505,000 as of September 30, 2004 with a
corresponding 13




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reduction in gross product sales. This reserve reflects an estimate of
future credit memoranda to be issued for Acthar and Nascobal, applied to the
quantity of product shipped from lots subject to the credit memoranda policy.
The reserve will be reduced as future credit memoranda are issued, with an
offset to accounts receivable. In estimating the return rate for expired
product subject to credit memoranda, we analyze (i) historical returns and
sales patterns, (ii) current inventory on hand at wholesalers and the remaining
shelf life of that inventory, and (iii) changes in demand measured by
prescriptions and other data as provided by an independent third party source
and our internal estimates. A new lot of Ethamolin is not expected to
be released until late
2005, at which time a reserve for credit memoranda will be estimated and recorded as a
reduction of gross product sales based upon the quantity of product shipped.
This will reduce the future amount recorded as net product sales. A transition period will extend through 2006 between the existing exchange
policy, applicable to product lots released prior to June 1, 2004, and the new
credit memoranda policy, applicable to product lots released after May 31,
2004. The exchange policy will continue through the return period (six months
after expiration) for all product lots released prior to June 1, 2004. These
return periods end as follows: Acthar, June 2005; Nascobal, May 2006;
Ethamolin, October 2006. Reserves for the estimated costs of exchanges will be
recorded on future sales of Ethamolin subject to the exchange policy. The
credit memoranda policy commenced with the actual release of product lots of
Acthar in June 2004 and Nascobal in July 2004, and will apply to the actual
release of an Ethamolin lot currently planned for late 2005. Planned releases
of products are subject to change. Reserves for the estimated credit memoranda
applicable to future returns related to sales from these product lots will be
recorded as shipments occur, and will reduce gross product sales. Until the
transition from our product exchange policy to a credit memoranda policy for
expired product is complete in 2006, both the replacement policy and the credit
memoranda policy will be in effect at the same time, which will result in lower
revenues than historically experienced due to the additional impact of
displacement of future sales from the exchange policy and reduction of gross
product sales for the reserves under the credit memoranda policy. If our transition to a credit memoranda policy for returns is not adhered
to, our options may be limited. We could either not sell our products to our
customers or we could be forced to issue credit memoranda for all returns
currently subject to the exchange policy. If we are forced to issue credit
memoranda for all returns currently subject to the exchange policy, a reserve
for returns (credit memoranda) would be necessary and would be recorded with an
offset to gross product sales at the time of the policy change. The reserve
would be based on an estimate of the future credit memoranda to be issued based
upon historical return rates by product, applied to the quantity of product
sold that has not yet expired. In the event this occurred, the negative impact on our
revenues, operations and cash position would be substantial in the near term. Further, if such a policy change were made, the
currently recorded reserve for product exchanges would be eliminated resulting
in a reduction of cost of product sales. Certain customers have deducted the full price of expired product which
they planned to return from the amounts owed to us (returns receivable). We
reached an agreement with these customers to accept replacement product and pay
the amounts previously deducted in return for an administration fee, however it
remains their standard practice to deduct from payments to us the sales value
of expired product that they have requested authorization to return. As of
September 30, 2004, our returns receivable is $119,000, primarily due to return
materials authorization requests for expired product from Acthar lots that
expired in May 2003 and January 2004 and Ethamolin lots that expired in October
2003, January 2004 and February 2004. Customers have indicated that they will
reimburse us for these deductions upon the replacement of expired units in
accordance with our exchange policy; however, in our experience the timing of
such reimbursements is slower than the collection of our normal trade
receivables. As of September 30, 2004, replacement units have been shipped with
respect to approximately 66% of the amounts owing to us and we are seeking
reimbursement from these customers. As long as our customers standard practice
is to deduct amounts related to the return of expired product, a returns
receivable will arise. Should our customers not comply with our exchange
policy, the amounts deducted by them for returns may not be collectible, and we
would need to increase our allowance for bad debts. In estimating Medicaid rebates, we match the actual rebates to the
quantity of product sold by pharmacies on a product-by-product basis to arrive
at an actual rebate percentage. This historical percentage is used to estimate
a rebate percentage that is applied to the sales to which the rebates apply to
arrive at the rebate expense (reserve) for the period. In particular, we
consider allowable prices by Medicaid. In estimating government chargeback
reserves, we analyze actual chargeback amounts by product and apply historical
chargeback rates to sales to which chargebacks apply. 14




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We routinely assess our experience with Medicaid rebates
and government chargebacks and adjust the reserves accordingly. For qualified customers, we grant payment terms of 2%, net 30 days.
Allowances for cash discounts are estimated based upon the amount of trade
accounts receivable subject to the cash discounts. If actual product returns, government chargebacks, Medicaid rebates and
cash discounts are greater than our estimates, or if our customers fail to
adhere to our exchange or credit memoranda policy, additional reserves may be
required. To date, actual amounts have been consistent with our estimates. Inventories We maintain inventory reserves primarily
for excess and obsolete inventory (due to the
expiration of shelf life of a product). In estimating inventory excess and obsolescence
reserves, we analyze on a product-by-product basis (i) the expiration date,
(ii) our sales forecasts, and (iii) historical demand. Judgment is required in
determining whether the forecasted sales information is sufficiently reliable
to enable us to reasonably estimate excess and obsolete inventory. If actual future
usage and demand for our products are less favorable than those projected by
our management, additional inventory write-offs may be required in the future. Intangible Assets We have intangible assets related to purchased technology, goodwill and
other acquired intangibles. The determination of related estimated useful lives
and whether or not these assets are impaired involves significant judgment.
Changes in strategy and/or market conditions could significantly impact these
judgments and require adjustments to recorded asset balances. In accordance
with SFAS 144, we review intangible assets, as well as other long-lived assets,
for impairment whenever events or circumstances indicate that the carrying
amount may not be fully recoverable. In accordance with SFAS 142, we review
goodwill and other intangible assets with no definitive lives for impairment on
an annual basis. Our fair value is compared to the carrying value of our net
assets, including the intangible assets. If the fair value is greater than the
carrying amount, then no impairment is indicated. To date, no impairment has
been indicated. Results of Operations Three months ended September 30, 2004 compared to the three months ended September 30, 2003: Total Revenues Three Months EndedSeptember 30,
    
