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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 JUNE 30, 2004 OR [  ]
    
    TRANSITION REPORT
PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF
1934.
FOR THE TRANSITION PERIOD FROM            
TO
 COMMISSION FILE NUMBER: 0-20772 QUESTCOR PHARMACEUTICALS, INC. (Exact name of Registrant as specified in its charter)
 CALIFORNIA
(State or other jurisdiction
of incorporation or organization)
    
    33-0476164
(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 August 9, 2004 there were 51,111,346 shares of the Registrants common
stock, no par value per share, outstanding.




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##### Table of Contents



QUESTCOR PHARMACEUTICALS, INC. FORM 10-Q TABLE OF CONTENTS PART I. FINANCIAL INFORMATIONItem 1
    
    Financial Statements and Notes (Unaudited)
    
    3Condensed
Consolidated Balance Sheets  June 30, 2004 and December 31, 2003
    
    3Condensed Consolidated Statements of Operations  for the three months and six months ended June 30, 2004 and 2003
    
    4Condensed Consolidated Statements of Cash Flows  for the six months ended June 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 Market Risk
    
    25Item 4
    
    Controls and Procedures
    
    25PART II. OTHER INFORMATION
    
    26Item 1
    
    Legal Proceedings
    
    26Item 2
    
    Changes in Securities and Use of Proceeds
    
    26Item 3
    
    Defaults Upon Senior Securities
    
    26Item 4
    
    Submission of Matters to a Vote of Security Holders
    
    26Item 5
    
    Other Information
    
    26Item 6
    
    Exhibits and Reports on Form 8-K
    
    27Signatures
    
    
    
    28EXHIBIT 10.31EXHIBIT 10.32EXHIBIT 10.33EXHIBIT 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)
 June 30,
    
    December 31,2004
    
    2003(Unaudited)
    
    (Note 1)ASSETSCurrent assets:Cash and cash equivalents
    
    $
    5,899
    
    
    $
    3,220Accounts receivable, net of allowances for doubtful accounts of
$50 and $60 at June 30, 2004 and December 31, 2003, respectively
    
    
    2,178
    
    
    
    2,161Inventories, net
    
    
    990
    
    
    
    1,050Prepaid expenses and other current assets
    
    
    584
    
    
    
    873Total current assets
    
    
    9,651
    
    
    
    7,304Property and equipment, net
    
    
    678
    
    
    
    609Purchased technology, net
    
    
    13,236
    
    
    
    13,709Goodwill and other indefinite lived intangible assets
    
    
    479
    
    
    
    479Deposits and other assets
    
    
    825
    
    
    
    828Total assets
    
    $
    24,869
    
    
    $
    22,929LIABILITIES AND STOCKHOLDERS EQUITYCurrent liabilities:Accounts payable
    
    $
    1,046
    
    
    $
    1,402Accrued compensation
    
    
    247
    
    
    
    358Other accrued liabilities
    
    
    1,130
    
    
    
    1,052Short-term debt
    
    
    56
    
    
    
    140Convertible debentures, (face amount of $4,000), net of
deemed discount of $350 at June 30, 2004
    
    
    3,650
    
    
    
    Total current liabilities
    
    
    6,129
    
    
    
    2,952Convertible debentures, (face amount of $4,000), net of deemed
discount of $598 at December 31, 2003
    
    
    
    
    
    
    3,402Other non-current liabilities
    
    
    933
    
    
    
    916Commitments and contingenciesPreferred stock, no par value, 7,500,000 shares authorized; 2,155,715
Series A shares issued and outstanding at June 30, 2004 and December 31, 2003
(aggregate liquidation preference of $10,000 at June 30, 2004 and December 31, 2003)
    
    
    5,081
    
    
    
    5,081Stockholders equity:Preferred stock, no par value, 8,400 and 9,100 Series B shares issued and outstanding at June
30, 2004 and December 31, 2003, respectively, net of issuance costs (aggregate liquidation
preference of $8,400 and $9,100 at June 30, 2004 and December 31, 2003, respectively)
    
    
    7,578
    
    
    
    8,278Common stock, no par value, 105,000,000 shares authorized; 51,111,346 and 45,387,802 shares
issued and outstanding at June 30, 2004 and December 31, 2003, respectively
    
    
    88,392
    
    
    
    85,232Deferred compensation
    
    
    (12
    )
    
    
    (17
    )Accumulated deficit
    
    
    (83,232
    )
    
    
    (82,915
    )Total stockholders equity
    
    
    12,726
    
    
    
    10,578Total liabilities and stockholders equity
    
    $
    24,869
    
    
    $
    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
    
    Six Months EndedJune 30,
    
    June 30,2004
    
    2003
    
    2004
    
    2003Revenues:Net product sales
    
    $
    4,090
    
    
    $
    2,880
    
    
    $
    9,238
    
    
    $
    5,242Technology and grant revenue
    
    
    
    
    
    
    25
    
    
    
    
    
    
    
    284Total revenues
    
    
    4,090
    
    
    
    2,905
    
    
    
    9,238
    
    
    
    5,526Operating costs and expenses:Cost of product sales
    
    
    961
    
    
    
    1,149
    
    
    
    1,817
    
    
    
    1,824Selling, general and administrative
    
    
    2,515
    
    
    
    2,517
    
    
    
    5,543
    
    
    
    5,320Research and development
    
    
    421
    
    
    
    711
    
    
    
    999
    
    
    
    1,322Depreciation and amortization
    
    
    301
    
    
    
    212
    
    
    
    599
    
    
    
    381Total operating costs and expenses
    
    
    4,198
    
    
    
    4,589
    
    
    
    8,958
    
    
    
    8,847Income (loss) from operations
    
    
    (108
    )
    
    
    (1,684
    )
    
    
    280
    
    
    
    (3,321
    )Non-cash amortization of deemed discount
on convertible debentures
    
    
    (131
    )
    
    
    (130
    )
    
    
    (262
    )
    
    
    (261
    )Interest expense, net
    
    
    (68
    )
    
    
    (18
    )
    
    
    (140
    )
    
    
    (14
    )Other income (expense), net
    
    
    
    
    
    
    (3
    )
    
