** **

**UNITED STATES**

**SECURITIES AND EXCHANGECOMMISSION**

 

**WASHINGTON, D.C.  20549**

 

**FORM 10-Q**

 

**(Mark One)**

 

| **ý**                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         | ** ** | **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**                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             |
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               |       |                                                                                           |
| **o**                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              | ** ** | **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  1-10581**                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           |

 

**BENTLEY PHARMACEUTICALS, INC.**

(Exact name of registrant as specified in itscharter)

 

| **DELAWARE**                                                    | ** ** | **No. 59-1513162**                    |
|-----------------------------------------------------------------|------------|---------------------------------------|
| (State or other jurisdiction of  incorporation or organization) |       | (I.R.S. Employer  Identification No.) |

 

**Bentley Park, 2 Holland Way, Exeter, NewHampshire  03833**

(Current Address of Principal ExecutiveOffices)

 

Registrant’s telephone number, including areacode:  **(603)658-6100**

 

Indicate by check mark whether the registrant (1) has filed all reportsrequired to be filed by Section 13 or 15(d) of the Securities Exchange Act of1934 during the preceding 12 months (or for such shorter period that theregistrant was required to file such reports), and (2) has been subject to suchfiling requirements for the past 90 days.    YES  ý    NO  o

 

Indicate by check mark whether the registrant is an accelerated filer(as defined in rule 12b-2 of the Exchange Act). YES  ý    NO  o

 

The number of shares of theregistrant’s common stock outstanding as of August 4, 2004 was 20,787,576.

 

 

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**BENTLEY PHARMACEUTICALS, INC. ANDSUBSIDIARIES**

**FORM 10-Q FOR THE QUARTER ENDED JUNE 30, 2004**

 

**INDEX**

 
| ** ** | ** **                      | **Page**                                                                                                                                                                   |
|------------|---------------------------------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| Part I.    | UNAUDITED FINANCIAL INFORMATION |                                                                                                                                                                       |
|       |                            |                                                                                                                                                                       |   |
|       | Item 1.                         | Condensed Consolidated Financial Statements:                                                                                                                               |   |
|       |                            |                                                                                                                                                                       |   |
|       |                            | Consolidated Balance Sheets as of June 30, 2004 and December 31, 2003                                                                                                      | 3 |
|       |                            |                                                                                                                                                                       |   |
|       |                            | Consolidated Income  Statements and Statements of Comprehensive Income for the three months ended  June 30, 2004 and 2003, and the six months ended June 30, 2004 and 2003 | 4 |
|       |                            |                                                                                                                                                                       |   |
|       |                            | Consolidated Statement of Changes in  Stockholders’ Equity for the six months ended June 30, 2004                                                                     | 5 |
|       |                            |                                                                                                                                                                       |   |
|       |                            | Consolidated Statements of Cash Flows for  the six months ended June 30, 2004 and 2003                                                                                     | 6 |
|       |                            |                                                                                                                                                                       |   |
|       |                            | Notes to Condensed Consolidated Financial  Statements                                                                                                                      | 8 |
|       |                            |                                                                                                                                                                       |   |
|       | Item 2.                         | Management’s Discussion and Analysis of  Financial Condition and Results of Operations                                                                                | 17 |
|       |                            |                                                                                                                                                                       |   |
|       | Item 3.                         | Quantitative and Qualitative Disclosures  About Market Risk                                                                                                                | 37 |
|       |                            |                                                                                                                                                                       |   |
|       | Item 4.                         | Controls and Procedures                                                                                                                                                    | 38 |
|       |                            |                                                                                                                                                                       |   |
| Part II.   | OTHER INFORMATION               |                                                                                                                                                                       |
|       |                            |                                                                                                                                                                       |   |
|       | Item 1.                         | Legal Proceedings                                                                                                                                                          | 39 |
|       |                            |                                                                                                                                                                       |   |
|       | Item 4.                         | Submission of Matters to a Vote of Security  Holders                                                                                                                       | 39 |
|       |                            |                                                                                                                                                                       |   |
|       | Item 6.                         | Exhibits  and Reports on Form 8-K                                                                                                                                          | 40 |

 

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**BENTLEY PHARMACEUTICALS,  INC. ANDSUBSIDIARIES**

**CONSOLIDATED  BALANCE SHEETS**

 
| **(in  thousands, except per share data)**                                                                 | ** ** | **June 30,  2004** | ** ** | **December 31,  2003** | ** ** |
|------------------------------------------------------------------------------------------------------------|------------|--------------------|------------|------------------------|------------|
| ** **                                                                                                 |       |               |       |                   |       |
| **ASSETS**                                                                                                 |       |               |       |                   |       |
| Current assets:                                                                                            |       |               |       |                   |       |
| Cash and cash equivalents                                                                                  |       | $                  | 35,743     |                   | $          | 39,393 |   |
| Marketable securities                                                                                      |       | 465                |       | 1,252                  |       |
| Receivables, net                                                                                           |       | 23,772             |       | 18,036                 |       |
| Inventories, net                                                                                           |       | 9,605              |       | 7,106                  |       |
| Deferred taxes                                                                                             |       | 237                |       | 213                    |       |
| Prepaid expenses and other                                                                                 |       | 1,857              |       | 899                    |       |
| Total current assets                                                                                       |       | 71,679             |       | 66,899                 |       |
| Non-current assets:                                                                                        |       |               |       |                   |       |
| Fixed assets, net                                                                                          |       | 23,057             |       | 18,566                 |       |
| Drug licenses and related costs, net                                                                       |       | 13,889             |       | 13,818                 |       |
| Restricted cash                                                                                            |       | 1,000              |       | 1,000                  |       |
| Other                                                                                                      |       | 162                |       | 180                    |       |
| Total non-current assets                                                                                   |       | 38,108             |       | 33,564                 |       |
|                                                                                                       |       | $                  | 109,787    |                   | $          | 100,463 |   |
|                                                                                                       |       |               |       |                   |       |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                              |       |               |       |                   |       |
| Current liabilities:                                                                                       |       |               |       |                   |       |
| Accounts payable                                                                                           |       | $                  | 14,949     |                   | $          | 10,154 |   |
| Accrued expenses                                                                                           |       | 8,355              |       | 7,103                  |       |
| Short-term borrowings                                                                                      |       | 1,871              |       | 1,915                  |       |
| Current portion of long-term debt                                                                          |       | —             |       | 70                     |       |
| Deferred income                                                                                            |       | 3,167              |       | 1,956                  |       |
| Total current liabilities                                                                                  |       | 28,342             |       | 21,198                 |       |
| Non-current liabilities:                                                                                   |       |               |       |                   |       |
| Deferred taxes                                                                                             |       | 2,353              |       | 2,555                  |       |
| Long-term debt                                                                                             |       | 360                |       | 369                    |       |
| Other                                                                                                      |       | 75                 |       | 176                    |       |
| Total non-current liabilities                                                                              |       | 2,788              |       | 3,100                  |       |
|                                                                                                       |       |               |       |                   |       |
| Commitments and contingencies                                                                              |       |               |       |                   |       |
|                                                                                                       |       |               |       |                   |       |
| Stockholders’ equity:                                                                                 |       |               |       |                   |       |
| Preferred stock, $1.00 par value,  authorized 2,000 shares, issued and outstanding, none                   |       | —             |       | —                 |       |
| Common stock, $.02 par value, authorized  100,000 shares, issued and outstanding, 20,787 and 20,573 shares |       | 416                |       | 412                    |       |
| Stock purchase warrants (to purchase 400  and 420 shares of common stock)                                  |       | 333                |       | 333                    |       |
| Additional paid-in capital                                                                                 |       | 138,578            |       | 136,850                |       |
| Accumulated deficit                                                                                        |       | (64,301            | )          | (66,599                | )          |
| Accumulated other comprehensive income                                                                     |       | 3,631              |       | 5,169                  |       |
| Total stockholders’ equity                                                                            |       | 78,657             |       | 76,165                 |       |
|                                                                                                       |       | $                  | 109,787    |                   | $          | 100,463 |   |

 

*The accompanying Notes to Condensed Consolidated FinancialStatements are an integral part of these financial statements.*

 

3

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**BENTLEY PHARMACEUTICALS, INC. AND SUBSIDIARIES**

**CONSOLIDATED  INCOME STATEMENTS**

**AND STATEMENTS OF COMPREHENSIVE INCOME**

 
| **(in thousands, except per share  data)**  | ** ** | **For the Three Months Ended June 30,** | ** ** | **For the Six Months Ended June 30,** | ** ** |
|---------------------------------------------|------------|-----------------------------------------|------------|---------------------------------------|------------|
| ** **                                  | ** ** | **2004**                                | ** ** | **2003**                              | ** ** | **2004** | ** ** | **2003** | ** ** |
| Revenues:                                   | ** ** | ** **                              | ** ** | ** **                            | ** ** | ** ** | ** ** | ** ** | ** ** |
| Net product sales                           |       | $                                       | 17,407     |                                  | $          | 16,596 |   | $ | 34,013 |   | $ | 30,831 |   |
| Licensing and collaboration revenues        |       | 1,063                                   |       | 158                                   |       | 1,759 |   | 911 |   |
| Total revenues                              |       | 18,470                                  |       | 16,754                                |       | 35,772 |   | 31,742 |   |
|                                        |       |                                    |       |                                  |       |   |   |   |   |
| Cost of net product sales                   |       | 8,396                                   |       | 6,819                                 |       | 16,592 |   | 12,940 |   |
|                                        |       |                                    |       |                                  |       |   |   |   |   |
| Gross profit                                |       | 10,074                                  |       | 9,935                                 |       | 19,180 |   | 18,802 |   |
|                                        |       |                                    |       |                                  |       |   |   |   |   |
| Operating expenses:                         |       |                                    |       |                                  |       |   |   |   |   |
| Selling and marketing                       |       | 3,851                                   |       | 3,626                                 |       | 7,721 |   | 6,979 |   |
| General and administrative                  |       | 2,287                                   |       | 1,786                                 |       | 4,451 |   | 3,345 |   |
| Research and development                    |       | 946                                     |       | 879                                   |       | 1,941 |   | 1,897 |   |
| Depreciation and amortization               |       | 407                                     |       | 328                                   |       | 813 |   | 611 |   |
|                                        |       |                                    |       |                                  |       |   |   |   |   |
| Total operating expenses                    |       | 7,491                                   |       | 6,619                                 |       | 14,926 |   | 12,832 |   |
|                                        |       |                                    |       |                                  |       |   |   |   |   |
| Income from operations                      |       | 2,583                                   |       | 3,316                                 |       | 4,254 |   | 5,970 |   |
|                                        |       |                                    |       |                                  |       |   |   |   |   |
| Other income (expenses):                    |       |                                    |       |                                  |       |   |   |   |   |
| Interest income                             |       | 132                                     |       | 82                                    |       | 242 |   | 165 |   |
| Interest expense                            |       | (58                                     | )          | (64                                   | )          | (111 | ) | (118 | ) |
| Other, net                                  |       | 1,274                                   |       | —                                |       | 1,274 |   | — |   |
|                                        |       |                                    |       |                                  |       |   |   |   |   |
| Income before income taxes                  |       | 3,931                                   |       | 3,334                                 |       | 5,659 |   | 6,017 |   |
|                                        |       |                                    |       |                                  |       |   |   |   |   |
| Provision for income taxes                  |       | 2,441                                   |       | 1,805                                 |       | 3,361 |   | 2,956 |   |
|                                        |       |                                    |       |                                  |       |   |   |   |   |
| Net income                                  |       | $                                       | 1,490      |                                  | $          | 1,529 |   | $ | 2,298 |   | $ | 3,061 |   |
|                                        |       |                                    |       |                                  |       |   |   |   |   |
| Net income per common share:                |       |                                    |       |                                  |       |   |   |   |   |
| Basic                                       |       | $                                       | 0.07       |                                  | $          | 0.09 |   | $ | 0.11 |   | $ | 0.17 |   |
| Diluted                                     |       | $                                       | 0.07       |                                  | $          | 0.07 |   | $ | 0.10 |   | $ | 0.15 |   |
|                                        |       |                                    |       |                                  |       |   |   |   |   |
| Weighted average common shares outstanding: |       |                                    |       |                                  |       |   |   |   |   |
| Basic                                       |       | 20,644                                  |       | 17,534                                |       | 20,620 |   | 17,495 |   |
| Diluted                                     |       | 22,800                                  |       | 20,878                                |       | 22,787 |   | 20,617 |   |
|                                        |       |                                    |       |                                  |       |   |   |   |   |
| Net income                                  |       | $                                       | 1,490      |                                  | $          | 1,529 |   | $ | 2,298 |   | $ | 3,061 |   |
| Other comprehensive (loss) income:          |       |                                    |       |                                  |       |   |   |   |   |
| Foreign currency translation (losses) gains |       | (309                                    | )          | 1,513                                 |       | (1,538 | ) | 2,193 |   |
| Comprehensive income                        |       | $                                       | 1,181      |                                  | $          | 3,042 |   | $ | 760 |   | $ | 5,254 |   |