    
    
    
    
    %2004
    
    2003
    
    (Decrease)
    
    Change(in $000s)Net product sales
    
    $
    3,869
    
    
    $
    3,943
    
    
    $
    (74
    )
    
    
    (2
    %)Technology and grant revenue
    
    
    
    
    
    
    24
    
    
    
    (24
    )
    
    
    Total revenues
    
    $
    3,869
    
    
    $
    3,967
    
    
    $
    (98
    )
    
    
    (2
    %)
 Total revenues for the quarter ended September 30, 2004 decreased $98,000,
or 2%, from the quarter ended September 30, 2003 due primarily to reserves
against revenues relating to our new credit memoranda policy for expired
product initiated in the second quarter of 2004. Net product sales for the quarter ended September 30, 2004 decreased by
$74,000, or 2%, from the quarter ended September 30, 2003. The decrease in net
product sales is primarily the result of reserves recorded under our credit
memoranda policy initiated in late second quarter of 2004, which lowered
overall net sales. During the quarter ended September 30, 2004, net product
sales of Acthar and Nascobal were reduced by $395,000 for reserves for credit
memoranda under the credit memoranda policy for returns. Net product sales of Nascobal,
which was introduced in July 2003, were $1,136,000 and $924,000
in the quarters ended September 30, 2004 and 2003, respectively.
Nascobal net product sales in the third quarter 2003 were impacted by
one of our three major customers not purchasing any significant
quantities of Nascobal due to their inventory levels at the time of
our acquisition of that product. Nascobal net product sales in the
third quarter 2004 decreased from the previous quarter, partially the
result of declines in wholesaler inventory following an inventory
build-up in the previous quarter. Net product sales of Acthar and
Ethamolin decreased as compared to the third quarter of 2003. Net
product sales of Acthar represented the largest percentage of our
total net product sales for the quarter ended September 30,
2004. Acthar inventory at the wholesale level has declined as
compared to the beginning of 2004. VSL #3 net product sales were
higher in the third quarter of 2004 as compared to the same period in
2003. 15




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##### Table of Contents



Our product exchange policy for expired product remains in effect for lots
released prior to June 1, 2004. Pursuant to our exchange policy, during the
quarter ended September 30, 2004, we replaced vials of Acthar at no cost for
certain returned product from Acthar batches that expired in May 2003 and
January 2004, having a sales value of approximately $153,000, and Ethamolin
that expired in October 2003, January 2004 and February 2004, having a sales
value of approximately $30,000. Subsequent to September 30, 2004, we will
continue to replace Acthar and Ethamolin returned from these expired lots. The
replacement of product subsequent to September 30, 2004 for product that has
expired and future expiring product may displace future quarter sales. The full
extent of this displacement is not ascertainable at this time as it is subject
to market conditions and customer behavior not within our control. The costs
related to replacement products are reserved for and are included as a
component of Cost of Product Sales. Under our exchange policy, as of September
30, 2004, customers have requested the replacement of expired Acthar and
Ethamolin with a sales value of approximately $582,000 which we have
not yet replaced. We intend to replace
this expired product in the fourth quarter of 2004 and the first quarter of
2005. These replacements will likely displace future sales. We review the amount of inventory at the wholesale level in order to help
assess the demand for Acthar, Ethamolin and Nascobal. We expect quarterly
fluctuations in the net sales of all of our products due to the timing of
shipments, changes in wholesaler inventory levels, expiration dates of products
sold, the timing of replacement units shipped under our exchange policy, the impact
of reserves provided for under our credit memo policy and the
reallocation of promotional efforts for each product. We did not recognize any technology, contract research, grant and royalty
revenue for the quarter ended September 30, 2004, as compared to the $24,000 we
recognized in the third quarter of 2003 from reimbursements under our Small
Business Innovation Research grant related to our GERI compound research
projects. The grant ended in July 2003. Cost of Product Sales Cost of product sales for the quarter ended September 30, 2004 increased
$47,000, or 6%, to $843,000 from $796,000 for the quarter ended September 30,
2003. Cost of product sales includes material cost, packaging, warehousing and
distribution, product liability insurance, royalties, quality control, quality
assurance and write-offs of excess/obsolete inventory. The increase in cost of
product sales is primarily due to increases in costs of product stability
testing and higher distribution costs, offset by decreased replacement costs as
a result of the transition to our new credit memoranda policy. During the
second quarter of 2004, one of our largest customers began charging a fee for
distribution services provided to us. Another major customer has informed us
that they intend to implement a similar fee for distribution services in the
fourth quarter of 2004. Cost of product sales as a percentage of net product
sales increased to 22% for the quarter ended September 30, 2004 from 20% for
the quarter ended September 30, 2003. We expect per unit material costs for
Acthar to increase in the future due to higher contract manufacturing and
laboratory costs, which we anticipate could decrease our gross margin on Acthar. Selling, General and Administrative Three Months EndedSeptember 30,
    
    Increase/
    
    %2004
    
    2003
    
    (Decrease)
    
    Change(in $000s)Selling, general and administrative expense
    
    $
    3,415
    
    
    $
    2,630
    
    
    $
    785
    
    
    