    
    3
    
    
    
    (80
    )Rental income, net
    
    
    60
    
    
    
    66
    
    
    
    142
    
    
    
    137Net income (loss)
    
    
    (247
    )
    
    
    (1,769
    )
    
    
    23
    
    
    
    (3,539
    )Non-cash deemed dividend related to
beneficial conversion feature of Series B
Preferred Stock
    
    
    
    
    
    
    93
    
    
    
    
    
    
    
    1,394Dividends on Series B Preferred Stock
    
    
    168
    
    
    
    200
    
    
    
    340
    
    
    
    367Net loss applicable to common stockholders
    
    $
    (415
    )
    
    $
    (2,062
    )
    
    $
    (317
    )
    
    $
    (5,300
    )Basic and diluted net loss per share
applicable to common stockholders
    
    $
    (0.01
    )
    
    $
    (0.05
    )
    
    $
    (0.01
    )
    
    $
    (0.13
    )Shares used in computing basic and
diluted net loss per share applicable to
common stockholders
    
    
    51,060
    
    
    
    39,949
    
    
    
    50,546
    
    
    
    39,316
 See accompanying notes. 4




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QUESTCOR PHARMACEUTICALS, INC. 
 CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (IN THOUSANDS)
(UNAUDITED)
 Six Months EndedJune 30,2004
    
    2003OPERATING ACTIVITIESNet income (loss)
    
    $
    23
    
    
    $
    (3,539
    )Adjustments to reconcile net income (loss) to net cash provided by (used in) operating activities:Stock-based compensation expense
    
    
    17
    
    
    
    25Amortization of deemed discount on convertible debentures
    
    
    262
    
    
    
    261Amortization of deferred compensation
    
    
    4
    
    
    
    13Depreciation and amortization
    
    
    599
    
    
    
    381Other-than-temporary loss on investment
    
    
    
    
    
    
    51Deferred rent expense
    
    
    17
    
    
    
    18Loss on the sale of investments
    
    
    
    
    
    
    14Loss on the sale of equipment, net
    
    
    
    
    
    
    13Changes in operating assets and liabilities:Accounts receivable
    
    
    (17
    )
    
    
    231Inventories
    
    
    60
    
    
    
    (495
    )Prepaid expenses and other current assets
    
    
    299
    
    
    
    319Accounts payable
    
    
    (356
    )
    
    
    71Accrued compensation
    
    
    (111
    )
    
    
    (215
    )Other accrued liabilities
    
    
    78
    
    
    
    (255
    )Net cash flows provided by (used in) operating activities
    
    
    875
    
    
    
    (3,107
    )INVESTING ACTIVITIESPurchase of property and equipment
    
    
    (195
    )
    
    
    (298
    )Purchase of short-term investments
    
    
    
    
    
    
    (3,058
    )Proceeds from maturities and sales of short-term investments
    
    
    
    
    
    
    1,068Acquisition of purchased technology
    
    
    
    
    
    
    (9,124
    )Proceeds from sale of property and equipment
    
    
    
    
    
    
    15(Increase) decrease in other assets
    
    
    (11
    )
    
    
    1Net cash flows used in investing activities
    
    
    (206
    )
    
    
    (11,396
    )FINANCING ACTIVITIESIssuance of common stock, net of issuance costs
    
    
    2,430
    
    
    
    5,065Issuance of Series B preferred stock and warrants, net of issuance costs
    
    
    
    
    
    
    9,404Short-term borrowings
    
    
    211
    
    
    
    288Repayment of short-term and long-term debt
    
    
    (295
    )
    
    
    (418
    )Payment of Series B preferred stock dividends
    
    
    (336
    )
    
    
    (367
    )Repayments of capital lease obligations
    
    
    
    
    
    
    (1
    )Net cash flows provided by financing activities
    
    
    2,010
    
    
    
    13,971Increase (decrease) in cash and cash equivalents
    
    
    2,679
    
    
    
    (532
    )Cash and cash equivalents at beginning of period
    
    
    3,220
    
    
    
    6,156Cash and cash equivalents at end of period
    
    $
    5,899
    
    
    $
    5,624SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION:Cash paid for interest
    
    $
    164
    
    
    $
    170Amount
payable relating to product acquisition
    
    $
    
    
    
    $
    5,183NON-CASH INVESTING AND FINANCING ACTIVITIES:Common stock issued upon conversion of Series B preferred stock and accrued dividends for Series
B preferred stock
    
    $
    704
    
    
    $
    
 See accompanying notes. 5




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QUESTCOR PHARMACEUTICALS, INC. 
 NOTES TO CONDENSED CONSOLIDATED JUNE 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 and 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
    
    Six months endedJune 30,
    
    June 30,2004
    
    2003
    
    2004
    
    2003Net loss applicable to common stockholders as reported
    
    $
    (415
    )
    
    $
    (2,062
    )
    
    $
    (317
    )
    
    $
    (5,300
    )Add: Stock-based employee compensation expense included in reported
net loss
    
    
    2
    
    
    
    7
    
    
    
    7
    
    
    
    14Deduct: Total stock-based employee compensation expense determined
under fair value method for all awards
    
    
    (198
    )
    
    
    (310
    )
    
    
    (342
    )
    
    
    (666
    )Net loss applicable to common stockholders, pro forma
    
    $
    (611
    )
    
    $
    (2,365
    )
    
    $
    (652
    )
    
    $
    (5,952
    )Basic and diluted net loss per share applicable to common stockholders:As reported
    
    $
    (0.01
    )
    
    $
    (0.05
    )
    
    $
    (0.01
    )
    
    $
    (0.13
    )Pro forma
    
    $
    (0.01
    )
    
    $
    (0.06
    )
    
    $
    (0.01
    )
    
    $
    (0.15
    )
 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. 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 allowances against product revenues
for government chargebacks, Medicaid rebates, payment discounts and product
returns for credit memos based on historical chargebacks, rebates, discounts
and product returns, as required. The Companys policy of issuing credit
memorandums 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 net product sales. This allowance will be reduced
as future credit memos 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 allowances 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 allowances as appropriate. For Glofil
and VSL#3 the Company accepts no returns for expired product. Allowances for Medicaid rebates, government chargebacks, product exchanges
and credit memoranda were $719,000 and $582,000 at June 30, 2004 and December
31, 2003, respectively, and are included in Other Accrued Liabilities. The
allowances at June 30, 2004 include $110,000 for estimated
returns for credit memoranda on product
lots of Acthar 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 7