 

*The accompanying Notes to Condensed Consolidated FinancialStatements are an integral part of these financial statements.*

 

4

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**BENTLEY PHARMACEUTICALS, INC. AND SUBSIDIARIES**

**CONSOLIDATED STATEMENT OF CHANGES INSTOCKHOLDERS’ EQUITY**

 
| **(in  thousands, except per share data)** | ** ** | ** ** | ** ** | **Stock  Purchase  Warrants** | ** ** | **Additional  Paid-In  Capital** | ** ** | **Accumulated  Deficit** | ** ** | **Accumulated  Other  Comprehensive  Income** | ** ** | **Total** | ** ** |
|--------------------------------------------|------------|------------|------------|-------------------------------|------------|----------------------------------|------------|--------------------------|------------|-----------------------------------------------|------------|-----------|------------|
| **$ .02 Par Value  Common Stock**     |
| **Shares**                                 | ** ** | **Amount** |
|                                       |       |       |       |                          |       |                             |       |                     |       |                                          |       |      |       |   |   |
| Balance at December 31, 2003               |       | 20,573     |       | $                             | 412        |                             | $          | 333                      |       | $                                             | 136,850    |      | $          | (66,599 | ) | $ | 5,169 |   | $ | 76,165 |   |
| Exercise of stock options                  |       | 204        |       | 4                             |       | —                           |       | 1,599                    |       | —                                        |       | —    |       | 1,603 |   |
| Equity based compensation                  |       | 10         |       | —                        |       | —                           |       | 129                      |       | —                                        |       | —    |       | 129 |   |
| Foreign currency translation adjustment    |       | —     |       | —                        |       | —                           |       | —                   |       | —                                        |       | (1,538    | )          | (1,538 | ) |
| Net income                                 |       | —     |       | —                        |       | —                           |       | —                   |       | 2,298                                         |       | —    |       | 2,298 |   |
| Balance at June 30, 2004                   |       | 20,787     |       | $                             | 416        |                             | $          | 333                      |       | $                                             | 138,578    |      | $          | (64,301 | ) | $ | 3,631 |   | $ | 78,657 |   |

 

*The accompanying Notes to Condensed Consolidated FinancialStatements are an integral part of these financial statements.*

 

5

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**BENTLEY PHARMACEUTICALS, INC. AND SUBSIDIARIES**

**CONSOLIDATED STATEMENTS OF CASH FLOWS**

 

 
| ** **                                                                         | ** ** | **For the Six Months Ended June 30,** | ** ** |
|------------------------------------------------------------------------------------|------------|---------------------------------------|------------|
| **(in thousands)**                                                                 | ** ** | **2004**                              | ** ** | **2003** | ** ** |
|                                                                               |       |                                  |       |   |   |
| Cash flows from operating activities:                                              |       |                                  |       |   |   |
| Net income                                                                         |       | $                                     | 2,298      |   | $ | 3,061 |   |
| Adjustments to reconcile net income to net  cash provided by operating activities: |       |                                  |       |   |   |
| Depreciation and amortization                                                      |       | 1,696                                 |       | 1,078 |   |
| Forgiveness of related party loans                                                 |       | —                                |       | (150 | ) |
| Equity-based compensation expense                                                  |       | 129                                   |       | 237 |   |
| Other non-cash items                                                               |       | (87                                   | )          | 1 |   |
| (Increase) decrease in assets and increase  (decrease) in liabilities:             |       |                                  |       |   |   |
| Receivables                                                                        |       | (6,583                                | )          | (4,709 | ) |
| Inventories                                                                        |       | (2,620                                | )          | 33 |   |
| Prepaid expenses and other current assets                                          |       | (1,119                                | )          | (134 | ) |
| Other assets                                                                       |       | 9                                     |       | (9 | ) |
| Accounts payable and accrued expenses                                              |       | 6,753                                 |       | 3,732 |   |
| Deferred income                                                                    |       | 1,347                                 |       | 753 |   |
| Other liabilities                                                                  |       | (256                                  | )          | (7 | ) |
|                                                                               |       |                                  |       |   |   |
| Net cash provided by operating activities                                          |       | 1,567                                 |       | 3,886 |   |
|                                                                               |       |                                  |       |   |   |
| Cash flows from investing activities:                                              |       |                                  |       |   |   |
| Proceeds from sale of investments                                                  |       | 149,100                               |       | 114,600 |   |
| Purchase of investments                                                            |       | (148,219                              | )          | (114,509 | ) |
| Purchase of API manufacturing assets                                               |       | (3,309                                | )          | — |   |
| Additions to fixed assets                                                          |       | (3,476                                | )          | (4,131 | ) |
| Additions to drug licenses and related  costs                                      |       | (549                                  | )          | (2,054 | ) |
|                                                                               |       |                                  |       |   |   |
| Net cash used in investing activities                                              |       | (6,453                                | )          | (6,094 | ) |
|                                                                                    |            |                                       |            |  |  |  |  |

 

(Continued on following page)

 

*The accompanying Notes to Condensed Consolidated FinancialStatements are an integral part of these financial statements.*

 

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**BENTLEY PHARMACEUTICALS, INC. AND SUBSIDIARIES**

**CONSOLIDATED STATEMENTS OF CASH FLOWS(concluded)**

 
| ** **                                                                                      | ** ** | **For the Six Months Ended June 30,** | ** ** |
|-------------------------------------------------------------------------------------------------|------------|---------------------------------------|------------|
| **(in thousands)**                                                                              | ** ** | **2004**                              | ** ** | **2003** | ** ** |
|                                                                                            |       |                                  |       |   |   |
| Cash flows from financing activities:                                                           |       |                                  |       |   |   |
| Proceeds from exercise of stock  options/warrants                                               |       | $                                     | 1,603      |   | $ | 962 |   |
| Repayment of borrowings                                                                         |       | (2,550                                | )          | (1,329 | ) |
| Proceeds from borrowings                                                                        |       | 2,500                                 |       | 1,150 |   |
| Increase in restricted cash                                                                     |       | —                                |       | (1,000 | ) |
|                                                                                            |       |                                  |       |   |   |
| Net cash provided by (used in) financing  activities                                            |       | 1,553                                 |       | (217 | ) |
|                                                                                            |       |                                  |       |   |   |
| Effect of exchange rate changes on cash                                                         |       | (317                                  | )          | 667 |   |
|                                                                                            |       |                                  |       |   |   |
| Net decrease in cash and cash equivalents                                                       |       | (3,650                                | )          | (1,758 | ) |
|                                                                                            |       |                                  |       |   |   |
| Cash and cash equivalents at beginning of  period                                               |       | 39,393                                |       | 26,581 |   |
|                                                                                            |       |                                  |       |   |   |
| Cash and cash equivalents at end of period                                                      |       | $                                     | 35,743     |   | $ | 24,823 |   |
|                                                                                            |       |                                  |       |   |   |
| **Supplemental Disclosures of Cash Flow Information**                                           |       |                                  |       |   |   |
| The Company paid cash during the period for:                                                    |       |                                  |       |   |   |
|                                                                                            |       |                                  |       |   |   |
| Interest                                                                                        |       | $                                     | 106        |   | $ | 97 |   |
| Foreign income taxes                                                                            |       | $                                     | 638        |   | $ | 847 |   |
|                                                                                            |       |                                  |       |   |   |
| **Supplemental Disclosures of Non-Cash Financing and  Investing Activities**                    |       |                                  |       |   |   |
| The Company has issued Common Stock in exchange for services as  follows:                       |       |                                  |       |   |   |
|                                                                                            |       |                                  |       |   |   |
| Shares                                                                                          |       | 10                                    |       | 55 |   |
| Amount                                                                                          |       | $                                     | 129        |   | $ | 465 |   |
|                                                                                            |       |                                  |       |   |   |
| Included in accounts payable at period-end are fixed asset and drug  license purchases totaling |       | $                                     | 1,539      |   | $ | 320 |   |

 

*The accompanying Notes to Condensed Consolidated FinancialStatements are an integral part of these financial statements.*

 

7

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**BENTLEY PHARMACEUTICALS, INC. ANDSUBSIDIARIES**

 

**NOTES TO CONDENSED CONSOLIDATED FINANCIALSTATEMENTS**

 

HISTORY AND OPERATIONS:

 

BentleyPharmaceuticals, Inc. and Subsidiaries (which may be referred to as *Bentley Pharmaceuticals*, *Bentley*, *the Company*, *we*, *us* or *our*) is aU.S.-based international specialty pharmaceutical company, incorporated in theState of Delaware, focused on:

 

•                  research,development and licensing/commercialization of advanced drug deliverytechnologies and pharmaceutical products; and

 

•                  development,licensing and sales of generic and branded pharmaceutical products and themanufacturing of pharmaceuticals for others.

 

In our research and development activities, we have U.S. andinternational patents and other proprietary rights to technologies thatfacilitate the absorption of drugs. Our pharmaceutical product sales andlicensing activities are based in Spain, where we have a significant commercialpresence and manufacture and market approximately 100 pharmaceutical productsthrough three wholly-owned Spanish subsidiaries, Laboratorios Belmac,Laboratorios Davur and Laboratorios Rimafar. These products represent variousdosage strengths and product formulations of more than 30 chemical entities infour primary therapeutic areas: cardiovascular, gastrointestinal, neurologicaland infectious diseases. We continually add to our product portfolio inresponse to increasing market demand for generic and branded therapeutic agentsand divest portfolio products that we consider to be redundant or that havebecome non-strategic.  Although most ofour sales of these products are currently in the Spanish market, we haverecently focused on increasing our sales in other European countries and othergeographic regions through strategic alliances with companies in theseterritories. In April of 2004, wepurchased a manufacturing facility located in Spain which specializes in the manufactureof several active pharmaceutical ingredients (API), of which, one ingredienthas been approved by the Food and Drug Administration for marketing and sale inthe U.S. We are manufacturing and marketing these products through our newlyformed subsidiary, Bentley API. Additionally, we have a strategic alliance with Teva PharmaceuticalIndustries Ltd. granting us the right to register and market several ofTeva’s pharmaceutical products in Spain through our sales force ofapproximately 150 full-time personnel located in major cities throughoutSpain.  In addition, our Spanishmanufacturing facility produces pharmaceutical products that are marketed bypharmaceutical companies both in Spain and in other markets. We have also recently developed a strategyto introduce certain of our generic pharmaceutical products into the U.S.marketplace.