    30
    %Percentage of total revenue
    
    
    88
    %
    
    
    66
    %
 Selling, general and administrative expenses for the quarter ended
September 30, 2004 increased $785,000 from the quarter ended September 30,
2003, primarily due to severance and related expenses associated with the
resignation of our CEO. Increased access fees to Sigma-Tau Pharmaceuticals due to higher VSL#3
net product sales and higher expenses for Board of Director fees caused by an increase in
meetings associated with the resignation of our CEO, were partially offset by lower bad debt expense, as compared to the same period in 2003. Selling, general and administrative expenses were 88%
of revenue for the quarter ended September 30, 2004 as compared to 66% for the
quarter ended September 30, 2003. On August 5, 2004, Mr. Charles J. Casamento resigned as Chairman,
President and CEO of the Company. Under the separation agreement entered into
by us and Mr. Casamento, and consistent with certain terms of his employment
agreement, we (i) will continue to pay Mr. Casamento his regular monthly base
salary of $38,208 for 18 months, (ii) paid the prorated portion of his 2004
annual bonus potential in the amount of $136,294 in August 2004, and (iii) extended the
exercise period for 18 months of 129,251 stock options with an exercise price
of $1.25 per share. All other stock options held by Mr. Casamento expired on
November 3, 2004. Although certain payments will be paid on a monthly basis
over the 18 months, Mr. Casamento will not be performing further services for
us, other than part-time consulting services. A charge of approximately
$920,000 was recorded in the third quarter of 2004 to recognize the cost of 16




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##### Table of Contents



the separation arrangement including the payroll and bonus, and other
associated costs. The stock compensation expense related to the
extension of the option exercise period will be insignificant. Research and Development Research and development expenses for the quarter ended September 30, 2004
were $522,000 as compared to $590,000 for the quarter ended September 30, 2003.
The costs included in research and development relate primarily to our
manufacturing site transfers and medical and regulatory affairs compliance
activities. The quarter ended September 30, 2004 includes increased regulatory
fees related to Nascobal, which we introduced in July 2003, and higher Acthar
site transfer costs as compared to the same period in 2003. Higher research and
development expenses in the third quarter of 2003 resulted from closure costs
incurred when we ceased use of our Carlsbad distribution facility and recorded
charges associated with the closure. Research and development expenses for the quarter ended September 30, 2004
include approximately $157,000 related to the manufacturing site transfer of
Acthar, as compared to approximately $114,000 for the quarter ended September
30, 2003. These amounts include costs associated with the Acthar bulk
manufacturing site transfer and the transfer of the potency assay to a new
contract laboratory. We expect site transfer costs in the remainder of 2004 to
approximate costs incurred in the third quarter of 2004. In fiscal year 2003, a
third party contract laboratory performed tests in attempts to validate the
transfer of the potency assay. As of September 30, 2003, this laboratory had
been unsuccessful in validating the assay in order to complete the transfer.
Based in part on the results of these tests, we were not able to complete the
transfer of the assay to a new contract laboratory during 2003. In the fourth
quarter of 2003, we temporarily suspended the testing and instead completed a
review of the results achieved to date. In the first quarter of 2004, we
performed assays evaluating the variables involved that may have affected the
validation of the assay. Beginning in the second quarter of 2004, we resumed
the testing necessary to transfer the potency assay to a new contract
laboratory. However, recent results have not yet met the transfer criteria and
we are evaluating the next steps that will be undertaken. If this laboratory is
unable to validate this specific assay, we may be forced to find a new
contractor to complete this work, which in turn could increase our costs
substantially. Depreciation and Amortization Depreciation and amortization expense for the quarter ended September 30,
2004 decreased to $306,000 from $441,000 for the quarter ended
September 30, 2003. This decrease was due primarily to certain assets becoming
fully amortized in late fiscal year 2003. Amortization in the third quarter of
2004 relates to the purchased technology associated with the Nascobal product
acquisition (for $14.2 million) in June 2003. The Nascobal purchased technology
is being amortized over 15 years. Upon payment of $2 million to Nastech for
approval of the NDA for Nascobal nasal spray, which is expected to occur in the
fourth quarter 2004, we will commence amortization of this cost over 15
years. Other Income and Expense Items Three Months EndedSeptember 30,
    
    Increase/
    
    %2004
    
    2003
    
    (Decrease)
    
    Change(in $000s)Non-cash amortization of deemed discount on convertible
debentures
    
    $
    (130
    )
    
    $
    (130
    )
    
    $
    
    
    
    
    Interest income
    
    
    24
    
    
    
    64
    
    
    
    (40
    )
    
    
    (63
    )%Interest expense
    
    
    (118
    )
    
    
    (82
    )
    
    
    36
    
    
    
    44
    %Other income
    
    
    5
    
    
    
    5
    
    
    
    
    
    
    
    Rental income, net
    
    
    70
    
    
    
    57
    
    
    
    13
    
    
    
    23
    %
 Non-cash amortization of deemed discount on convertible debentures for the
quarter ended September 30, 2004 was $130,000, which was consistent with the
quarter ended September 30, 2003. The convertible debentures were issued in
March 2002. Interest income for the quarter ended September 30, 2004 decreased by
$40,000 from the quarter ended September 30, 2003. The decrease was
due in part to interest earned
in the third quarter of 2003 on a 17