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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 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 and cash equivalents of $5,899,000 and $3,220,000 at June 30, 2004 and
December 31, 2003, respectively. All cash equivalents are in money market
funds. The fair value of the funds approximated cost. During the six months ended June 30, 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): June 30,
    
    December 31,2004
    
    2003Raw materials
    
    $
    340
    
    
    $
    534Work in process
    
    
    368
    
    
    
    197Finished goods
    
    
    528
    
    
    
    660Less allowance for excess and obsolete inventories
    
    
    (246
    )
    
    
    (341
    )$
    990
    
    
    $
    1,050
 6. PURCHASED TECHNOLOGY AND INTANGIBLE ASSETS Goodwill and assembled workforce no longer subject to amortization
amounted to $479,000 at June 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 June 30, 2004, no indicators of potential
impairment existed. No such impairment losses have been recorded to date. Purchased technology at June 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 $987,000 as of June 30, 2004. 7. 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 June 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. 8. NET LOSS PER SHARE APPLICABLE TO COMMON STOCKHOLDERS Basic and diluted net loss per share applicable to common stockholders is
based on net loss applicable to common stockholders for the relevant period,
divided by the weighted average number of common shares outstanding during the
period. Diluted earnings per share applicable to common stockholders gives
effect to all potentially dilutive common shares outstanding during the period
such as 8




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options, warrants, convertible preferred stock, and contingently issuable
shares. Diluted net loss per share applicable to common stockholders 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 June 30, 2004,
shares used in calculating diluted earnings per share applicable to common
stockholders would have included, if dilutive, the effect of the outstanding
9,217,460 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 127,678 common shares and 4,539,407
warrants to purchase common shares. 9. 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 Finanziaria SpA (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. 10. 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. 11. 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 June 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 June 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. 9




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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 six months ended June 30, 2003, the
deemed dividend increased the loss applicable to common stockholders in the
calculation of basic and diluted net loss per common share. 12. 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. Sigma-Tau beneficially owned approximately 28% of
the Companys outstanding stock as of June 30, 2004. 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 June 30, 2004 was $375,000 and is included in Net Product Sales.
Included in Accounts Payable is $218,000 for amounts owed to Sigma-Tau
Pharmaceuticals at June 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 June 30, 2004, the amount of the access fee was $119,000 and is included
in Selling, general and administrative expense in the accompanying Consolidated
Statement of Operations. During the quarter ended June 30, 2004 the Company
paid $168,000 to Sigma-Tau Pharmaceuticals for the purchase of VSL#3 product
and access fees. 13. COMPREHENSIVE INCOME (LOSS) Comprehensive income (loss) is comprised of net income (loss) and the
change in unrealized holding gains and losses on available-for-sale securities. Three Months Ended
    
    Six Months endedJune 30,
    
    June 30,2004
    
    2003
    
    2004
    
    2003($000s)
    
    ($000s)Net income (loss)
    
    $
    (247
    )
    
    $
    (1,769
    )
    
    $
    23
    
    
    $
    (3,539
    )Change in unrealized gains on available-for-sale securities
    
    
    
    
    
    
    1
    
    
    
    
    
    
    
    42Comprehensive income (loss)
    
    $
    (247
    )
    
    $
    (1,768
    )
    
    $
    23
    
    
    $
    (3,497
    )
 14. SUBSEQUENT EVENTS 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. The interest rate on the note is 9.83% per annum.
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. The note will be secured by the Nascobal intellectual property
including the NDA for the spray formulation when it is approved. Questcor
purchased the world-wide rights to Nascobal, including the rights to the spray
formulation from Nastech Pharmaceutical in June 2003. 10




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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 will (i) continue to pay Mr. Casamento his
regular monthly base salary of $38,208 for 18 months, (ii) pay the prorated
portion of his 2004 annual bonus potential in the amount of $136,294, and (iii)
extend 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 will expire, if not previously exercised, 90 days after his
resignation. 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 severance liability and
corresponding compensation expense of approximately $825,000 will be recorded
in the third quarter of 2004 to recognize the cost of the separation
arrangement including the payroll and bonus. The stock compensation expense
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 and 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 central nervous system (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
spray, an improved 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 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. 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. (Rigel) of South San
Francisco, California for our antiviral drug discovery program, and granted
rights to Dainippon Pharmaceuticals Co., Ltd. (Dainippon) of Osaka, Japan for
our antibacterial program. We have incurred an accumulated deficit of $83.2 million at June 30, 2004.
At June 30, 2004, we had $5.9 million in cash and cash equivalents. 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 memos to be issued under our credit
memo 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 allowances, bad debts, inventories, investments 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 Allowances We have estimated allowances 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 allowances by
utilizing historical information for existing products and data obtained from
external sources. For new products, we estimate our allowances 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. Our customers have expressed dissatisfaction
with our exchange policy and, although they have complied to date, our ability
to enforce this policy in the future on customers whose influence within the
pharmaceutical industry and resources are far greater than ours may prove to be
difficult. In response to dissatisfaction with our exchange policy expressed by
our three largest customers, during the quarter ended June 30, 2004 we
implemented a plan to transition from the current exchange policy to a credit
memorandum 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 will continue to be subject to the product exchange
policy. Expired product returned from lots released after May 31, 2004 will be
subject to a credit memo policy in which a credit memo will be issued for the
original purchase price of the returned product. We commenced shipping a new lot of Acthar on June 1, 2004 which will be
subject to the credit memo policy. An allowance for the sales value of
estimated returns on shipments of product lots of Acthar released and shipped
after May 31, 2004 has been recorded 13