 

We are developing products which incorporate our drug deliverytechnologies and have licensed applications of our proprietary CPE-215® drugdelivery technology to Auxilium Pharmaceuticals, Inc., which launched TestimTM,the first product incorporating our drug delivery technology, in February2003.  Testim is a gel indicated fortestosterone replacement therapy which restores serum testosterone levels inmen and thereby improves symptoms of health problems associated with low testosteronelevels (hypogonadism), including loss of muscle mass and a decrease in sexualdesire, sexual motivation and frequency of spontaneous erections. We are indiscussions with other pharmaceutical and biotechnology companies to formadditional strategic alliances to facilitate the development andcommercialization of other products using our drug delivery technologies,including product candidates that deliver insulin to diabetic patientsintranasally and treat nail fungus infections topically.

 

8

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The Company’s Common Stock began trading on the New York Stock Exchange(*NYSE)* on May 12, 2004, under the tradesymbol *BNT*. Prior thereto, the Company’s stock was traded on the American StockExchange.

 

BASIS OF CONSOLIDATED FINANCIAL STATEMENTS:

 

The consolidated financial statements of Bentley Pharmaceuticals as ofJune 30, 2004 and for the three and six months ended June 30, 2004 and 2003,included herein, have been prepared by us, without audit, pursuant to the rulesand regulations of the Securities and Exchange Commission.  Certain information and footnote disclosuresnormally included in financial statements prepared in accordance withaccounting principles generally accepted in the United States of America havebeen condensed or omitted insofar as such information was disclosed in ourconsolidated financial statements for the year ended December 31, 2003.  These consolidated financial statementsshould be read in conjunction with the summary of significant accountingpolicies and the audited consolidated financial statements and notes theretoincluded in our Annual Report on Form 10-K for the year ended December 31,2003.

 

In the opinion of management, the accompanying unaudited consolidatedfinancial statements as of June 30, 2004 and for the three and six months endedJune 30, 2004 and 2003 are presented on a basis consistent with the auditedconsolidated financial statements for the year ended December 31, 2003 andcontain all adjustments, consisting only of normal recurring adjustments, necessaryto present fairly Bentley’s financial position as of June 30, 2004 and theresults of its operations and cash flows for the three and six months endedJune 30, 2004 and 2003.  The results ofoperations for the three and six months ended June 30, 2004 should notnecessarily be considered indicative of the results to be expected for the fullyear ending December 31, 2004.

 

CASH AND CASH EQUIVALENTS AND RESTRICTED CASH:

 

Included in *cash andcash equivalents* at June 30, 2004 and December 31, 2003 are approximately$4,604,000 and $29,156,000, respectively, of short-term investments consideredto be cash equivalents, as the remaining maturity dates of such investmentswere three months or less when purchased.

 

The Companyacquired intellectual property during the year ended December 31, 2003 for$1,000,000 plus future royalties on sales and licensing income. In connectionwith the acquisition, the Company obtained a renewable, irrevocable letter ofcredit in the amount of $1,000,000 in favor of the seller to guarantee futureroyalty payments. This irrevocable letter of credit was renewed in June of 2004for a one year period. The $1,000,000 used to secure the letter of credit hasbeen classified as *restricted cash*in the Consolidated Balance Sheets as of June 30, 2004 and December 31, 2003.

 

MARKETABLE SECURITIES:

 

The Company has investments in securities,with maturities of greater than three months when purchased, which areclassified as available-for-sale, totaling $465,000 as of June 30, 2004,compared to $1,252,000 as of December 31, 2003. The Company’s investments are carried at amortized cost whichapproximates fair value due to the short-term nature of these investments.  Accordingly, no unrealized gains or losseshave been recognized on these investments. Should the fair values differsignificantly from the amortized costs, unrealized gains or losses would beincluded as a component of *othercomprehensive income (loss)*.

 

9

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INVENTORIES:

 

Inventories are stated at the lower of costor market, cost being determined on the first in, first out (“FIFO”) method,and are comprised of the following (in thousands):

 
| ** **                               | ** ** | **June 30, 2004** | ** ** | **December 31, 2003** | ** ** |
|------------------------------------------|------------|-------------------|------------|-----------------------|------------|
| Raw materials                            |       | $                 | 6,731      |                  | $          | 5,351 |   |
| Finished goods                           |       | 2,940             |       | 1,829                 |       |
|                                     |       | 9,671             |       | 7,180                 |       |
| Less allowance for slow moving inventory |       | (66               | )          | (74                   | )          |
|                                     |       | $                 | 9,605      |                  | $          | 7,106 |   |

 

FIXED ASSETS:

 

Fixed assets consist of the following (in thousands):

 
| ** **                    | ** ** | **June 30, 2004** | ** ** | **December 31, 2003** | ** ** |
|-------------------------------|------------|-------------------|------------|-----------------------|------------|
| Land                          |       | $                 | 2,243      |                  | $          | 1,900 |   |
| Buildings                     |       | 9,467             |       | 9,085                 |       |
| Equipment                     |       | 15,668            |       | 10,953                |       |
| Furniture and fixtures        |       | 1,482             |       | 1,497                 |       |
| Leasehold improvements        |       | 42                |       | 43                    |       |
|                          |       | 28,902            |       | 23,478                |       |
| Less accumulated depreciation |       | (5,845            | )          | (4,912                | )          |
|                          |       | $                 | 23,057     |                  | $          | 18,566 |   |

 

In April of 2004, we purchaseda Spanish manufacturing facility and related machinery and equipment,used to manufacture active pharmaceutical ingredients, for approximately $3,300,000. We aremanufacturing and marketing some of these products through our newly formedsubsidiary, Bentley API. The 20,000 square foot facility is currently FDA approved for oneproduct, which it sells to several customers, including customers in the UnitedStates.

 

In order tosupport the Company’s growth in Europe, we are adding additional capacity toour finished pharamaceutical product manufacturing facility through a series ofimprovements. During the six months ended June 30, 2004, the Company investedapproximately $2,000,000 for machinery and equipment, including new high speedmanufacturing and packaging equipment.

 

Depreciation expense of approximately$275,000 and $147,000 has been charged to operations as a component of *depreciation and amortization expense* inthe Consolidated Income Statements for the six months ended June 30, 2004 and2003, respectively. We have included depreciation totaling approximately$883,000 and $467,000 in *cost of net productsales* during the three months ended June 30, 2004 and 2003,respectively.

 

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STOCKHOLDERS’ EQUITY:

 

A substantial amount of our business is conducted in Europe and istherefore influenced by fluctuations in the U.S. Dollar’s value against othercurrencies, specifically the Euro. The exchange rates at June 30, 2004 andDecember 31, 2003 were .83 Euros and .80 Euros per U.S. Dollar, respectively.The weighted average exchange rates for the three months ended June 30,2004 and 2003 were .83 Euros and .88 Euros per U.S. Dollar, respectively. Theweighted average exchange rates for the six months ended June 30, 2004 and2003 were .82 Euros and .91 Euros per U.S. Dollar, respectively.  The effect of foreign currency fluctuationson long lived assets for the six months ended June 30, 2004 was a decreaseof $1,538,000 and the cumulative historical effect was an increase of $3,631,000,as reflected in our Consolidated Balance Sheets as *accumulated other**comprehensiveincome*. Although exchange rates fluctuated significantly in recentyears, we do not believe that the effect of foreign currency fluctuation ismaterial to our results of operations as the expenses related to much of ourforeign currency revenues are in the same functional currency, the Euro, asthose revenues. However, the carrying value of assets and liabilities can bematerially impacted by foreign currency translation, as can the translatedamounts of revenues and expenses.

 

During the six months ended June 30, 2004, we received proceeds ofapproximately $1,600,000 from the issuance of approximately 204,000 shares ofCommon Stock upon exercise of employee stock options. We also issuedapproximately 10,000 shares of Common Stock as equity-based compensation inlieu of cash contributions to the Company-sponsored 401(k) retirement savingsplan.  Additionally, we granted to our employeesand directors stock options to purchase approximately 533,000 shares of CommonStock during the six months ended June 30, 2004.

 

LICENSING AND COLLABORATION REVENUES:

 

Our licensee, Auxilium Pharmaceuticals, Inc., launched its testosteronereplacement gel, Testim, which utilizes our patented CPE-215 drug deliverytechnology, during the first quarter of 2003. Auxilium paid a $500,000milestone payment to us during the first quarter of 2003, which we recorded as *licensing and collaboration revenues* in the ConsolidatedIncome Statement for the three months ended March 31, 2003.  In connection with the Testim product launch,we began earning royalty revenues on a percentage of Testim sales as defined inthe licensing agreement with Auxilium. Royalty revenues on Testim product salesare recognized based on an estimate of Auxilium’s sell-through of the Testimproduct based on prescriptions filled, until such time that returns fromwholesalers and pharmacies can be reasonably estimated. For the three and sixmonths ended June 30, 2004 we recognized royalty revenues of $644,000 and$1,198,000, respectively, compared to $158,000 and $208,000 in the three andsix months ended June 30, 2003, respectively. The difference between the total amount earned from Auxilium under theroyalty arrangement and the amount recognized as a component of *licensing and collaboration revenues* isrecorded as a component of *deferred income*in the Consolidated Balance Sheets.  Asof June 30, 2004 and December 31, 2003, deferred income from Testim royaltiestotaled $995,000 and $634,000, respectively. We will continue to use available market information to determine theamount and timing of royalty revenue recognition. Auxilium completed itsinitial public offering of its common stock on July 23, 2004. A portion of theoffering proceeds were designated to be used to commercialize its products.

 

11

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OTHER INCOME (EXPENSES):

 

In addition tointerest income on our investment and cash balances and interest expense on ourdebt obligations, other income (expenses) for the three and six months endedJune 30, 2004 includes the reversal of previously accrued tax assessments, aswell as interest and penalties associated with the settlement of the tax auditof our Spanish subsidiary’s tax years 1998 - 2000 (see Provision for IncomeTaxes footnote below). We recorded a pre-tax benefit totaling $1,467,000($954,000 after taxes) as a component of other income and expenses as theresult of the reversal of previously accrued pharmaceutical tax assessments inSpain. These assessments had been accrued to be paid to the Spanish governmentas a vehicle to help reduce the impact of the rising health care costs inSpain. Due to recent changes in the pharmaceutical industry in Spain and achange in the Spanish political environment, these liabilities no longer exist.Accordingly, these accruals were reversed during the quarter ended June 30,2004.  These amounts have also beenrecorded in accrued expenses in the consolidated balance sheet as of June 30,2004.

 

PROVISION FOR INCOME TAXES:

 

A tax review of our Spanish subsidiary, Laboratorios Belmac S.A. by theSpanish tax authorities for the tax years 1998, 1999 and 2000, which hadcommenced over a year ago, was completed in the quarter ended June 30, 2004.  As a result of this audit, our subsidiary hasbeen assessed an additional tax liability of approximately $604,000, which hasbeen recorded as a component of *provision for income taxes*,and approximately $193,000 for related interest and penalties, which have beenrecorded as components of *other income and expenses*,in the consolidated income statements for the three and six months ended June30, 2004.

 

As a result of reporting taxable income in Spain, we recordedprovisions for foreign income taxes totaling $2,441,000 ($1,837,000 income taxexpense on operations plus $604,000 recorded as a result of the tax audit ofour Spanish subsidiary) and $1,805,000 for the three months ended June 30, 2004and 2003, respectively. The effective tax rate for the three months ended June30, 2004 is 52%, however, when the $604,000 tax audit settlement related toprior years is excluded, the effective tax rate is 39% compared to 42% in theprior year second quarter. We have recorded provisions for foreign income taxestotaling $3,361,000 ($2,757,000 income tax expense on operations plus $604,000tax liability recorded as a result of the tax audit of our Spanish subsidiary)and $2,956,000 for the six months ended June 30, 2004 and 2003, respectively.The effective tax rate in Spain for the six months ended June 30, 2004 is 47%,however, when the $604,000 tax audit settlement related to prior years isexcluded, the effective tax rate is 39% compared to 40% in the comparable sixmonth period of the prior year.