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##### Table of Contents



financing lease of equipment. Interest expense for the quarter ended
September 30, 2004 increased by $36,000 from the quarter ended September 30,
2003. Interest expense consists primarily of interest on our convertible
debentures and on the $2.2 million promissory note we issued to Sigma-Tau in
July 2004. Rental income, net, for the quarter ended September 30, 2004 increased by
$13,000 from the quarter ended September 30, 2003. Rental income, net,
arises primarily from the lease and sublease of our former headquarters
facility in Hayward, California. In August 2004, the sublessee of the Hayward
facility failed to make timely payment. The sublessee has since made payment,
however, there can be no assurance that the sublessee will make timely payments
in the future. Although the current rental income from the sublessee exceeds
the current rental expense on the Hayward facility, there can be no assurance
our sublessee will not default on the sublease agreement, and if they were to
do so, we would still be obligated to pay rent on this property through
November 2012. Series B Preferred Stock Dividends Preferred Stock dividends of $168,000 and $200,000 for the quarters ended
September 30, 2004 and 2003, respectively, represent the 8% cash dividends paid
to our Series B Preferred Stockholders. These dividends are required to be paid
by us in cash quarterly. The Series B Preferred Stock was issued in January
2003. Nine months ended September 30, 2004 compared to the nine months ended September 30, 2003: Total Revenues Nine Months EndedSeptember 30,
    
    Increase/
    
    %2004
    
    2003
    
    (Decrease)
    
    Change(in $000s)Net product sales
    
    $
    13,107
    
    
    $
    9,185
    
    
    $
    3,922
    
    
    
    43
    %Technology and grant revenue
    
    
    
    
    
    
    308
    
    
    
    (308
    )
    
    
    Total revenues
    
    $
    13,107
    
    
    $
    9,493
    
    
    $
    3,614
    
    
    
    38
    %
 Total revenues for the nine months ended September 30, 2004 increased
$3,614,000, or 38%, from the nine months ended September 30, 2003, due to
increases in net product sales. Net product sales for the nine months ended September 30, 2004 increased
by $3,922,000, or 43%, from the nine months ended September 30, 2003. The
increase in net product sales is primarily the result of revenue from sales of
Nascobal, which was introduced in July 2003, and increases in sales of VSL #3
and Ethamolin offset by a decrease in sales of Acthar. In addition, net product
sales for the first nine months of 2004 included $325,000 of shipments to
wholesalers in January 2004 for orders received in December 2003. Nascobal inventory at the wholesale level has increased since the
beginning of 2004. Wholesaler inventories declined slightly in the third quarter
following this inventory buildup in previous quarters. To the extent that
inventory levels are too high, future net product sales may be adversely
affected. During the nine months ended September 30, 2004 gross product sales
of Nascobal were reduced by the reserve for credit memoranda under our new
credit memoranda policy. The increase in net product sales in the nine months ended September 30,
2004 over the same period in 2003 also reflects higher net product sales of VSL
#3 and Ethamolin. The increase in net product sales of Ethamolin in the first
nine months of 2004 over the first nine months of 2003 was partially the result
of lower shipments in the first quarter of 2003 resulting from the impact of
the advanced buying by wholesalers of Ethamolin in mid-2002 after we
pre-announced a price increase. During the nine months ended September 30,
2004, we replaced units of Ethamolin at no cost having a sales value of
approximately $198,000 under our exchange policy. Inventory of Acthar at the wholesale level has declined as compared to the
beginning of 2004. Revenues from the sale of Acthar declined in part due to the
reductions in inventory at the wholesale level during the nine months ended
September 30, 2004. Based on internal estimates and information provided by our
major customers, inventory levels of Acthar declined by more than one month of
demand from inventory levels at the beginning of 2004, as major customers
purchased less than their reported sales. During the nine months ended
September 30, 2004, we replaced vials of Acthar at no cost having a sales value
of approximately $873,000 under our exchange policy. In addition, during the
nine months ended September 30, 2004 gross product sales of Acthar were reduced
by the reserve for credit memoranda under our new credit memoranda policy. 18




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##### Table of Contents



We expect quarterly fluctuations in the net sales of all of our products
due to the timing of shipments, changes in wholesaler inventory levels,
expiration dates of products sold, the timing of replacement units shipped
under our exchange policy, the impact of reserves provided for under our credit memo policy
and the reallocation of promotional efforts for each product. We did not recognize any technology revenue for the nine months ended
September 30, 2004. We recognized $250,000 in technology revenue for the nine
months ended September 30, 2003 from our License Agreement with Fabre-Kramer. We did not recognize any grant revenue for the nine months ended September
30, 2004, as compared to the $58,000 we recognized in the first nine months of
2003 from reimbursements under our Small Business Innovation Research grant
related to our GERI compound research projects. The grant was terminated in
July 2003. Cost of Product Sales Cost of product sales for the nine months ended September 30, 2004
increased $40,000 to $2,660,000 from $2,620,000 for the nine months ended
September 30, 2003. The increase was primarily due to increased material and
distribution costs related to higher product sales and the new distribution
agreement with one of our major distributors, and increases in costs of product
stability testing. These increases were partially offset by decreases in the
provision for inventory obsolescence, lower royalties, and decreased
replacements costs due to the transition to our new credit memoranda policy.
Cost of product sales as a percentage of net product sales decreased to 20% for
the nine months ended September 30, 2004 from 28% for same period in 2003. The
decrease in the percentage of cost of product sales as compared to net product
sales results from changes in the mix of products sold and decreases in our
allowance for inventory obsolescence. We expect per unit material costs for
Acthar to increase in the future due to higher contract manufacturing and
laboratory costs, which we anticipate could decrease our gross margin on
Acthar. In April 2003, we decided to outsource certain functions previously
performed in our Carlsbad, California distribution center, including, but not
limited to, warehousing, shipping and quality control studies. Selling, General and Administrative Nine Months EndedSeptember 30,
    
    Increase/
    
    %2004
    
    2003
    
    (Decrease)
    
    Change(in $000s)Selling, general and administrative expense
    
    $
    8,958
    
    
    $
    7,950
    
    
    $
    1,008
    
    
    