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as a liability in the amount of $110,000 as of June 30, 2004 with a
corresponding reduction in net product sales. This allowance reflects an
estimate of future credit memoranda to be issued for Acthar, applied to the
quantity of product shipped from lots subject to the credit memoranda policy.
The allowance 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. For Nascobal and Ethamolin, once new lots are
released (in July 2004 for Nascobal and early 2006 for Ethamolin), credit
memoranda allowances will be estimated for those products and recorded as a
reduction of net product sales based upon the quantity of product shipped for
the lots subject to the credit memo policy. This will reduce the future amount
recorded as net product sales. There will be a transition period extending 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. Allowances for the estimated
costs of exchanges will be recorded on future sales of product lots subject to
the exchange policy. The credit memoranda policy commences with the actual
release of product lots currently planned as follows: Acthar, June 2004;
Nascobal, July 2004; Ethamolin, February 2006. Planned releases of products
are subject to change. Allowances 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 net product sales. Until the
transition from our product exchange policy to a credit memo policy for expired
product is complete in 2006, both the replacement policy and the credit memo
policy will be in effect at the same time, which will result in lower revenues
than historically experienced due to the double impact of displacement of
future sales from the exchange policy and reduction of net product sales for
the reserves under the credit memo policy. If our transition to a credit memo 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, an
allowance for returns (credit memoranda) would be necessary and would be
recorded with an offset to net product sales at the time of the policy change.
The allowance 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. Further, if such a policy
change were made, the currently recorded allowance for product exchanges would
be eliminated resulting in a reduction of cost of product sales. If we are
forced to issue credit memoranda for all returns currently subject to the
exchange policy, there would be a significant negative financial impact at the
time of the change. If we adopted a policy of issuing credit memoranda for all
returns currently subject to the exchange policy, we would need to record an
additional total allowance of approximately $2 million to $3 million based on
historical return rates for each product, thus reducing net product sales by
that amount offset by a reduction in cost of product sales for the elimination
of the allowance for product replacement. Such a change would be considered a
change in accounting estimate and would be accounted for on a prospective
basis. The issuance of credit memoranda would negatively impact cash flow in
the short-term but may increase future sales as shipment of replacement product
at no cost to the customer would no longer occur. 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 June
30, 2004, the returns receivable is $356,000, 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 June 30, 2004, replacement units have been shipped with respect to
approximately 75% 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 (allowance) for the period. In particular, we
consider allowable prices by Medicaid. In estimating government chargeback
allowances, we analyze actual chargeback amounts by product and apply
historical chargeback rates to sales to which chargebacks apply, typically
sales to the Veterans Administration and other U.S. 14




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government organizations. We routinely assess our experience with Medicaid
rebates and government chargebacks and adjust the allowances accordingly. For qualified customers, we grant payment terms of 2%, net 30 days.
Allowances for cash discounts are estimated based upon historical experience
and 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 allowances may be
required. To date, actual amounts have approximated our estimates. Inventories We maintain inventory reserves primarily for obsolescence (due to the
expiration of shelf life of a product). In estimating inventory 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 inventory obsolescence. 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 June 30, 2004 compared to the three months ended June 30,
2003: Total Revenues Three Months EndedJune 30,Increase/
    
    %2004
    
    2003
    
    (Decrease)
    
    Change(in $000s)Net product sales
    
    $
    4,090
    
    
    $
    2,880
    
    
    $
    1,210
    
    
    
    42
    %Technology and grant revenue
    
    
    
    
    
    
    25
    
    
    
    (25
    )
    
    
    Total revenues
    
    $
    4,090
    
    
    $
    2,905
    
    
    $
    1,185
    
    
    
    41
    %
 Total revenues for the quarter ended June 30, 2004 increased $1,185,000,
or 41%, from the quarter ended June 30, 2003 due to increases in net product
sales. Net product sales for the quarter ended June 30, 2004 increased by
$1,210,000, or 42%, from the quarter ended June 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 an increase of net product sales of VSL #3.
Net product sales of Nascobal for the second quarter of 2004 were $1,911,000.
During the second quarter of 2004, one of our major customers purchased
Nascobal in higher quantities than it had historically purchased. Based on the
review of information provided by this customer, it appears that these
purchases increased the customers inventory level significantly. To the
extent this major customers inventory level exceeds demand, future net product
sales may be adversely affected. The increase in Nascobal sales was partially
offset by decreases in net product sales of Acthar and Ethamolin as compared to
the second quarter of 2003. During the quarter ended June 30, 2004, net
product sales of Acthar were reduced by $110,000 for an allowance for credit
memos under our credit memo policy. Sales of Acthar decreased in the
second quarter of 2004 as compared to the first quarter of 2004 due
in part to the reduction in inventory held by customers during the
second quarter as customers purchased less product from us than their
reported sales to pharmacies. Ethamolin sales were lower in the second
quarter of 2004 as compared to the first quarter of 2004, and we believe that
Ethamolin sales will remain lower in the remaining quarters of 2004. We expect
quarterly 15




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fluctuations in the net sales of all of our products due to the timing of
shipments, changes in wholesaler inventory levels and the reallocation of
promotional efforts for each product. Nascobal net product sales over the four quarters since its introduction
in July 2003 are: Three months endedJune 30,
    