 

As future domestic operating profits cannot be reasonably assured, notax benefit has been recorded for U.S. losses, which totaled ($727,000) and($976,000) for the three months ended June 30, 2004 and 2003, respectively, and($1,481,000) and ($1,465,000) for the six months ended June 30, 2004 and 2003,respectively. Accordingly, we have established a valuation allowance equal tothe full amount of the U.S. deferred tax assets. The provisions for incometaxes differ from the amounts computed by applying the U.S. federal income taxrate of 34% to pre-tax income, primarily as a result of the increase in thevaluation allowance to offset U.S. deferred tax assets, certain nondeductibleexpenses in Spain and the higher statutory income tax rate of 35% in Spain.

 

Should we determine that it is more likely than not that we willrealize certain of our net deferred tax assets for which we have previouslyprovided a valuation allowance, an adjustment

 

12

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wouldbe required to reduce the existing valuation allowance. In addition, we operatewithin multiple taxing jurisdictions and are subject to audit in thosejurisdictions. These audits can involve complex issues, which may require anextended period of time for resolution. During the quarter ended June 30, 2004,we identified certain tax contingencies that we have determined are probableand reasonably estimable. Consequently, we have included a charge totaling$188,000 in the *provision for income taxes* forthe quarter ended June 30, 2004 related to these contingencies. No other potential tax contingencies wereconsidered probable or reasonably estimable by the Company at period end.However, there is the possibility that the ultimate resolution of such potentialcontingencies could have an adverse effect on our results of operations.

 

# **BASIC ANDDILUTED NET INCOME PER COMMON SHARE:**

 

Basic and diluted net income per common share is based on the weightedaverage number of shares of common stock outstanding during each period. Thedilutive effect of our outstanding stock options and stock purchase warrants,as calculated using the treasury stock method, were considered in the netincome per share calculations for the three and six months ended June 30, 2004and 2003.

 

The following is a reconciliation between basic and diluted net incomeper common share for the three and six months ended June 30, 2004 and2003.  Dilutive securities issuable forthe three and six months ended June 30, 2004 include approximately 2,156,000and 2,167,000 shares, respectively, issuable as a result of various stockoptions and warrants that are outstanding and exercisable.  Dilutive securities issuable for the threeand six months ended June 30, 2003 include approximately 1,334,000 and1,260,000 shares, respectively, issuable as a result of exercisable Class BWarrants and approximately 2,010,000 and 1,862,000 shares, respectively,issuable as a result of various stock options and other warrants that wereoutstanding and exercisable at that time.

 

(in thousands, except per share data)

 

For the Three Months Ended June 30, 2004:

 
| ** **                                 | ** ** | **Basic EPS** | ** ** | **Effect of Dilutive  Securities** | ** ** | **Diluted EPS** | ** ** |
|--------------------------------------------|------------|---------------|------------|------------------------------------|------------|-----------------|------------|
| Net Income                                 |       | $             | 1,490      |                               | $          | —          |       | $ | 1,490 |   |
| Weighted Average Common Shares Outstanding |       | 20,644        |       | 2,156                              |       | 22,800          |       |
| Net Income Per Common Share                |       | $             | 0.07       |                               | $          | —          |       | $ | 0.07 |   |

 

For the Three Months Ended June 30, 2003:

 
| ** **                                 | ** ** | **Basic EPS** | ** ** | **Effect of Dilutive  Securities** | ** ** | **Diluted EPS** | ** ** |
|--------------------------------------------|------------|---------------|------------|------------------------------------|------------|-----------------|------------|
| Net Income                                 |       | $             | 1,529      |                               | $          | —          |       | $ | 1,529 |   |
| Weighted Average Common Shares Outstanding |       | 17,534        |       | 3,344                              |       | 20,878          |       |
| Net Income Per Common Share                |       | $             | 0.09       |                               | $          | (0.02           | )          | $ | 0.07 |   |

 

For the Six Months Ended June 30, 2004:

 
| ** **                                 | ** ** | **Basic EPS** | ** ** | **Effect of Dilutive  Securities** | ** ** | **Diluted EPS** | ** ** |
|--------------------------------------------|------------|---------------|------------|------------------------------------|------------|-----------------|------------|
| Net Income                                 |       | $             | 2,298      |                               | $          | —          |       | $ | 2,298 |   |
| Weighted Average Common Shares Outstanding |       | 20,620        |       | 2,167                              |       | 22,787          |       |
| Net Income Per Common Share                |       | $             | 0.11       |                               | $          | (0.01           | )          | $ | 0.10 |   |

 

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For the Six Months Ended June 30, 2003:

 
| ** **                                 | ** ** | **Basic EPS** | ** ** | **Effect of Dilutive  Securities** | ** ** | **Diluted EPS** | ** ** |
|--------------------------------------------|------------|---------------|------------|------------------------------------|------------|-----------------|------------|
| Net Income                                 |       | $             | 3,061      |                               | $          | —          |       | $ | 3,061 |   |
| Weighted Average Common Shares Outstanding |       | 17,495        |       | 3,122                              |       | 20,617          |       |
| Net Income Per Common Share                |       | $             | 0.17       |                               | $          | (0.02           | )          | $ | 0.15 |   |

 

Excluded from the diluted EPS presentation,because their exercise prices were greater than the average fair value of theCommon Stock in the respective periods, were warrants and options to purchasean aggregate of 468,000 shares of Common Stock, for the three and six monthsended June 30, 2004 and warrants and options to purchase an aggregate of518,000 and 1,328,000 shares of Common Stock, for the three and six monthsended June 30, 2003, respectively.

 

STOCK BASED COMPENSATION:

 

We have stock-based employee compensation plans that are described morefully in Note 11 of the Notes to Consolidated Financial Statements included inthe Annual Report on Form 10-K for the year ended December 31, 2003.  We account for these plans under therecognition and measurement principles of Accounting Principles Board (“APB”)Opinion No. 25, *Accounting for Stock Issued to Employees*,and related Interpretations.  Optionsgranted under these plans have exercise prices equal to or greater than themarket value of the underlying Common Stock on the dates of grant, which isgenerally the date on which compensation is measured. In addition to theseplans, we also sponsor a 401(k) retirement savings plan for eligible employeesand match eligible contributions with shares of the Company’s CommonStock.  From time to time, at thediscretion of the Compensation Committee of the Board of Directors (*the Compensation Committee*), the Company grants shares ofits Common Stock to employees in lieu of cash compensation. Related stock-basedemployee compensation costs are reflected in the Consolidated Income Statementsand Statements of Cash Flows.

 

General and administrative expenses for the three and six months endedJune 30, 2004 include $15,000 and $47,000, respectively, of non-cashequity-based compensation. General and administrative expenses for the threeand six months ended June 30, 2003 include $54,000 and $102,000,respectively, of non-cash equity-based compensation.  Research and development expenses for thethree and six months ended June 30, 2004 include $41,000 and $82,000,respectively, of non-cash equity-based compensation. Research and developmentexpenses for the three and six months ended June 30, 2003 include $65,000and $135,000, respectively, of non-cash equity-based compensation.

 

The following table illustrates the effect onnet income per share if we had applied the fair value recognition provisions ofStatement of Financial Accounting Standards (“SFAS”) No. 123, *Accounting for Stock-Based Compensation*, to stock-basedemployee compensation.

 

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| ** **                                                                                                 | ** ** | **For the Three Months  Ended June 30,** | ** ** | **For the Six Months  Ended June 30,** | ** ** |
|------------------------------------------------------------------------------------------------------------|------------|------------------------------------------|------------|----------------------------------------|------------|
| ** **                                                                                                 | ** ** | **2004**                                 | ** ** | **2003**                               | ** ** | **2004** | ** ** | **2003** | ** ** |
| Net income, as reported                                                                                    |       | $                                        | 1,490      |                                   | $          | 1,529 |   | $ | 2,298 |   | $ | 3,061 |   |
|                                                                                                       |       |                                     |       |                                   |       |   |   |   |   |
| Add: Stock-based employee compensation  expense included in reported net income                            |       | 56                                       |       | 109                                    |       | 129 |   | 237 |   |
|                                                                                                       |       |                                     |       |                                   |       |   |   |   |   |
| Deduct: Total stock-based employee  compensation expense determined under fair value method for all awards |       | (596                                     | )          | (775                                   | )          | (1,720 | ) | (1,512 | ) |
|                                                                                                       |       |                                     |       |                                   |       |   |   |   |   |
| Pro forma net income                                                                                       |       | $                                        | 950        |                                   | $          | 863 |   | $ | 707 |   | $ | 1,786 |   |
|                                                                                                       |       |                                     |       |                                   |       |   |   |   |   |
| Net income per common share:                                                                               |       |                                     |       |                                   |       |   |   |   |   |
| Basic - as reported                                                                                        |       | $                                        | 0.07       |                                   | $          | 0.09 |   | $ | 0.11 |   | $ | 0.17 |   |
| Basic - pro forma                                                                                          |       | $                                        | 0.05       |                                   | $          | 0.05 |   | $ | 0.03 |   | $ | 0.10 |   |
|                                                                                                       |       |                                     |       |                                   |       |   |   |   |   |
| Diluted - as reported                                                                                      |       | $                                        | 0.07       |                                   | $          | 0.07 |   | $ | 0.10 |   | $ | 0.15 |   |
| Diluted - pro forma                                                                                        |       | $                                        | 0.04       |                                   | $          | 0.04 |   | $ | 0.03 |   | $ | 0.09 |   |

 

The preceding pro forma results werecalculated using the Black-Scholes option pricing model with the followingweighted average assumptions (results may vary depending on the assumptionsapplied within the model):

 
| ** **                    | ** ** | **For the Three Months  Ended June 30,** | ** ** | **For the Six Months  Ended June 30,** | ** ** |
|-------------------------------|------------|------------------------------------------|------------|----------------------------------------|------------|
| ** **                    | ** ** | **2004**                                 | ** ** | **2003**                               | ** ** | **2004** | ** ** | **2003** | ** ** |
|                          |       |                                     |       |                                   |       |   |   |   |   |
| Risk-free interest rate       |       | 2.10%                                    |       | 3.62%                                  |       | 2.97% |   | 3.89% |   |
| Dividend yield                |       | 0.00%                                    |       | 0.00%                                  |       | 0.00% |   | 0.00% |   |
| Expected life                 |       | 5 years                                  |       | 5 years                                |       | 5 years |   | 5 years |   |
| Volatility                    |       | 50.49%                                   |       | 53.06%                                 |       | 49.28% |   | 54.30% |   |
| Fair value of options granted |       | $                                        | 5.70       |                                   | $          | 4.87 |   | $ | 6.03 |   | $ | 4.98 |   |
|                               |            |                                          |            |                                        |            |  |  |  |  |  |  |  |  |

 

Stock or other equity-based compensation for non-employees is accountedfor under the fair value method as required by SFAS No. 123 and EmergingIssues Task Force (“EITF”) Issue No. 96-18, *Accountingfor Equity Instruments That Are Issued to Other Than Employees for Acquiring,or in Conjunction with Selling, Goods or Services* and other relatedinterpretations.

 

RECLASSIFICATIONS:

 

Certain prior period amounts have beenreclassified to conform with the current period’s presentation.  Such reclassifications are not material tothe Consolidated Financial Statements.