    13
    %Percentage of total revenue
    
    
    68
    %
    
    
    84
    %
 Selling, general and administrative expenses for the nine months ended
September 30, 2004 increased $1,008,000, or 13%, from the nine months ended
September 30, 2003, primarily due to severance and related expenses associated
with the resignation of our CEO in August 2004. As a percentage of revenue,
selling, general and administrative expenses decreased to 68% for the nine
months ended September 30, 2004 compared to 84% for the nine months ended
September 30, 2003, largely due to the increase in total revenues. In the third
quarter of 2004, we recorded a charge of approximately $920,000 for severance
and related costs associated with the resignation of our CEO in August 2004.
Increased spending on sales and marketing, increased access fees to Sigma-Tau
Pharmaceuticals due to higher net product sales of VSL#3 and higher costs for
Board of Director fees associated with the resignation of our CEO, partially
offset lower legal and investor relations expenses. Research and Development Research and development expenses for the nine months ended September 30,
2004 were $1,521,000 as compared to $1,912,000 for the nine months ended
September 30, 2003. In the third quarter of 2003 we ceased use of our
distribution facility and recorded a charge related to the remaining lease
payments. Lower Acthar site transfer costs for the nine months ended September
30, 2004 as compared to the same period in 2003 were offset by regulatory fees
related to Nascobal, which we introduced in July 2003. Research and development expenses for the nine months ended September 30,
2004 include approximately $391,000 related to the manufacturing site transfer
of Acthar, as compared to approximately $670,000 for the nine months ended
September 30, 2003. These amounts for site transfer include costs associated with the
Acthar bulk manufacturing site transfer and the transfer of the potency assay
to a new contract laboratory. 19




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##### Table of Contents



Depreciation and Amortization Depreciation and amortization expense for the nine months ended September 30, 2004 increased to $905,000 from $822,000 for the nine months ended
September 30, 2003. This increase was due primarily to the amortization of the
purchased technology related to the Nascobal product acquisition (for $14.2 million) in June 2003, partially offset by certain assets becoming fully
amortized in late fiscal 2003. Other Income and Expense Items Nine Months EndedSeptember 30,
    
    Increase
    
    %2004
    
    2003
    
    (Decrease)
    
    Change(in $000s)Non-cash amortization of deemed discount on
convertible debentures
    
    $
    (392
    )
    
    $
    (391
    )
    
    $
    1
    
    
    
    Interest income
    
    
    48
    
    
    
    219
    
    
    
    (171
    )
    
    
    (78
    )%Interest expense
    
    
    (282
    )
    
    
    (251
    )
    
    
    31
    
    
    
    12
    %Other income
    
    
    8
    
    
    
    
    
    
    
    8
    
    
    
    Other expense
    
    
    
    
    
    
    (75
    )
    
    
    (75
    )
    
    
    Rental income, net
    
    
    212
    
    
    
    194
    
    
    
    18
    
    
    
    9
    %
 Non-cash amortization of deemed discount on convertible debentures for the
nine months ended September 30, 2004 was $392,000, which was consistent with
the nine months ended September 30, 2003. The convertible debentures were
issued in March 2002. Interest income for the nine months ended September 30, 2004 decreased by
$171,000 from the nine months ended September 30, 2003. The decrease was
primarily due to lower cash balances during the first nine months of 2004 and
interest earned in the first nine months of 2003 on a financing lease of
equipment. Interest expense for the nine months ended September 30, 2004
increased by $31,000 from the nine months ended September 30, 2003. Interest
expense consists primarily of interest on our convertible debentures and on the
$2.2 million promissory note we issued to Sigma-Tau in July 2004. Other expense for the nine months ended September 30, 2004 decreased by
$75,000 from the nine months ended September 30, 2003. The expense in the first
nine months of fiscal year 2003 was primarily due to the other-than-temporary
loss of $51,000 and realized losses of $14,000 related to our investment in the
common stock of Rigel Pharmaceuticals. We liquidated our investment in Rigel
common stock in the second quarter of fiscal year 2003. Rental income, net, for the nine months ended September 30, 2004 increased
$18,000 from the nine months ended September 30, 2003. Rental income, net,
arises primarily from the lease and sublease of our former headquarters
facility in Hayward, California. Although the current rental income from the
sublessee exceeds the current rental expense on the Hayward facility, there can
be no assurance our sublessee will not default on the sublease agreement, and
if they were to do so, we would still be obligated to pay rent on this property
through November 2012. Series B Preferred Stock Dividends Preferred Stock dividends of $508,000 and $567,000 for the nine months
ended September 30, 2004 and 2003, respectively, represent the 8% cash
dividends paid to our Series B Preferred Stockholders. These dividends are
required to be paid by us in cash quarterly. The Series B Preferred Stock was
issued in January 2003. Non-cash deemed dividends of $1,394,000 at September 30, 2003 are related
to the beneficial conversion feature in connection with the Series B Preferred
Stock and warrants issued in January 2003. A beneficial conversion feature was
recorded because the effective conversion price of the Series B Preferred Stock
was less than the fair value of our common stock on the commitment date. Liquidity and Capital Resources We have funded our activities to date principally through various
issuances of equity securities. Through September 30, 2004, we have raised
total net proceeds of $63.1 million. We have also funded our activities to date
to a lesser extent through product sales. 20