    March 31,
    
    December 31,
    
    September 30,2004
    
    2004
    
    2003
    
    2003($000s)Nascobal net product sales
    
    $
    1,911
    
    
    $
    1,788
    
    
    $
    1,176
    
    
    $
    924
 Nascobal revenues in 2003 were impacted by one of our three major
customers not purchasing any significant quantities of Nascobal until early
November 2003 due to their inventory levels at the time of our acquisition of
that product. 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 June 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 $585,000, and Ethamolin that expired in
October 2003, January 2004 and February 2004, having a sales value of
approximately $145,000. Subsequent to June 30, 2004, we will continue to
replace Acthar and Ethamolin returned from these expired lots. The replacement
of product subsequent to June 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 June 30, 2004, customers
have requested the replacement of expired Acthar and Ethamolin with a sales
value of approximately $620,000. We intend to replace this expired product in
the third and fourth quarter of 2004. 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. Quarterly revenues will
fluctuate based on buying patterns of the wholesalers, inventory levels at
wholesalers, expiration dates of product sold and timing of shipment of
replacement product under our exchange policy. We did not recognize any technology, contract research, grant and royalty
revenue for the quarter ended June 30, 2004, as compared to the $25,000 we
recognized in the second 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 June 30, 2004 decreased
$188,000, or 16%, to $961,000 from $1,149,000 for the quarter ended June 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 decrease in cost of
product sales is primarily due to decreases in our provision for inventory
obsolescence and royalties on Acthar net sales. The decreases were offset by
increased material costs related to higher unit sales, increases in costs of
product stability testing and higher distribution costs. During the quarter
ended June 30, 2004, one of our largest customers began charging a fee for
distribution services provided to us. Higher distribution costs are also due in
part to higher unit sales. 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 by less than 5%.
Cost of product sales as a percentage of net product sales decreased to 23% for
the quarter ended June 30, 2004 from 40% for the quarter ended June 30, 2003.
The decrease in the percentage of cost of product sales as compared to net
product sales is in part the result of a charge of $233,000 in the second
quarter of 2003 to increase the provision for inventory obsolescence, and
changes in the mix of products sold. 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. 16




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##### Table of Contents



Selling, General and Administrative Three Months EndedJune 30,%2004
    
    2003
    
    (Decrease)
    
    Change(in $000s)Selling, general and administrative expense
    
    $
    2,515
    
    
    $
    2,517
    
    
    $
    (2
    )
    
    
    Percentage of total revenue
    
    
    61
    %
    
    
    87
    %
 Selling, general and administrative expenses for the quarter ended June
30, 2004 decreased $2,000 from the quarter ended June 30, 2003. As a percentage
of revenue, selling, general and administrative expenses decreased to 61% for
the quarter ended June 30, 2004 compared to 87% for the quarter ended June 30,
2003, largely due to the increase in total revenues. Increased spending during
the second quarter of 2004 on access fees to Sigma-Tau Pharmaceuticals due to
higher VSL#3 net product sales and certain marketing related activities were
offset by compensation related expenses and expenses for professional services. 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 will (i) continue to pay Mr. Casamento his
regular monthly base salary of $38,208 for 18 months, (ii) pay the prorated
portion of his 2004 annual bonus potential in the amount of $136,294, and (iii)
extend 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 will expire, if not previously exercised, 90 days after his
resignation. 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 severance liability and
corresponding compensation expense of approximately $825,000 will be recorded
in the third quarter of 2004 to recognize the cost of the separation
arrangement including the payroll and bonus. The stock compensation expense
will be insignificant. Research and Development Research and development expenses for the quarter ended June 30, 2004 were
$421,000 as compared to $711,000 for the quarter ended June 30, 2003. The costs
included in research and development relate primarily to our manufacturing site
transfers and medical and regulatory affairs compliance activities. The
decrease is primarily due to lower Acthar site transfer costs, offset in part
by increased regulatory fees related to Nascobal, which we introduced in July
2003. Research and development expenses for the quarter ended June 30, 2004
include approximately $50,000 related to the manufacturing site transfer of
Acthar, as compared to approximately $320,000 for the quarter ended June 30,
2003. These amounts for site transfer include costs for the consulting and
outside testing necessary to transfer a potency assay to a new contract
laboratory. Decreased site transfer costs for the quarter ended June 30, 2004
are due in part to the timing of certain expenses that have shifted from the
second quarter to the third quarter of 2004. We expect site transfer costs in
the second half of 2004 to exceed costs incurred in the first half 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 fiscal year 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 have resumed the testing necessary to transfer the potency assay to a
new contract laboratory and have made additional progress in the assay
transfer. 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 June 30, 2004
increased to $301,000, or 42%, from $212,000 for the quarter ended June 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. The Nascobal purchased technology will be amortized over 15 years. 17




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##### Table of Contents



Other Income and Expense Items Three Months EndedJune 30,Increase/
    
    %2004
    
    2003
    
    (Decrease)
    
    Change(in $000s)Non-cash
amortization of
deemed discount on
convertible
debentures
    
    $
    (131
    )
    
    $
    (130
    )
    
    $
    1
    
    
    
    1
    %Interest income
    
    
    13
    
    
    
    65
    
    
    
    (52
    )
    
    
    (80
    )%Interest expense
    
    
    (81
    )
    
    
    (83
    )
    
    
    (2
    )
    
    
    (2
    )%Other expense
    
    
    
    
    
    
    (3
    )
    
    
    3
    
    
    
    Rental income, net
    
    
    60
    
    
    
    66
    
    
    
    (6
    )
    
    
    (9
    )%
 Non-cash amortization of deemed discount on convertible debentures for the
quarter ended June 30, 2004 was $131,000, which was consistent with the quarter
ended June 30, 2003. The convertible debentures were issued in March 2002. Interest income for the quarter ended June 30, 2004 decreased by $52,000
from the quarter ended June 30, 2003. The decrease was primarily due to lower
cash balances during the second quarter of 2004 and interest earned in the
second quarter of 2003 on a financing lease of equipment. Interest expense for
the quarter ended June 30, 2004, which consists primarily of interest on the
convertible debentures, was consistent with the quarter ended June 30, 2003. Rental income, net, for the quarter ended June 30, 2004 decreased 9% from
the quarter ended June 30, 2003. Rental income, net, primarily arises 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 verbally assured us that they will pay within
thirty days. However, there can be no assurance that we will receive such
payment within thirty days or 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
June 30, 2004 and 2003, respectively, represent the 8% cash dividends paid to
our Series B Preferred Stockholders. These dividends are required to be paid in
cash quarterly. The Series B Preferred Stock was issued in January 2003. Non-cash deemed dividends of $93,000 at June 30, 2003 are related to
revaluation of warrants issued in January 2003 to the Series B Preferred
Stockholders. In connection with the revaluation, we recorded $93,000 related
to the beneficial conversion feature on the Series B Preferred Stock as an
additional deemed dividend, which increased the carrying value of the Series B
Preferred Stock. The deemed dividend increased the net loss applicable to
common stockholders in the calculation of basic and diluted net loss per common
share. Six months ended June 30, 2004 compared to the six months ended June 30, 2003: Total Revenues Six Months EndedJune 30,Increase/
    