 

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NEW ACCOUNTING PRONOUNCEMENTS:

 

In November 2002, the EITF released Issue No. 00-21, *Accounting for Revenue Arrangements with Multiple Deliverables*,which addresses certain aspects of the accounting by a vendor for arrangementsunder which it will perform multiple revenue-generating activities. EITF IssueNo. 00-21 establishes three principles: revenue arrangements with multipledeliverables should be evaluated to determine if separate units of accountingexist; arrangement consideration should be allocated among the separate unitsof accounting based on their relative fair values; and revenue recognitioncriteria should be considered individually for each separate unit ofaccounting. EITF Issue No. 00-21 is effective for all revenue arrangementsentered into in fiscal periods beginning after June 15, 2003. The adoption ofEITF Issue No. 00-21 in our third quarter of 2003 did not have a materialeffect on our financial position, results of operations or cash flows for theyear ended December 31, 2003.  However,the adoption of EITF Issue No. 00-21 requires the deferral and recognition overextended periods of certain up-front fees, even if such fees or payments arenon-refundable, associated with our multiple element collaboration and licenseagreements and of our marketing, distribution and supply agreements and mayhave an impact on future periods.

 

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# **Item 2.    Management’s Discussion and Analysis ofFinancial Condition and Results of**Operations

 

The following discussion and analysis should be read together with allfinancial and non-financial information appearing elsewhere in this report andwith our consolidated financial statements and related notes included in ourAnnual Report on Form 10-K for the year ended December 31, 2003, which has beenpreviously filed with the Securities and Exchange Commission. In addition tohistorical information, the following discussion and other parts of this reportcontain forward-looking information that involves risks and uncertainties.  Our actual results could differ materiallyfrom those anticipated by such forward-looking information due to competitivefactors and other risks discussed below under the caption “Important FactorsThat May Affect Future Results”.

 

**RESULTS OF OPERATIONS:**

 

**Three Months Ended June 30, 2004 versus ThreeMonths Ended June 30, 2003**

 

*Revenues*

 
| ** **                             | ** ** | **For the Three Months Ended June 30,** | ** ** | **Change** | ** ** |
|----------------------------------------|------------|-----------------------------------------|------------|------------|------------|
| **(in  thousands)**                    | ** ** | **2004**                                | ** ** | **%**      | ** ** | **2003** | ** ** | **%** | ** ** | **$** | ** ** | **%** | ** ** |
| *Revenues:*                            | * *   | * *                                | * *   | * *   | * *   | * * | * * | * * | * * | * * | * * | * * | * * |
| *Net product sales*                    | * *   | *$*                                     | *17,407*   | * *   | *94*       | *%* | *$* | *16,596* | * * | *99* | *%* | *$* | *811* | * * | *5* | *%* |
| *Licensing and collaboration revenues* | * *   | *1,063*                                 | * *   | *6*        | *%*        | *158* | * * | *1* | *%* | *905* | * * | *573* | *%* |
| *Total revenues*                       | * *   | *$*                                     | *18,470*   | * *   | *100*      | *%* | *$* | *16,754* | * * | *100* | *%* | *$* | *1,716* | * * | *10* | *%* |

 

Total revenues for the three months ended June 30, 2004 increased 10%from the same period in the prior year. However, our total revenues increasedapproximately 4% when expressed in constant currency. An increase in theweighted average value of the Euro, inrelation to the U.S. Dollar, had the effect of increasing revenues byapproximately $1,043,000, partially offsetting the impact of price reductionsin Spain. Price reductions were mandated for certain pharmaceutical products bythe Spanish government in late 2003, which we put into effect on December 1,2003. Over the past six months we have implemented several initiatives toreduce our production costs and increase our margins on several of our productsaffected by the price reductions. Additionally, through strategic pricing, wehave been able to increase our market share on these and other products. Theadvancement of our proprietary drug delivery programs in the U.S., as evidencedby the growing royalty stream from sales of Testim, the first marketed productincorporating our CPE-215 drug delivery technology, and other licensingrevenues have increased our revenues by approximately $905,000 in the threemonths ended June 30, 2004 over the same period in the prior year.

 

Our revenuesare generated through our five primary sales channels (branded pharmaceuticals,generic pharmaceuticals, contract manufacturing for other pharmaceuticalcompanies, sales outside of Spain and licensing and collaborations). Set forthbelow is a summary of our revenues by sales channel and top-selling productlines:

 

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For the threemonths ended June 30, 2004 (in thousands):

 
| ** **                     | ** ** | **Sales Within Spain** | ** ** | ** **            | ** ** | ** **                     | ** ** | ** **          | ** ** |
|--------------------------------|------------|------------------------|------------|-----------------------|------------|--------------------------------|------------|---------------------|------------|
| **Product  Line**              | ** ** | **Branded  Products**  | ** ** | **Generic  Products** | ** ** | **Contract  Manu-  facturing** | ** ** | **Other  Revenues** | ** ** | **Total** | ** ** | **%****of Total  Revenues** | ** ** |
|                           |       |                   |       |                  |       |                           |       |                |       |   |   |   |   |
| *Omeprazole*                   | * *   | *$*                    | *647*      | * *              | *$*        | *3,204*                        | * *   | *$*                 | *—*   | * * | *$* | *—* | * * | *$* | *3,851* | * * | *21* | *%* |
| *Simvastatin*                  | * *   | *354*                  | * *   | *868*                 | * *   | *—*                       | * *   | *—*            | * *   | *1,222* | * * | *7* | *%* |
| *Enalapril*                    | * *   | *893*                  | * *   | *327*                 | * *   | *—*                       | * *   | *—*            | * *   | *1,220* | * * | *7* | *%* |
| *Paroxetine*                   | * *   | *228*                  | * *   | *765*                 | * *   | *—*                       | * *   | *—*            | * *   | *993* | * * | *5* | *%* |
| *Codeisan*                     | * *   | *608*                  | * *   | *—*              | * *   | *—*                       | * *   | *—*            | * *   | *608* | * * | *3* | *%* |
| *All other products*           | * *   | *1,535*                | * *   | *1,646*               | * *   | *—*                       | * *   | *264*               | * *   | *3,445* | * * | *19* | *%* |
| *Contract manufacturing*       | * *   | *—*               | * *   | *—*              | * *   | *2,304*                        | * *   | *—*            | * *   | *2,304* | * * | *12* | *%* |
| *Sales outside of Spain*       | * *   | *—*               | * *   | *—*              | * *   | *—*                       | * *   | *3,764*             | * *   | *3,764* | * * | *20* | *%* |
| *Licensing and collaborations* | * *   | *—*               | * *   | *—*              | * *   | *—*                       | * *   | *1,063*             | * *   | *1,063* | * * | *6* | *%* |
| *Total Revenues*               | * *   | *$*                    | *4,265*    | * *              | *$*        | *6,810*                        | * *   | *$*                 | *2,304*    | * * | *$* | *5,091* | * * | *$* | *18,470* | * * | *100* | *%* |
| * *                       | * *   | * *               | * *   | * *              | * *   | * *                       | * *   | * *            | * *   | * * | * * | * * | * * |
| *% of Total Revenues*          | * *   | *23*                   | *%*        | *37*                  | *%*        | *12*                           | *%*        | *28*                | *%*        | *100* | *%* | * * | * * |

 

For the threemonths ended June 30, 2003 (in thousands):

 
| ** **                     | ** ** | **Sales Within Spain** | ** ** | ** **            | ** ** | ** **                     | ** ** | ** **          | ** ** |
|--------------------------------|------------|------------------------|------------|-----------------------|------------|--------------------------------|------------|---------------------|------------|
| **Product  Line**              | ** ** | **Branded  Products**  | ** ** | **Generic  Products** | ** ** | **Contract  Manu-  facturing** | ** ** | **Other  Revenues** | ** ** | **Total** | ** ** | **% of Total  Revenues** | ** ** |
|                           |       |                   |       |                  |       |                           |       |                |       |   |   |   |   |
| *Omeprazole*                   | * *   | *$*                    | *1,694*    | * *              | *$*        | *3,431*                        | * *   | *$*                 | *—*   | * * | *$* | *—* | * * | *$* | *5,125* | * * | *31* | *%* |
| *Simvastatin*                  | * *   | *588*                  | * *   | *1,128*               | * *   | *—*                       | * *   | *—*            | * *   | *1,716* | * * | *10* | *%* |
| *Enalapril*                    | * *   | *743*                  | * *   | *460*                 | * *   | *—*                       | * *   | *—*            | * *   | *1,203* | * * | *7* | *%* |
| *Paroxetine*                   | * *   | *—*               | * *   | *207*                 | * *   | *—*                       | * *   | *—*            | * *   | *207* | * * | *1* | *%* |
| *Codeisan*                     | * *   | *524*                  | * *   | *—*              | * *   | *—*                       | * *   | *—*            | * *   | *524* | * * | *3* | *%* |
| *All other products*           | * *   | *1,236*                | * *   | *1,629*               | * *   | *—*                       | * *   | *—*            | * *   | *2,865* | * * | *17* | *%* |
| *Contract manufacturing*       | * *   | *—*               | * *   | *—*              | * *   | *2,607*                        | * *   | *—*            | * *   | *2,607* | * * | *16* | *%* |
| *Sales outside of Spain*       | * *   | *—*               | * *   | *—*              | * *   | *—*                       | * *   | *2,349*             | * *   | *2,349* | * * | *14* | *%* |
| *Licensing and collaborations* | * *   | *—*               | * *   | *—*              | * *   | *—*                       | * *   | *158*               | * *   | *158* | * * | *1* | *%* |
| *Total Revenues*               | * *   | *$*                    | *4,785*    | * *              | *$*        | *6,855*                        | * *   | *$*                 | *2,607*    | * * | *$* | *2,507* | * * | *$* | *16,754* | * * | *100* | *%* |
| * *                       | * *   | * *               | * *   | * *              | * *   | * *                       | * *   | * *            | * *   | * * | * * | * * | * * |
| *% of Total Revenues*          | * *   | *28*                   | *%*        | *41*                  | *%*        | *16*                           | *%*        | *15*                | *%*        | *100* | *%* | * * | * * |

 

*SpanishOperations.*   The core of our Spanish operations has been the efficient manufacturingand in-country marketing of branded and generic pharmaceutical products.  Historically, our pharmaceutical productswere sold only within Spain.  However,the execution of our long-term strategic plan over the past eight years hascreated an opportunity for our Spanish operations to expand beyond the bordersof Spain into other European countries and other countries outside of Europe.The increase in second quarter 2004 product sales over the 2003 second quarteris due primarily to the introduction of our paroxetine product line, which waslaunched in May of 2003. Our paroxetine product line generated net sales of$993,000, representing 5% of our total revenues during the three months endedJune 30, 2004, compared to 1% in the comparable period of the prior year.  However, revenues from our top two sellingproducts, omeprazole and simvastatin, comprised 28% of our total revenues inthe second quarter of 2004, compared to 41% in the same quarter of the prioryear, as a result of price reductions that we implemented on December 1, 2003.

 

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Prices forprescription pharmaceutical products in Spain must be approved by the Ministryof Health. For several years now, the Ministry of Health has encouraged thesubstitution of generic-equivalent products in order to help control rising healthcarecosts. In further efforts to reduce healthcare costs, the Ministry of Healthhad contemplated new laws and regulations that would significantly reduce themarket prices of certain pharmaceutical products in Spain, includinggeneric-equivalent drugs. In late October 2003, the Spanish government enacteda regulation that reduced the prices that the government reimburses for six ofour chemical entities, including the chemical entities omeprazole, simvastatinand enalapril, which accounted for approximately 65% to 70% of net productsales in the year ended December 31, 2003. These new prices were required totake effect on December 26, 2003. However, we, and some other pharmaceutical companies in Spain, strategicallyimplemented the new prices on December 1, 2003.