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##### Table of Contents



At September 30, 2004, we had cash, cash equivalents and short-term
investments of $8,743,000 compared to $3,220,000 at December 31, 2003. At
September 30, 2004, our working capital was $4,470,000 compared to $4,352,000
at December 31, 2003. The increase in our working capital was principally due
to proceeds of $2.2 million received from a secured promissory note issued in
July 2004, net proceeds of $2.4 million received in our private placement in
January 2004 and funds provided by operations, partially offset by the
reclassification of $3,773,000 of convertible debentures to current liabilities
during the first quarter of 2004. The convertible debentures, with a face value
of $4 million, mature and become due and payable in March 2005. Prior to March 31, 2005, we may have to make cash payments totaling $4
million, which include $2 million payable at maturity on the convertible
debenture held by a wholly-owned subsidiary of Sigma-Tau, Defiante Farmaceutica
LdA (Defiante), and a $2 million contingent payment to Nastech relating to
our agreement to acquire rights to the new Nascobal nasal spray, an alternative
dosage form of Nascobal. Additionally, another $2 million contingent payment may be due to Nastech if and when a United States patent issues, based upon Nastech's patent filings, that covers any nasal formulation that treats any indication in the approved NDA. The $4 million total of 8% convertible debentures were issued in March
2002, $2 million to an institutional investor, and $2 million to Defiante. At
maturity on March 15, 2005, we may redeem the institutional investors
debentures for stock, subject to certain limitations. We may redeem Defiantes
debenture for stock at maturity, provided the market price of our common stock
at the time of redemption is greater than $1.50 per share (representing the
five day average closing sale price of our common stock immediately prior to
March 15, 2002). If the price of our common stock is not greater than $1.50 per
share on March 15, 2005, we would be required to pay $2 million in cash to
Defiante at the maturity date. We may also attempt to restructure the terms of
the convertible debenture held by Defiante in order to extend the term of the
note or provide for a lower conversion price. In connection with our acquisition of Nascobal, we also agreed to acquire
the rights to Nascobal nasal spray, an alternative dosage form of Vitamin B-12,
for which there will be two contingent payments to Nastech of $2 million each.
Upon approval by the FDA of an NDA filed by Nastech for Nascobal nasal spray,
Nastech is obligated to transfer the NDA to us, and we are obligated to pay $2
million to Nastech. Upon subsequent issuance of a United States patent including claims for a nasal spray that treats any indication in the approved NDA,
we are obligated to pay an additional $2 million to Nastech. An NDA for the
intranasal spray was filed by Nastech with the FDA in December 2003. The target
date for FDAs review and action on this NDA application was ten months from
the date of submission, or October 29, 2004. We are now aware that the FDA
issued an approvable letter to Nastech for the nasal spray NDA on October 28,
2004. There were no FDA requirements for Nastech to conduct additional work
related to manufacturing, preclinical or clinical studies. Remaining items to
be completed for product approval include an FDA inspection of the Vitamin B-12
raw material manufacturing facility (scheduled for November 15, 2004) and
finalization of the product labeling. Hence the NDA could be approved by the
end of the fourth quarter of 2004. The United States patent applications for the Nascobal
nasal spray have been filed by Nastech. On July 31, 2004, we issued a $2.2 million secured promissory note to
Defiante. We intend to use a majority of the proceeds from the note to fund the
$2 million payment to be made to Nastech upon approval of the NDA for the
Nascobal spray. The note will be secured by the Nascobal intellectual property
including the NDA for the spray formulation when it is approved. The note,
bearing interest at 9.83% per annum, requires interest only payments for the
first twelve months, with monthly principal and interest payments thereafter
through August 2008. We may have substantial cash outlays for the Acthar site transfer. We
incurred approximately $400,000 of expenses during the nine months ended
September 30, 2004 related to the Acthar site transfer. The site transfer
process is not complete and may require substantial cash outlays for the work
performed, capital expenditures and inventory, prior to the transfer being
complete. It is currently our customers standard practice to deduct from payments
to us the amount of the sales value of expired product, or returns receivable,
that they have requested for return. The returns receivable amounted to
$119,000 at September 30, 2004. Customers have indicated that they will
reimburse us for these deductions upon the replacement of units in accordance
with our exchange policy, however, our experience has been the timing of such
reimbursements is slower than the collection of our normal trade receivables.
As of September 30, 2004, replacement units have been shipped relating to
approximately 66% of amounts owing to us and we are seeking reimbursement from
these customers. As long as our customers standard practice is to deduct
amounts related to the return of expired product, a returns receivable will
arise. Should our customers not comply with our exchange policy, the amounts
deducted by them for returns may not be collectible. On August 5, 2004, Mr. Charles J. Casamento resigned as Chairman,
President and CEO of the Company. Under the separation agreement entered into
by us and Mr. Casamento, and consistent with certain terms of his
employment agreement, we (i) will continue to pay Mr. Casamento his regular
monthly base salary of $38,208 for 18 months, (ii) paid the prorated portion of
his 2004 annual bonus potential in the amount of $136,294 in August 2004, and
(iii) extended the exercise period for 18 months of 129,251 stock options with
an exercise price of $1.25 per share. All other stock options held by Mr.
Casamento expired on November 3, 2004. 21