    %2004
    
    2003
    
    (Decrease)
    
    Change(in $000s)Net product sales
    
    $
    9,238
    
    
    $
    5,242
    
    
    $
    3,996
    
    
    
    76
    %Technology and grant revenue
    
    
    
    
    
    
    284
    
    
    
    (284
    )
    
    
    Total revenues
    
    $
    9,238
    
    
    $
    5,526
    
    
    $
    3,712
    
    
    
    67
    %
 Total revenues for the six months ended June 30, 2004 increased
$3,712,000, or 67%, from the six months ended June 30, 2003 due to increases in
net product sales. 18




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##### Table of Contents



Net product sales for the six months ended June 30, 2004 increased by
$3,996,000, or 76%, from the six months ended June 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 Ethamolin and VSL
#3 offset by a decrease in sales of Acthar. Net product sales of Nascobal for
the six months ended June 30, 2004 were $3,699,000. In addition, net product
sales for the first six months of 2004 included $325,000 of shipments to
wholesalers in January 2004 for orders received in December 2003. We expect
quarterly fluctuations in the net sales of all of our products due to the
timing of shipments, changes in wholesaler inventory levels, and the
reallocation of promotional efforts for each product. The Nascobal net product sales during the first six months of 2004 include
purchases by one of our major customers in higher quantities than it has
historically purchased. Based on the review of information provided by this
customer, it appears that these purchases increased the customers inventory
level significantly. To the extent this major customers inventory level
exceeds demand, future net product sales may be adversely affected. The increase in net product sales in the six months ended June 30, 2004
over the same period in 2003 also reflects higher net product sales of
Ethamolin and VSL #3. The increase in net product sales of Ethamolin in the
first six months of 2004 over the first six 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 six months ended June 30, 2004, we
replaced units of Ethamolin at no cost having a sales value of approximately
$168,000 under our exchange policy. Revenues from the sale of Acthar declined in part due to the reductions in
inventory at the wholesale level during the six months ended June 30, 2004.
Based on internal estimates and information provided by our major customers,
inventory levels of Acthar declined by nearly one month, from inventory levels
at the beginning of 2004, as major customers purchased less than their reported
sales. During the six months ended June 30, 2004, we replaced vials of Acthar
at no cost having a sales value of approximately $720,000 under our
exchange policy. In addition, during
the six months ended June 30, 2004 net product sales of Acthar were reduced by
$110,000 for the allowance for credit memos under our new credit memo policy. We did not recognize any technology revenue for the six months ended June
30, 2004. We recognized $250,000 in technology revenue for the six months ended
June 30, 2003 from our License Agreement with Fabre-Kramer. We did not recognize any contract research, grant and royalty revenue for
the six months ended June 30, 2004, as compared to the $25,000 we recognized in
the first six 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 six months ended June 30, 2004 decreased
$7,000 to $1,817,000 from $1,824,000 for the six months ended June 30, 2003.
Increased material and distribution costs related to higher product sales and
increases in costs of product stability testing in the first six months of 2004
were offset by decreases in the provision for inventory obsolescence and lower
royalties. 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 by less than 5%. Cost
of product sales as a percentage of net product sales decreased to 20% for six
months ended June 30, 2004 from 35% for same period in 2003. The decrease in
the percentage of cost of product sales as compared to net product sales is the
result in part of changes in the mix of products sold and decreases in our
allowance for inventory obsolescence. 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 Six Months EndedJune 30,Increase/
    
    %2004
    
    2003
    
    (Decrease)
    
    Change(in $000s)Selling, general and
administrative expense
    
    $
    5,543
    
    
    $
    5,320
    
    
    $
    223
    
    
    
    4
    %Percentage of total revenue
    
    
    60
    %
    
    
    96
    %
 Selling, general and administrative expenses for the six months ended June
30, 2004 increased $223,000, or 4%, from the six 19




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##### Table of Contents



months ended June 30, 2003. As a percentage of revenue, selling, general
and administrative expenses decreased to 60% for the six months ended June 30,
2004 compared to 96% for the six months ended June 30, 2003, largely due to the
increase in total revenues. Increased spending on sales and marketing,
including certain market research and marketing planning studies, and increased
access fees to Sigma-Tau Pharmaceuticals due to higher net product sales of
VSL#3, were offset by lower legal expenses, compensation and investor relations
expenses. Research and Development Research and development expenses for the six months ended June 30, 2004
were $999,000 as compared to $1,322,000 for the six months ended June 30, 2003.
The decrease is primarily due to lower Acthar site transfer costs, offset in
part by regulatory fees related to Nascobal, which we introduced in July 2003. Research and development expenses for the six months ended June 30, 2004
include approximately $240,000 related to the manufacturing site transfer of
Acthar, as compared to approximately $560,000 for the six months ended June 30,
2003. These amounts for site transfer include costs for the consulting and
outside testing necessary to transfer a potency assay to a new contract
laboratory. Decreased site transfer costs for the six months ended June 30,
2004 are due in part to the timing of certain expenses that have shifted from
the first half to the second half of 2004. Depreciation and Amortization Depreciation and amortization expense for the six months ended June 30,
2004 increased to $599,000, or 57%, from $381,000 for the six months ended June
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. The Nascobal purchased technology will be amortized over 15 years. Other Income and Expense Items Six Months EndedJune 30,Increase/
    
    %2004
    
    2003
    
    (Decrease)
    
    Change(in $000s)Non-cash
amortization of
deemed discount on
convertible
debentures
    
    $
    (262
    )
    
    $
    (261
    )
    
    $
    1
    
    
    
    Interest income
    
    
    24
    
    
    
    155
    
    
    
    (131
    )
    
    
    (85
    )%Interest expense
    
    
    (164
    )
    
    
    (169
    )
    
    
    (5
    )
    
    
    (3
    )%Other income
    
    
    3
    
    
    
    
    
    
    
    3
    
    
    
    Other expense
    
    
    
    
    
    
    (80
    )
    
    
    (80
    )
    
    
    Rental income, net
    
    
    142
    
    
    
    137
    
    
    
    5
    
    
    