 

Although thelaw required laboratories to begin selling at the new prices in December 2003,pharmacies in Spain were able to continue to sell at the old higher pricesuntil January 31, 2004.  This transitionperiod was an attempt to reduce returns of the higher priced products byallowing the higher priced products to pass through the distribution channel tothe end users. On average, our customers maintain a stock of approximately oneto two months’ supply of our products. As we began selling at the new lower prices on December 1, 2003 weexpected the majority of our products that were labeled and stamped at the oldhigher prices to have cleared the distribution channel by January 31, 2004. Weexperienced an unforeseen level of returns totaling approximately $1,800,000 inFebruary and March 2004.  A majority ofthe products returned were either expired, nearing expiration or otherwise notresalable and consequently were destroyed. These product returns exceeded our allowance for estimated sales returnsat that time, which resulted in a reduction in total revenues of approximately$1,800,000 and a reduction in our gross profit of approximately $1,600,000 inthe first quarter of 2004. Consequently our gross margins on net product salesin that quarter were negatively impacted, resulting in a temporary decline ingross our margins to 51%, compared to 57% in the three months ended March 31,2003. Product returns in the second quarter of 2004 decreased; product returnsin April and May 2004 totaled $462,000, reducing revenues by this amount duringthe second quarter of 2004. Gross margins on pharmaceutical product salesexcluding sales of active pharmaceutical ingredients were 53% in the secondquarter of 2004. See additional discussion in the *Gross Profit*section.

 

Over the pastsix months we have implemented several initiatives which have effectivelyreduced our production costs on several of our products and increased our grossmargins.  These initiatives include thepurchase of new high speed manufacturing equipment; new product launches; andincreased sales volume and marketshare through strategic pricing. We expect tocontinue to increase our future sales volume through our pipeline ofapproximately 100 products. Additionally, we recently purchased a manufacturing facility, located in Spain, whichspecializes in the manufacture of several active pharmaceutical ingredients,and has diversified our revenue base. We will continue to focus on acquiring,developing and launching new products that will improve our product mix. Wewill also continue our efforts to increase our sales outside of Spain throughadditional registration, marketing, and supply agreements. We will alsocontinue to make significant investments in renovating and increasing capacityin our manufacturing facilities, as well as continued investments in new highspeed, high volume equipment. We anticipate that our gross margins willcontinue to gradually increase in the following quarters as we continue toimplement our strategy and benefit from economies of scale.

 

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*BrandedPharmaceutical Products*  

 
| ** **                   | ** ** | **For the Three Months Ended June 30,** | ** ** | **Change** | ** ** |
|------------------------------|------------|-----------------------------------------|------------|------------|------------|
| **(in  thousands)**          | ** ** | **2004**                                | ** ** | **%**      | ** ** | **2003** | ** ** | **%** | ** ** | **$** | ** ** | **%** | ** ** |
| *Branded Product Sales:*     |       |                                    |       |       |       |   |   |   |   |   |   |   |   |
| *Enalapril*                  |       | $                                       | 893        |       | *21*       | *%* | $ | 743 |   | *16* | *%* | $ | 150 |   | *20* | *%* |
| *Omeprazole*                 |       | 647                                     |       | *15*       | *%*        | 1,694 |   | *35* | *%* | (1,047 | ) | *-62* | *%* |
| *Codeisan*                   |       | 608                                     |       | *14*       | *%*        | 524 |   | *11* | *%* | 84 |   | *16* | *%* |
| *All other branded products* |       | 2,117                                   |       | *50*       | *%*        | 1,824 |   | *38* | *%* | 293 |   | *16* | *%* |
| *Total branded sales*        |       | $                                       | 4,265      |       | *100*      | *%* | $ | 4,785 |   | *100* | *%* | $ | (520 | ) | *-11* | *%* |

 

Sales of ourbranded pharmaceutical products in the three months ended June 30, 2004decreased by approximately 11% compared to the same period of the prior year,and they accounted for 23% of total revenues during the three months ended June30, 2004 compared to 28% of total revenues during the three months ended June30, 2003. An increase in the weighted average value of the Euro, in relation to the U.S. Dollar, had theeffect of increasing branded net product sales by approximately $248,000in the second quarter of 2004.  Pricereductions continued to erode the sales of our branded omeprazole andsimvastatin, which decreased by approximately $1,047,000 and $234,000,respectively, from the same quarter in the prior year. Our branded omeprazole,Belmazol, experienced the most severe of the price reductions, suffering onaverage a 61% price cut. Even in the face of these price cuts and stronggeneric competition, we were successful in maintaining market share and soldapproximately the same number of units of Belmazol in the second quarter of2004 as in the comparable period of the prior year. Sales of our brandedenalapril which experienced a 66% increase in unit volume compared to the sameperiod of the prior year, increased 20% from the prior year second quarter inspite of price cuts, and now accounts for 21% of our branded productsales.  Strong sales of our cough andcold medicine, Codeisan, and the launch of our branded version of paroxetine inMay of 2003 also helped to mitigate the impact of price cuts. While we expectto continue to develop, acquire, and launch new branded products, our focus ongenerics and sales outside of Spain are expected to increase those revenues ata significantly higher pace than that of our branded products.

 

*GenericPharmaceutical Products*   

 
| ** **                   | ** ** | **For the Three Months Ended June 30,** | ** ** | **Change** | ** ** |
|------------------------------|------------|-----------------------------------------|------------|------------|------------|
| **(in  thousands)**          | ** ** | **2004**                                | ** ** | **%**      | ** ** | **2003** | ** ** | **%** | ** ** | **$** | ** ** | **%** | ** ** |
| *Generic Product Sales:*     |       |                                    |       |       |       |   |   |   |   |   |   |   |   |
| *Omeprazole*                 |       | $                                       | 3,204      |       | *47*       | *%* | $ | 3,431 |   | *50* | *%* | $ | (227 | ) | *-7* | *%* |
| *Simvastatin*                |       | 868                                     |       | *13*       | *%*        | 1,128 |   | *16* | *%* | (260 | ) | *-23* | *%* |
| *Paroxetine*                 |       | 765                                     |       | *11*       | *%*        | 207 |   | *3* | *%* | 558 |   | *270* | *%* |
| *Pentoxifylline*             |       | 587                                     |       | *9*        | *%*        | 527 |   | *8* | *%* | 60 |   | *11* | *%* |
| *All other generic products* |       | 1,386                                   |       | *20*       | *%*        | 1,562 |   | *23* | *%* | (176 | ) | *-11* | *%* |
| *Total generic sales*        |       | $                                       | 6,810      |       | *100*      | *%* | $ | 6,855 |   | *100* | *%* | $ | (45 | ) | *-1* | *%* |

 

Sales of ourgeneric pharmaceutical products remained relatively consistent during the threemonths ended June 30, 2004 when expressed in U.S. dollars, compared to thethree months ended June 30, 2003.  Anincrease in the weighted average value of the Euro, in relation to the U.S. Dollar, had the effect of increasinggeneric product sales by approximately $396,000 in the second quarter of 2004.Sales of our generic omeprazole in the second quarter of 2004, while higher interms of units sold,

 

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decreased by 7% in U.S. dollarswhen compared to the prior year and account for 47% of our genericpharmaceutical revenues in the second quarter of 2004, compared to 50% ofgeneric revenues in the second quarter of 2003, as a result of pricereductions.  Similarly, sales of ourgeneric simvastatin, while higher in terms of units sold, decreased byapproximately 23% when expressed in U.S. Dollars.  Sales of our generic paroxetine, which waslaunched in May of 2003, added approximately $558,000 to our generic sales, andcontinued to be a major contributor again in the second quarter of 2004accounting for 11% of generic product sales, compared to 3% in the secondquarter of the prior year.  Sales of ourgeneric pentoxifylline in the second quarter of 2004 increased by approximately$60,000, or approximately 11% from the same quarter in the prior year. Weexpect to continue to increase our generic drug portfolio and increase ourgeneric drug sales in Spain as products come off patent in the future.

 

*ContractManufacturing*

 
| ** **               | ** ** | **For the Three Months Ended June 30,** | ** ** | **Change** | ** ** |
|--------------------------|------------|-----------------------------------------|------------|------------|------------|
| **(in  thousands)**      | ** ** | **2004**                                | ** ** | **2003**   | ** ** | **$** | ** ** | **%** | ** ** |
|                     |       |                                    |       |       |       |   |   |   |   |
| *Contract manufacturing* | * *   | *$*                                     | *2,304*    | * *   | *$*        | *2,607* | * * | *$* | *(303* | *)* | *-12* | *%* |
|                          |            |                                         |            |            |            |  |  |  |  |  |  |  |

 

In addition tomanufacturing our own products, our Spanish manufacturing facility suppliesbranded and generic products to approximately 20 entities in Spain, whichmarket these products under their own names and with their own labeling.  Revenues generated from contractmanufacturing represented 12% of total revenues in the three months ended June30, 2004, compared to 16% of total revenues in the three months ended June 30,2003. An increase in the weighted average value of the Euro, in relation to the U.S. Dollar, had theeffect of increasing contract manufacturing sales by approximately$134,000 in the second quarter of 2004.

 

*SalesOutside of Spain*  

 
| ** **               | ** ** | **For the Three Months Ended June 30,** | ** ** | **Change** | ** ** |
|--------------------------|------------|-----------------------------------------|------------|------------|------------|
| **(in  thousands)**      | ** ** | **2004**                                | ** ** | **2003**   | ** ** | **$** | ** ** | **%** | ** ** |
|                     |       |                                    |       |       |       |   |   |   |   |
| *Sales outside of Spain* | * *   | *$*                                     | *3,764*    | * *   | *$*        | *2,349* | * * | *$* | *1,415* | * * | *60* | *%* |
|                          |            |                                         |            |            |            |  |  |  |  |  |  |  |

 

We haveentered into license and supply agreements with more than 25 entities to sellour products outside of Spain.  Salesunder these supply agreements increased 60% from 14% of total revenues in thethree months ended June 30, 2003 to 20% of total revenues in the three monthsended June 30, 2004.  The $1,415,000increase is attributable to increased demand for products that we are able tomanufacture at relatively low costs and sell to customers in other countriesaround the world as they search to find low cost manufacturing alternatives toremain competitive in their respective markets. We believe that our highly efficient manufacturing processes could leadto increased sales outside of Spain as other countries around the world seek toreduce health care costs and other pharmaceutical companies outside of Spainsearch for cost savings alternatives. An increase in the weighted average valueof the Euro, in relation to the U.S.Dollar, had the effect of increasing sales outside of Spain byapproximately $219,000 during the three months ended June 30, 2004 compared tothe second quarter of 2003.

 

*Licensing and Collaboration Revenues.*  Licensing and collaboration revenuesaccounted for 6% of total revenues in the three months ended June 30,2004.  These revenues include royaltiestotaling $644,000 (compared to $158,000 in the second quarter of the prioryear) from the commercialization and continuing sales of Testim, the firstproduct incorporating our drug delivery technology, which was launched by ourlicensee, Auxilium, in February 2003. Testim is currently reported to captureapproximately 10-11% of all new testosterone gel replacement prescriptions in

 

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the market. We have alsorecognized revenues totaling $419,000 during the three months ended June 30,2004, related to product licensing activities in Europe.