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##### Table of Contents



Although certain payments are being paid on a monthly basis over the 18
months, Mr. Casamento will not be performing further services for us, other
than part-time consulting services. Approximately $920,000 was recorded in the
third quarter of 2004 to recognize the cost of the separation arrangement
including the payroll and bonus, and other associated costs. In June 2004, we implemented a transition plan for expired product returns
from a product exchange policy to a credit memoranda policy. Under the credit
memoranda policy, a credit memorandum will be issued for the original purchase
price of the returned product, for expired product returned from lots released
after May 31, 2004. We expect that cash flow will be negatively impacted when
future credit memoranda are issued for expired product returned from lots
subject to our credit memoranda policy. In January 2004, we entered into agreements with existing shareholders and
issued 4,878,201 shares of common stock in exchange for $2.4 million in cash
and the surrender of outstanding warrants to purchase 3,878,201 shares of
common stock. Our offer to issue common stock for cash and the surrender of
warrants was made to all warrant holders. The warrants retired represented
approximately 46% of our warrants outstanding as of December 31, 2003. The
warrants surrendered were included as consideration at their aggregate fair
value of $743,000, which was determined using a Black-Scholes valuation method.
The purchase price of the common stock, which was payable in cash and surrender
of outstanding warrants, was $0.644 per share, which was the volume weighted
average price of our common stock in December 2003 for the five trading days
prior to reaching agreement on the terms of the transaction. Sigma-Tau
participated in the transaction, purchasing 759,493 shares of common stock for
aggregate consideration of $489,000 in cash and the surrender of 759,493
warrants with a fair value of $53,000 to purchase common stock. In January 2003, we completed a private placement of Series B Convertible
Preferred Stock and warrants to purchase common stock to various healthcare
investors. Our gross proceeds from the private placement were $10 million. Net
of issuance costs, our proceeds were $9.4 million. The Series B Preferred Stock
had an aggregate stated value at the time of issuance of $10 million and is
entitled to a quarterly dividend at an initial rate of 8% per year, which rate
will increase to 10% per year on and after January 1, 2006, and to 12% on and
after January 1, 2008. The dividends are paid in cash on a quarterly basis. In
addition, on the occurrence of designated events the dividend rate will
increase by an additional 6% per year. Under California General Corporation Law, in order to pay dividends or
other distributions a company must meet certain financial tests relating to
profits or working capital and net assets. Based upon internally prepared cash
forecasts we may be prohibited from paying the Series B Preferred Stock
quarterly dividend payable as of December 31, 2004, as the working capital
financial test may not be met. In the event of non-payment of the quarterly
dividend the Series B shareholders are entitled to an additional dividend of
6% which would accrue until the quarterly and the additional dividend are
paid. Based upon the current Series B Preferred Stock outstanding at September
30, 2004 the additional dividend would be $126,000 per quarter. We have
approached the holders of the Series B Preferred Stock regarding obtaining a
waiver of the additional dividend among other requirements, however, it is
unknown whether a waiver can be obtained or under what terms the waiver could
be obtained. The Series B Preferred Stock is entitled to a liquidation preference over
our common stock and Series A Preferred Stock upon a liquidation, dissolution
or winding up of Questcor. The Series B Preferred Stock is convertible at the
option of the holder into our common stock at a conversion price of $0.9412 per
share, subject to certain anti-dilution adjustments. To date, Series B
Preferred Stock having a stated value of $1.6 million and accrued and unpaid
dividends of $17,000 has been converted into 1,724,912 shares of common stock.
We have the right commencing on January 1, 2006 (assuming specified conditions
are met) to redeem the Series B Preferred Stock at a price of 110% of stated
value, together with all accrued and unpaid dividends and arrearage interest.
In addition, upon the occurrence of designated Optional Redemption Events, the
holders have the right to require us to redeem the Series B Preferred Stock at
100% of its stated value ($8.4 million at September 30, 2004), together with
all accrued and unpaid dividends and accrued interest. The terms of the Series
B Preferred Stock contain a variety of affirmative and restrictive covenants,
including limitations on indebtedness and liens. Each share of Series B
Preferred Stock is generally entitled to a number of votes equal to 0.875 times
the number of shares of common stock issuable upon conversion of such share of
Series B Preferred Stock. The purchasers of the Series B Preferred Stock also
received for no additional consideration warrants exercisable for an aggregate
of 3,399,911 shares of our common stock at an exercise price of $1.0824 per
share, subject to certain anti-dilution adjustments. The warrants expire in
January 2007. In June 2003, the exercise price of the warrants was adjusted to
$0.9412 per share. In January 2004 warrants to purchase 373,990 shares of
common stock were surrendered as consideration, along with cash, for the
issuance of 373,990 shares of common stock. Based on our internal forecasts and projections, we believe that our cash
on hand at September 30, 2004, the net cash flows generated from operations,
and the proceeds from the $2.2 million note issued to Defiante in July 2004,
will be sufficient to fund operations through at least September 30, 2005,
assuming that we are able to restructure or extend the terms of the convertible 22