    4
    %
 Non-cash amortization of deemed discount on convertible debentures for the
six months ended June 30, 2004 was $262,000, consistent with the six months
ended June 30, 2003. The convertible debentures were issued in March 2002. Interest income for the six months ended June 30, 2004 decreased by
$131,000 from the six months ended June 30, 2003. The decrease was primarily
due to lower cash balances during the first six months of 2004 and interest
earned in the first six months of 2003 on a financing lease of equipment.
Interest expense for the six months ended June 30, 2004, which consists
primarily of interest on the convertible debentures, was consistent with the
six months ended June 30, 2003. Other expense for the six months ended June 30, 2004 decreased $80,000
from the six months ended June 30, 2003. The expense in the first six 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 six months ended June 30, 2004 increased
$5,000 from the six months ended June 30, 2003. Rental income, net, primarily
arises 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. 20




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##### Table of Contents



Series B Preferred Stock Dividends Preferred Stock dividends of $340,000 and $367,000 for the six months
ended June 30, 2004 and 2003, respectively, represent the 8% cash dividends
paid to our Series B Preferred Stockholders. These dividends are required to be
paid in cash quarterly. The Series B Preferred Stock was issued in January
2003. Non-cash deemed dividends of $1,394,000 at June 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 June 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. At June 30, 2004, we had cash and cash equivalents of $5,899,000 compared
to $3,220,000 at December 31, 2003. At June 30, 2004, our working capital was
$3,522,000 compared to $4,352,000 at December 31, 2003. The decrease in our
working capital was principally due to the reclassification of $3,650,000 of
convertible debentures to current liabilities during the first quarter of 2004,
partially offset by net proceeds of $2.4 million received in our private
placement in January 2004 and funds provided by operations. The convertible
debentures, with a face value of $4 million, are due in March 2005. Prior to March 31, 2005, we may have to make cash payments totaling $6
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 $4 million in contingent payments to Nastech relating to
our agreement to acquire rights to the new Nascobal nasal spray, an improved
dosage form of Nascobal. 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 spray, an improved 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 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 patent for the nasal spray, we are obligated to pay an
additional $2 million to Nastech. An NDA was filed by Nastech with the FDA in
December 2003. We understand that the FDAs target for review and action on NDA
applications is ten months from the date of submission. Hence the NDA could be
approved as early as the fourth quarter of 2004. The final patent application
for Nascobal nasal spray has been filed. 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, will require 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. 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. We incurred approximately $240,000 of expenses during
the six months ended June 30, 2004 related to the Acthar site transfer, and
expect that expenses in future periods may exceed this amount. It is currently our customers standard practice to deduct from payments
to us the amount of the sales value of expired product, or 21




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##### Table of Contents



returns receivable, that they have requested for return. The returns
receivable amounted to $356,000 at June 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 June 30, 2004, replacement units have been shipped relating
to approximately 75% 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 the Company and Mr. Casamento, and consistent with certain terms of his
employment agreement, the Company will (i) continue to pay Mr. Casamento his
regular monthly base salary of $38,208 for 18 months, (ii) pay the prorated
portion of his 2004 annual bonus potential in the amount of $136,294, and (iii)
extend 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 will expire, if not previously exercised, 90 days after his
resignation. 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 severance liability and
corresponding compensation expense of approximately $825,000 will be recorded
in the third quarter of 2004 to recognize the cost of the separation
arrangement including the payroll and bonus. The stock compensation expense
will be insignificant. In June 2004, we implemented a transition plan for expired product returns
from a product exchange policy to a credit memo policy. Under the credit memo
policy, a credit memo 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 memo 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. 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 June 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 June 30, 2004, the net cash flows generated 22




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##### Table of Contents



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
June 30, 2005, 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; 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 factors supplement the risk factors contained in our Annual
Report on Form 10-K for the fiscal year ended December 31, 2003. You should
carefully consider the following risk factors as well as those contained our
Annual Report on Form 10-K. 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. If our customers do not comply with our exchange policy and/or demand that we
implement a credit memo return policy, our revenues would be significantly
impacted. We have a product exchange policy in which we will ship replacement
product for expired product returned to us within six months after expiration.
This policy is not commonplace in the industry as the standard policy is to
issue credit memoranda in exchange for expired product that is returned. Our
customers have expressed dissatisfaction with our exchange policy and, although
they have complied to date, our ability to enforce this policy in the future on
customers whose influence within the pharmaceutical industry and resources are
far greater than ours may prove to be difficult. Since we sell a majority of
our products to the three largest distributors and no viable alternatives
exist, we may be forced to change our current exchange policy to a credit memo
return policy in which credit memoranda are issued for all returns currently
subject to the exchange policy. In the event this occurred, the negative
financial impact on our revenues, operations and cash position would be
substantial in the near term. In response to dissatisfaction with our exchange policy expressed by our
three largest customers, during the quarter ended June 30, 2004 we implemented
a transition plan for expired product returns from the current exchange policy
to a credit memo 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, will continue to be subject to the exchange
policy. Expired product returned from lots released after May 31, 2004 will be
subject to a credit memo policy in which a credit memo will be issued for the
original purchase price of the returned product. Should this transition plan to a credit memo policy for returns not be
adhered to and we are forced to issue credit memoranda for all returns
currently subject to the exchange policy, an allowance for returns (credit
memoranda) would be necessary and would be recorded with an offset to net
product sales at the time of the policy change. A change in our business policy
to a return for credit memoranda basis would have a significant negative
financial impact at the time of the change. The impact of such a change would
be to reduce net product sales by the amount of the estimated future credit
memoranda to be issued offset by a reduction in cost of product sales for the
elimination of the allowance for product replacement. In December 2002, we noted that certain of our customers were not
complying with our expired product exchange policy. These 23