 

*GrossProfit.*    Grossprofit increased by approximately $139,000, or 1%, in the three months endedJune 30, 2004 when compared to the three months ended June 30, 2003, while ourgross margins on net product sales have decreased from 59% in the three monthsended June 30, 2003 to 52% in the three months ended June 30, 2004 (53% grossmargins on sales of pharmaceutical products, excluding sales of activepharmaceutical ingredients). As discussed previously, our gross margins on netproduct sales have been negatively impacted by the December 2003 pricereductions in Spain.  Product returns inApril and May 2004 totaled $462,000, reducing revenues by this amount duringthe second quarter of 2004. We performed a detailed analysis in the secondquarter of the current year in order to identify all potential returns relatedto the December 2003 price reductions. We are confident that we have captured the majority of such returns, asevidenced by a decrease in product returns in June and July 2004 to levelsconsistent with our historical experience and budgeted amounts.

 

Over the pastsix months we have implemented several initiatives to reduce our productioncosts on several of our products and increase our gross margins.  These initiatives include the purchase of newhigh speed manufacturing equipment; new product launches; and increased salesvolume and marketshare through strategic pricing. While it is possible that ourgross margins could decrease as sales of higher priced products are continuallyreplaced with sales of lower priced generic products, as a result of a changein our product mix, or by additional governmental action, we expect the effectof our many initiatives will mitigate these exposures. We anticipate that ourgross margins will continue to gradually increase in the following quarters aswe continue to implement our strategy and benefit from economies of scale.

 

*Selling andMarketing Expenses*  

 
| ** **              | ** ** | **For the Three Months Ended June 30,** | ** ** | **Change** | ** ** |
|-------------------------|------------|-----------------------------------------|------------|------------|------------|
| **(in  thousands)**     | ** ** | **2004**                                | ** ** | **2003**   | ** ** | **$** | ** ** | **%** | ** ** |
| *Selling and marketing* | * *   | *$*                                     | *3,851*    | * *   | *$*        | *3,626* | * * | *$* | *225* | * * | *6* | *%* |
|                         |            |                                         |            |            |            |  |  |  |  |  |  |  |

 

Selling andmarketing expenses for the three months ended June 30, 2004 increased 6% fromthe same period in the prior year. Theweighted average value of the Euro, in relation to the U.S. Dollar, had theeffect of increasing selling and marketing expenses by approximately $216,000in the three months ended June 30, 2004, accounting for approximately 96% ofthe increase.  Selling and marketingexpenses as a percentage of net product sales remained constant at 22% in thethree months ended June 30, 2004, compared to the three months ended June 30,2003.

 

*General andAdministrative Expenses*    

 
| ** **                   | ** ** | **For the Three Months Ended June 30,** | ** ** | **Change** | ** ** |
|------------------------------|------------|-----------------------------------------|------------|------------|------------|
| **(in  thousands)**          | ** ** | **2004**                                | ** ** | **2003**   | ** ** | **$** | ** ** | **%** | ** ** |
| *General and administrative* | * *   | *$*                                     | *2,287*    | * *   | *$*        | *1,786* | * * | *$* | *501* | * * | *28* | *%* |
|                              |            |                                         |            |            |            |  |  |  |  |  |  |  |

 

General andadministrative expenses for the three months ended June 30, 2004 increased 28%from the same period in the prior year. The $501,000 increase was the result of increased general and administrativeactivities required to support our continued growth and prepare for ouranticipated future growth. These expenditures include increased costs in thecurrent year for

 

22

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additional employees, outsideservices, insurance and other costs to support the growth of our organization.General and administrative expenses as a percent of total revenues increased toapproximately 12% in the three months ended June 30, 2004, compared toapproximately 11% of total revenues in the three months ended June 30,2003.  General and administrativeexpenses would have been approximately $77,000 lower, absent the increase inthe weighted average value of the Euro, in relation to the U.S. Dollar, in thethree months ended June 30, 2004. This foreign currency impact accounted foralmost 15% of the increase in general and administrative expenses when comparedto the prior year’s second quarter. We expect that our future expenditures forgeneral and administrative expenses will continue to increase as we grow.  Although we cannot reasonably estimate thetotal costs associated with implementation of the internal control provisionsof the Sarbanes-Oxley Act of 2002, we have incurred over $100,000 of externalcosts to date.

 

*Researchand Development Expenses*

 
| ** **                 | ** ** | **For the Three Months Ended June 30,** | ** ** | **Change** | ** ** |
|----------------------------|------------|-----------------------------------------|------------|------------|------------|
| **(in  thousands)**        | ** ** | **2004**                                | ** ** | **2003**   | ** ** | **$** | ** ** | **%** | ** ** |
| *Research and development* | * *   | *$*                                     | *946*      | * *   | *$*        | *879* | * * | *$* | *67* | * * | *8* | *%* |
|                            |            |                                         |            |            |            |  |  |  |  |  |  |  |

 

Researchand development expenses for the three months ended June 30, 2004 increased 8% from the sameperiod in the prior year. In the first quarter of 2004, we completed andreported the results of a Phase I intranasal insulin trial. We recently commenced Phase II studies ofour clinical program for the intranasal delivery of insulin. In addition, we have initiated certainclinical programs to support the eventual distribution of certain of ourSpanish generic pharmaceutical products in other countries, including the U.S.,and are in the planning stages of certain other clinical programs. We expect tocontinue to incur costs to conduct clinical trials and support the requiredregulatory submissions for our clinical programs. We also incur costs relatedto pre-clinical programs for product formulation and testing efforts beingperformed in the laboratory in our U.S. headquarters and at our facilities inSpain. We are using our U.S., laboratory to develop potential productapplications using our drug delivery technologies. The expenditures in researchand development reflect our focus on projects that are necessary for expansionof our portfolio of marketed products and clinical trials involving our drugdelivery technologies. Someof our cost estimates for our research and development programs arepreliminary, and the specific timing is not known; however, based upon our mostrecent information, we estimate that our research and development expenses forthe year ended December 31, 2004 could be approximately $500,000 to $1,000,000higher than in the year ending December 31, 2003.

 

*OtherIncome (Expenses)*

 
| ** **                | ** ** | **For the Three Months Ended June 30,** | ** ** | **Change** | ** ** |
|---------------------------|------------|-----------------------------------------|------------|------------|------------|
| **(in  thousands)**       | ** ** | **2004**                                | ** ** | **2003**   | ** ** | **$** | ** ** | **%** | ** ** |
| *Other income (expenses)* | * *   | *$*                                     | *1,348*    | * *   | *$*        | *18* | * * | *$* | *1,330* | * * | * * | *** |
|                           |            |                                         |            |            |            |  |  |  |  |  |  |  |

 

----

*      *Notmeaningful*

 

Other income(expenses) for the three months ended June 30, 2004 increased by $1,330,000from the same period in the prior year. The increase is primarily due to thereversal of previously accrued tax assessments totaling $1,467,000, partiallyoffset by interest and penalties totaling $193,000 associated with thesettlement of the tax audit of our Spanish subsidiary (see *Provisionfor Income Taxes*). We recorded a pre-tax benefit totaling $1,467,000($954,000 after

 

23

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taxes) as a component of otherincome and expenses as the result of the reversal of previously accruedpharmaceutical tax assessments in Spain. These assessments had been accrued tobe paid to the Spanish government as a vehicle to help reduce the impact of therising health care costs in Spain. Due to recent changes in the pharmaceuticalindustry in Spain and a change in the Spanish political environment, theseliabilities no longer exist. Accordingly, these accruals were reversed duringthe quarter ended June 30, 2004.

 

*Provisionfor Income Taxes*  

 

 
| ** **                                   | ** ** | **For the Three Months Ended June 30, 2004** | ** ** |
|----------------------------------------------|------------|----------------------------------------------|------------|
| **(in  thousands)**                          | ** ** | **Spain**                                    | ** ** | **U.S.** | ** ** | **Consolidated** | ** ** |
|                                         |       |                                         |       |   |   |   |   |
| *Income (loss) before income taxes*          | * *   | *$*                                          | *4,658*    | * * | *$* | *(727* | *)* | *$* | *3,931* | * * |
| * *                                     | * *   | * *                                     | * *   | * * | * * | * * | * * |
| *Provision (benefit) for income taxes*       | * *   | *1,837*                                      | * *   | *(247* | *)* | *1,590* | * * |
| *Tax liability, 1998 - 2000 audit*           | * *   | *604*                                        | * *   | *—* | * * | *604* | * * |
| * *                                     | * *   | * *                                     | * *   | * * | * * | * * | * * |
| *Total provision (benefit) for income taxes* | * *   | *2,441*                                      | * *   | *(247* | *)* | *2,194* | * * |
| *Valuation allowance*                        | * *   | *—*                                     | * *   | *247* | * * | *247* | * * |
| * *                                     | * *   | * *                                     | * *   | * * | * * | * * | * * |
| *Net provision for income taxes*             | * *   | *2,441*                                      | * *   | *—* | * * | *2,441* | * * |
| * *                                     | * *   | * *                                     | * *   | * * | * * | * * | * * |
| *Net income (loss)*                          | * *   | *$*                                          | *2,217*    | * * | *$* | *(727* | *)* | *$* | *1,490* | * * |
| * *                                     | * *   | * *                                     | * *   | * * | * * | * * | * * |
| *Effective tax rate*                         | * *   | *52*                                         | *%*        | *0* | *%* | *62* | *%* |

 

A tax review of our Spanish subsidiary, Laboratorios Belmac S.A., bythe Spanish tax authorities for the tax years 1998, 1999 and 2000, which hadcommenced over a year ago, was completed in the quarter ended June 30,2004.  As a result of this audit, oursubsidiary has been assessed an additional tax liability of approximately$604,000, which has been recorded as a component of *provisionfor income taxes*, and approximately $193,000 for related interestand penalties, which have been recorded as components of *other incomeand expenses*, in the consolidated income statement for the threemonths ended June 30, 2004.

 

As a result ofreporting taxable income in Spain, we recorded provisions for foreign incometaxes totaling $2,441,000 ($1,837,000 income tax expense on operations plus$604,000 recorded as a result of the tax audit of our Spanish subsidiary) and$1,805,000 for the three months ended June 30, 2004 and 2003, respectively. Theeffective tax rate in Spain for the three months ended June 30, 2004 is 52%;however, when the $604,000 tax audit settlement related to prior years isexcluded, the effective tax rate is 39% compared to 42% in the prior yearsecond quarter. The provision for foreign income taxes would have beenapproximately $137,000 lower than reported, absent the increase in the weightedaverage value of the Euro, in relation to the U.S. Dollar, during the threemonths ended June 30, 2004.

 

We generatedadditional U.S. federal net operating loss carry-forwards in the three monthsended June 30, 2004 and 2003 as a result of U.S. pre-tax losses of ($727,000)and ($976,000), respectively. As future domestic operating profits cannot bereasonably assured, no tax benefit has been recorded for U.S. losses. Accordingly,we have established a valuation allowance equal to the full amount of the U.S.deferred tax assets.

 

Should we determine that it is more likely than not that we willrealize certain of our net deferred tax assets for which we have previouslyprovided a valuation allowance, an adjustment would be required to reduce theexisting valuation allowance. In addition, we operate within multiple taxingjurisdictions and are subject to audit in those jurisdictions. These audits can

 

24

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involvecomplex issues, which may require an extended period of time for resolution.During the quarter ended June 30, 2004, we identified certain tax contingenciesthat we have determined are probable and reasonably estimable. Consequently, wehave included a charge totaling $188,000 related to these contingencies in the *provision for income taxes* for the quarter ended June 30,2004. No otherpotential tax contingencies were considered probable and/or reasonablyestimable by Bentley at period end. However, there is the possibilitythat the ultimate resolution of such potential contingencies could have anadverse effect on our results of operations.