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debenture held by Defiante and that the second contingent payment to
Nastech upon issuance of a patent for the nasal spray occurs subsequent to
September 30, 2005, or unless a substantial portion of our cash is used for
product acquisition or our revenues are less than we expect. Our future funding requirements will depend on many factors, including:
the timing and extent of product sales; returns of expired product; the
acquisition and licensing of products, technologies or compounds, if any; our
ability to manage growth; timing of payments to Nastech relating to the nasal
spray formulation of Nascobal; the results of our attempt to restructure or
extend the terms of the convertible debenture held by Defiante; competing
technological and market developments; costs involved in filing, prosecuting,
defending and enforcing patent and intellectual property claims; the receipt of
licensing or milestone fees from current or future collaborative and license
agreements, if established; the timing of regulatory approvals; the timing and
successful completion of the Acthar site transfer; payment of dividends and
compliance to prevent additional dividend events; any expansion or acceleration
of our development programs or optional redemption events, and other factors. If our revenues do not grow and provide cash flow from operations in an
amount sufficient to meet our obligations, or if we do not have sufficient
funds to redeem the convertible debentures, which have a face value of $4
million, for cash, or a combination of cash and stock, upon maturity in March
2005, or if we are unable to maintain compliance with certain covenants and
thus avoid the payment of additional dividends of 6% to the holders of our
Series B Convertible Preferred Stock, or we do not have sufficient funds to
make the contingent payments, if, and when due to Nastech for the NDA and the
patent approvals of the new nasal spray form of Nascobal, or if we have
insufficient funds to acquire additional products or expand our operations, we
will seek to raise additional capital through public or private equity
financing or from other sources. However, traditional asset based debt
financing has not been available on acceptable terms. Additionally, we may seek
to raise additional capital whenever conditions in the financial markets are
favorable, even if we do not have an immediate need for additional cash at that
time. There can be no assurance that we will be able to obtain additional funds
on desirable terms or at all. RISK FACTORS The following risk factor supplements the risk factors contained in our Annual
Report on Form 10-K for the fiscal year ended December 31, 2003 and our
Quarterly Report on Form 10-Q for the quarter ended June 30, 2004. You should
carefully consider the following risk factor as well as those contained our
Annual Report on Form 10-K and our Quarterly Report on Form 10-Q. Each of these
risks could adversely affect our business, financial condition and results of
operations, as well as adversely affect the value of an investment in our
common stock. The Company is operating without a full-time Chief Executive Officer. If we
lose the services of certain key personnel or are unable to hire skilled
personnel in the future, our business will be harmed. On August 5, 2004, Mr. Charles J. Casamento resigned as Chairman,
President and Chief Executive Officer. Mr. Casamento will continue to act as a
consultant to the Company under a part-time consulting arrangement. Mr. Timothy
Morris has announced his intention to resign as Senior Vice President of
Finance and Administration and Chief Financial Officer effective November 9,
2004. On November 1, 2004 the Board of Directors named Albert Hansen as
Chairman and Acting CEO. The Board of Directors is working to identify
successors and the Search Committee has made progress in identifying
candidates. If the Board is unsuccessful in hiring successors to these
positions, or if successors cannot be hired in a timely manner, our business
could be harmed. We are highly dependent on the services of our Chairman and
Acting CEO, Albert Hansen and Vice President of Sales and Marketing, Mr. R.
Jerald Beers. If we were to lose Mr. Hansen or Mr. Beers as employees, our
business could be harmed. Moreover, we do not carry key person life insurance for our senior
management or other personnel. Additionally, the future potential growth and
expansion of our business is expected to place increased demands on our
management skills and resources. Although only minor increases in staffing
levels are expected during 2004, recruiting and retaining management and
operational personnel to perform sales and marketing, business development,
regulatory affairs, quality assurance, medical affairs and contract
manufacturing in the future will also be critical to our success. We do not
know if we will be able to attract and retain skilled and experienced
management and operational personnel in the future on acceptable terms given
the intense competition among numerous pharmaceutical and biotechnology
companies for such personnel. If we are unable to hire necessary skilled
personnel in the future, our business could be harmed. 23




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ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK Our exposure to market risk at September 30, 2004 has not changed
materially from December 31, 2003, and reference is made to the more detailed
disclosures of market risk included in our Annual Report on Form 10-K for the
fiscal year ended December 31, 2003 as filed with the Securities and Exchange
Commission on March 30, 2004. 
 ITEM 4. CONTROLS AND PROCEDURES We maintain disclosure controls and procedures that are designed to ensure
that information required to be disclosed in our Exchange Act reports is
recorded, processed, summarized and reported within the time periods specified
in the Securities and Exchange Commissions rules and forms and that such
information is accumulated and communicated to our management, including our
Principal Executive Officers and Chief Financial Officer, as appropriate, to
allow for timely decisions regarding required disclosure. In designing and
evaluating the disclosure controls and procedures, management recognizes that
any controls and procedures, no matter how well designed and operated, can
provide only reasonable assurance of achieving the desired control objectives,
and management is required to apply its judgment in evaluating the cost-benefit
relationship of possible controls and procedures. As required by SEC Rule 13a-15(b), we carried out an evaluation, under the
supervision and with the participation of our management, including our
Principal Executive Officers and Chief Financial Officer, of the effectiveness
of the design and operation of our disclosure controls and procedures as of the
end of the quarter covered by this report. Based on the foregoing, our
Principal Executive Officers and Chief Financial Officer concluded that our
disclosure controls and procedures were effective at the reasonable assurance
level. There has been no change in our internal controls over financial reporting
during our most recent fiscal quarter that has materially affected, or is
reasonably likely to materially affect, our internal controls over financial
reporting. However, effective November 9, 2004, the Company will operate
without a Chief Financial Officer. Al Hansen, Chairman and Acting Chief
Executive Officer will be operating in a part-time capacity. Significant
effort is under way to recruit a Chief Executive Officer. The absence of a CFO
and the impact of a part-time CEO may have a material effect on our internal
controls over financial reporting. During the fourth quarter 2004, the Company
will re-assess and modify the internal controls to compensate for these changes
in personnel. 24




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PART II. OTHER INFORMATION 
 ITEM 1. LEGAL PROCEEDINGS Not applicable 
 ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS Not applicable 
 ITEM 3. DEFAULTS UPON SENIOR SECURITIES Not applicable 
 ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS Not applicable. 
 ITEM 5. OTHER INFORMATION Not applicable 
 ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K (a) Exhibits 10.34
    
    Promissory Note and Security Agreement dated July 31, 2004 between the Company and Defiante Farmaceutica LdA.31
    
    Certification pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.32
    
    Certification pursuant to Section 906 of the Public Company Accounting Reform and Investor Act of 2002.
 (b) Reports on Form 8-K On August 6, 2004, we furnished on Form 8-K, under Item 12, our press
release of our results for the quarter ended June 30, 2004. 25




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SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned hereunto duly authorized. QUESTCOR PHARMACEUTICALS, INC.Date: November 8, 2004
    By:
    /s/ TIMOTHY E. MORRISTimothy E. MorrisSenior Vice President, Finance & Administration,
Chief Financial Officer
(Principal Financial and Accounting Officer)
and Principal Executive OfficerBy:
    /s/ R. JERALD BEERSR. Jerald BeersOffice of the President
Vice President of Sales and Marketing
and Principal Executive Officer 26




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Exhibit Index 10.34
    
    Secured Promissory Note and Security Agreement dated July 31, 2004 between the Company and Defiante
Farmaceutica LdA.31
    
    Certification pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.32
    
    Certification pursuant to Section 906 of the Public Company Accounting Reform and Investor Act of 2002.