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customers were deducting from amounts owed to us the full price of expired
Acthar they planned to return to us. While we reached an agreement with these
customers to pay these short-remittances (returns receivable) upon their
receipt of replacement product for the Acthar that expired in November 2002 and
May 2003, customers have continued to deduct from amounts owed to us the full
price of expired Acthar they return to us. Additionally, certain customers
received an administration fee from us for the expired product that was
exchanged. Certain of our customers continued to short-remit for expired
product returns in 2003 and 2004. As of June 30, 2004, the returns receivable
amount is $356,000. A majority of returns of expired product, which in turn has
created this returns receivable, have been replaced in accordance with our
exchange policy, and we are in the process of seeking reimbursement. The next
batch of Acthar expires in December 2004, the next batch of Ethamolin expires
in December 2004 and the next Nascobal batch expires in February 2005. We
expect that our customers will continue to short remit us in the future as
these batches and future batches expire and our customers seek to return
expired product. Should our customers not reimburse us for the returns
receivable upon shipment of replacement product, the negative impact on our
cash and operations would be substantial. Due to the short shelf life of Acthar (18 months), significant quantities
could expire at the wholesale or pharmacy level, which could then be returned
for replacement product under our product exchange policy, or credit memos
under our credit memo policy. We are actively monitoring inventory levels at
the wholesalers and have implemented a plan designed to minimize the amount of
returns of expired product, however there can be no assurance that our actions
will be effective in reducing the return of expired product or minimizing the
negative impact on receivables and future sales. Such shipment of replacement
product may displace future sales. See the Critical Accounting Policies section in the Management Discussion
and Analysis of Financial Condition for further discussion of our exchange and
credit memo policies. If we lose the services of certain key personnel or are unable to hire skilled
personnel in the future, our business will be harmed. We are highly dependent on the services of our Senior Vice President of
Finance and Administration and Chief Financial Officer, Mr. Timothy E. Morris,
and our Vice President of Sales and Marketing, Mr. R. Jerald Beers. 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. The Board of Directors is
working to identify a successor. If the Board is unsuccessful in hiring a
successor to the position of President and Chief Executive Officer, or if a
successor cannot be hired in a timely manner, our business could be harmed.
In the interim, Mr. Morris and Mr. Beers will form an Office of the President
to guide the Company under the Board of Directors continuing oversight. If we
were to lose Mr. Morris 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. Our business is subject to changing regulation of corporate governance and
public disclosure that has increased both our costs and the risk of
noncompliance. Because our common stock is publicly traded, we are subject to certain
rules and regulations of federal, state and financial market exchange entities
charged with the protection of investors and the oversight of companies whose
securities are publicly traded. These entities, including the Public Company
Accounting Oversight Board, the SEC and the American Stock Exchange, have
recently issued new requirements and regulations and continue developing
additional regulations and requirements in response to recent corporate
scandals and laws enacted by Congress, most notably the Sarbanes-Oxley Act of
2002. Our efforts to comply with these new regulations have resulted in, and
are likely to continue resulting in, increased general and administrative
expenses and diversion of management time and attention from revenue-generating
activities to compliance activities. In particular, our efforts to prepare to comply with Section 404 of the
Sarbanes-Oxley Act and related regulations for fiscal years ending on or after
July 15, 2005 regarding our managements required assessment of our internal
control over financial reporting and 24




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our independent auditors attestation of that assessment will require the
commitment of significant financial and managerial resources. Although
management believes that ongoing efforts to assess our internal control over
financial reporting will enable management to provide the required report, and
our independent auditors to provide the required attestation, under Section
404, we can give no assurance that such efforts will be completed on a timely
and successful basis to enable our management and independent auditors to
provide the required report and attestation in order to comply with SEC rules
effective for us. Moreover, because the new and changed laws, regulations and standards are
subject to varying interpretations in many cases due to their lack of
specificity, their application in practice may evolve over time as new guidance
is provided by regulatory and governing bodies. This evolution may result in
continuing uncertainty regarding compliance matters and additional costs
necessitated by ongoing revisions to our disclosure and governance practices. 
 ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK Our exposure to market risk at June 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. 25




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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 The Company held its 2004 annual meeting of shareholders on May 17, 2004. The
following matters received the votes at the meeting as set forth below:  1.
    
    Election of Directors to hold office until the 2005 Annual Meeting of
Shareholders and until their successors are duly elected and qualified. Votes For
    
    Votes WithheldNeal C. Bradsher
    
    
    51,933,285
    
    
    
    1,073,010Charles J. Casamento
    
    
    51,473,579
    
    
    
    1,532,716Jon S. Saxe
    
    
    51,902,362
    
    
    
    1,103,933Roger G. Stoll
    
    
    51,950,515
    
    
    
    1,055,780Virgil D. Thompson
    
    
    51,912,585
    
    
    
    1,093,710Howard D. Palefsky
    
    
    59,758,904Albert Hansen
    
    
    59,758,904
  2.
    
    Approval of the Companys 2004 Non-Employee Directors Equity Incentive
Plan which provides for 1,250,000 shares of Common Stock to be authorized
for formula grants of non-qualified stock options to non-employee
directors of the Company. For
    17,889,927Against
    15,127,457Abstain
    4,781,288
  3.
    
    Ratification of Ernst & Young LLP as the Companys independent auditors
for the fiscal year ending December 31, 2004. For
    55,873,743Against
    391,460Abstain
    60,741
 
 ITEM 5. OTHER INFORMATION Not applicable 26




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ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K  (a)
    
    Exhibits 10.31
    
    Amendment dated June 25, 2004 to the Employment Agreement between the Company and Charles J. Casamento.10.32
    
    Amendment dated July 20, 2004 to the Employment Agreement between the Company and Charles J. Casamento.10.33
    
    Separation Agreement dated August 5, 2004 between the Company and Charles J. Casamento.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 April 29, 2004, we furnished on Form 8-K, under Item 12, our press
release of our results for the quarter ended March 31, 2004. 27




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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: August 12, 2004
    By:
    /s/ TIMOTHY E. MORRISTimothy E. MorrisSenior Vice President, Finance &
Administration, Chief Financial Officer
(Principal Financial and Accounting Officer)
and Principal Executive Officer 28




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Exhibit Index 10.31
    
    Amendment dated June 25, 2004 to the Employment Agreement between the Company and Charles J. Casamento.10.32
    
    Amendment dated July 20, 2004 to the Employment Agreement between the Company and Charles J. Casamento.10.33
    
    Separation Agreement dated August 5, 2004 between the Company and Charles J. Casamento.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.
 29