 

*Net Income*

 
| ** **                                    | ** ** | **For the Three Months Ended June 30,** | ** ** | **Change** | ** ** |
|-----------------------------------------------|------------|-----------------------------------------|------------|------------|------------|
| **(in  thousands, except per share data)**    | ** ** | **2004**                                | ** ** | **2003**   | ** ** | **$** | ** ** | **%** | ** ** |
|                                          |       |                                    |       |       |       |   |   |   |   |
| *Net income*                                  | * *   | *$*                                     | *1,490*    | * *   | *$*        | *1,529* | * * | *$* | *(39* | *)* | *-3* | % |
| * *                                      | * *   | * *                                | * *   | * *   | * *   | * * | * * | * * |   |
| *Net income per common share:*                | * *   | * *                                | * *   | * *   | * *   | * * | * * | * * |   |
| *Basic*                                       | * *   | *$*                                     | *0.07*     | * *   | *$*        | *0.09* | * * | *$* | *(0.02* | *)* | *-22* | % |
| *Diluted*                                     | * *   | *$*                                     | *0.07*     | * *   | *$*        | *0.07* | * * | *$* | *—* | * * | *0* | % |
| * *                                      | * *   | * *                                | * *   | * *   | * *   | * * | * * | * * |   |
| *Weighted average common shares outstanding:* | * *   | * *                                | * *   | * *   | * *   | * * | * * | * * |   |
| *Basic*                                       | * *   | *20,644*                                | * *   | *17,534*   | * *   | *3,110* | * * | *18* | % |
| *Diluted*                                     | * *   | *22,800*                                | * *   | *20,878*   | * *   | *1,922* | * * | *9* | % |

 

We reported income from operations of $2,583,000 in the three monthsended June 30, 2004 compared to $3,316,000 in the three months ended June 30,2003. The combination of income from operations of $2,583,000 and thenon-operating items, primarily the provision for income taxes of $2,441,000 and the reversalof previously accrued tax assessments totaling $1,467,000 resulted in netincome of $1,490,000, or $0.07 per basic common share ($0.07 per diluted commonshare) on 20,644,000 weighted average basic common shares outstanding(22,800,000 weighted average diluted common shares outstanding) in the threemonths ended June 30, 2004, compared to net income of $1,529,000, or $0.09 perbasic common share ($0.07 per diluted common share) on 17,534,000 weightedaverage basic common shares outstanding (20,878,000 weighted average dilutedcommon shares outstanding) in the same period of the prior year. Net income inthe future could be negatively impacted as a result of the lower selling pricesin Spain and anticipated increases in research and development programs thatare expected to benefit future periods. However, as previously discussed, ourbroad-based growth strategy should mitigate the impact of these developmentsover time.

 

25

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**Six Months Ended June 30, 2004 versus Six MonthsEnded June 30, 2003**

 

*Revenues*

 
| ** **                             | ** ** | **For the Six Months Ended June 30,** | ** ** | **Change** | ** ** |
|----------------------------------------|------------|---------------------------------------|------------|------------|------------|
| **(in  thousands)**                    | ** ** | **2004**                              | ** ** | **%**      | ** ** | **2003** | ** ** | **%** | ** ** | **$** | ** ** | **%** | ** ** |
| *Revenues:*                            | * *   | * *                              | * *   | * *   | * *   | * * | * * | * * | * * | * * | * * | * * | * * |
| *Net product sales*                    | * *   | *$*                                   | *34,013*   | * *   | *95*       | *%* | *$* | *30,831* | * * | *97* | *%* | *$* | *3,182* | * * | *10* | *%* |
| *Licensing and collaboration revenues* | * *   | *1,759*                               | * *   | *5*        | *%*        | *911* | * * | *3* | *%* | *848* | * * | *93* | *%* |
| *Total revenues*                       | * *   | *$*                                   | *35,772*   | * *   | *100*      | *%* | *$* | *31,742* | * * | *100* | *%* | *$* | *4,030* | * * | *13* | *%* |

 

Total revenues for thesix months ended June 30, 2004 increased 13% from the same six month period inthe prior year. However, our total revenues increased approximately 2% whenexpressed in constant currency. An increase in the weighted average value ofthe Euro, in relation to the U.S.Dollar, had the effect of increasing revenues by approximately$3,526,000, partially offsetting the impact of price reductions in Spain. Pricereductions were mandated for certain pharmaceutical products by the Spanishgovernment which we put into effect on December 1, 2003. The advancement of ourproprietary drug delivery programs in the U.S., as evidenced by the growingroyalty stream from sales of Testim, and other licensing revenues haveincreased our year to date 2004 revenues by approximately $848,000 whencompared to the same period in the prior year.

 

Setforth below is a summary of our revenues by sales channel and top-sellingproduct lines as generated through our five primary sales channels:

 

For the sixmonths ended June 30, 2004 (in thousands):

 
| ** **                     | ** ** | **Sales Within Spain** | ** ** | ** **            | ** ** | ** **                     | ** ** | ** **          | ** ** |
|--------------------------------|------------|------------------------|------------|-----------------------|------------|--------------------------------|------------|---------------------|------------|
| **Product  Line**              | ** ** | **Branded  Products**  | ** ** | **Generic  Products** | ** ** | **Contract  Manu-  facturing** | ** ** | **Other  Revenues** | ** ** | **Total** | ** ** | **% of Total  Revenues** | ** ** |
|                           |       |                   |       |                  |       |                           |       |                |       |   |   |   |   |
| *Omeprazole*                   | * *   | *$*                    | *1,180*    | * *              | *$*        | *6,492*                        | * *   | *$*                 | *—*   | * * | *$* | *—* | * * | *$* | *7,672* | * * | *21* | *%* |
| *Simvastatin*                  | * *   | *593*                  | * *   | *1,641*               | * *   | *—*                       | * *   | *—*            | * *   | *2,234* | * * | *6* | *%* |
| *Enalapril*                    | * *   | *1,555*                | * *   | *535*                 | * *   | *—*                       | * *   | *—*            | * *   | *2,090* | * * | *6* | *%* |
| *Paroxetine*                   | * *   | *478*                  | * *   | *1,584*               | * *   | *—*                       | * *   | *—*            | * *   | *2,062* | * * | *6* | *%* |
| *Codeisan*                     | * *   | *1,511*                | * *   | *—*              | * *   | *—*                       | * *   | *—*            | * *   | *1,511* | * * | *4* | *%* |
| *All other products*           | * *   | *3,244*                | * *   | *3,336*               | * *   | *—*                       | * *   | *265*               | * *   | *6,845* | * * | *19* | *%* |
| *Contract manufacturing*       | * *   | *—*               | * *   | *—*              | * *   | *4,837*                        | * *   | *—*            | * *   | *4,837* | * * | *14* | *%* |
| *Sales outside of Spain*       | * *   | *—*               | * *   | *—*              | * *   | *—*                       | * *   | *6,762*             | * *   | *6,762* | * * | *19* | *%* |
| *Licensing and collaborations* | * *   | *—*               | * *   | *—*              | * *   | *—*                       | * *   | *1,759*             | * *   | *1,759* | * * | *5* | *%* |
| *Total Revenues*               | * *   | *$*                    | *8,561*    | * *              | *$*        | *13,588*                       | * *   | *$*                 | *4,837*    | * * | *$* | *8,786* | * * | *$* | *35,772* | * * | *100* | *%* |
| * *                       | * *   | * *               | * *   | * *              | * *   | * *                       | * *   | * *            | * *   | * * | * * | * * | * * |
| *% of Total Revenues*          | * *   | *24*                   | *%*        | *38*                  | *%*        | *13*                           | *%*        | *25*                | *%*        | *100* | *%* | * * | * * |

 

26

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For the sixmonths ended June 30, 2003 (in thousands):

 
| ** **                     | ** ** | **Sales Within Spain** | ** ** | ** **            | ** ** | ** **                     | ** ** | ** **          | ** ** |
|--------------------------------|------------|------------------------|------------|-----------------------|------------|--------------------------------|------------|---------------------|------------|
| **Product  Line**              | ** ** | **Branded  Products**  | ** ** | **Generic  Products** | ** ** | **Contract  Manu-  facturing** | ** ** | **Other  Revenues** | ** ** | **Total** | ** ** | **% of Total  Revenues** | ** ** |
|                           |       |                   |       |                  |       |                           |       |                |       |   |   |   |   |
| *Omeprazole*                   | * *   | *$*                    | *3,193*    | * *              | *$*        | *6,582*                        | * *   | *$*                 | *—*   | * * | *$* | *—* | * * | *$* | *9,775* | * * | *31* | *%* |
| *Simvastatin*                  | * *   | *961*                  | * *   | *1,924*               | * *   | *—*                       | * *   | *—*            | * *   | *2,885* | * * | *9* | *%* |
| *Enalapril*                    | * *   | *1,248*                | * *   | *916*                 | * *   | *—*                       | * *   | *—*            | * *   | *2,164* | * * | *7* | *%* |
| *Paroxetine*                   | * *   | *—*               | * *   | *207*                 | * *   | *—*                       | * *   | *—*            | * *   | *207* | * * | *1* | *%* |
| *Codeisan*                     | * *   | *1,230*                | * *   | *—*              | * *   | *—*                       | * *   | *—*            | * *   | *1,230* | * * | *4* | *%* |
| *All other products*           | * *   | *2,459*                | * *   | *3,127*               | * *   | *—*                       | * *   | *—*            | * *   | *5,586* | * * | *17* | *%* |
| *Contract manufacturing*       | * *   | *—*               | * *   | *—*              | * *   | *5,094*                        | * *   | *—*            | * *   | *5,094* | * * | *16* | *%* |
| *Sales outside of Spain*       | * *   | *—*               | * *   | *—*              | * *   | *—*                       | * *   | *3,890*             | * *   | *3,890* | * * | *12* | *%* |
| *Licensing and collaborations* | * *   | *—*               | * *   | *—*              | * *   | *—*                       | * *   | *911*               | * *   | *911* | * * | *3* | *%* |
| *Total Revenues*               | * *   | *$*                    | *9,091*    | * *              | *$*        | *12,756*                       | * *   | *$*                 | *5,094*    | * * | *$* | *4,801* | * * | *$* | *31,742* | * * | *100* | *%* |
| * *                       | * *   | * *               | * *   | * *              | * *   | * *                       | * *   | * *            | * *   | * * | * * | * * | * * |
| *% of Total Revenues*          | * *   | *29*                   | *%*        | *40*                  | *%*        | *16*                           | *%*        | *15*                | *%*        | *100* | *%* | * * | * * |

 

*SpanishOperations.*   The increase in product sales for the first half of 2004 over the firsthalf of 2003 was primarily due to the introduction of our paroxetine productline, which was launched in May of 2003. Our paroxetine product line generatednet sales of $2,062,000, representing 6% of our total revenues during the sixmonths ended June 30, 2004 and 46% of our growth.  In spite of reduced selling prices, revenuesfrom our omeprazole products in the first half of 2004 comprised 21% of ouryear to date 2004 revenues, compared to 31% in the same period of the prioryear.

 

Productreturns totalted $1,800,000 in the first quarter of 2004. Product returns inthe second quarter of 2004 decreased; returns in April and May 2004 totaled$462,000 and served to reduce revenues by the same amount during the secondquarter. These returns resulted in gross margins of 51% in the six months endedJune 30, 2004. See additional discussion in the *Gross Profit*section.

 

*BrandedPharmaceutical Products*

 
| ** **                   | ** ** | **For the Six Months Ended June 30,** | ** ** | **Change** | ** ** |
|------------------------------|------------|---------------------------------------|------------|------------|------------|
| **(in  thousands)**          | ** ** | **2004**                              | ** ** | **%**      | ** ** | **2003** | ** ** | **%** | ** ** | **$** | ** ** | **%** | ** ** |
| *Branded Product Sales:*     | * *   | * *                              | * *   | * *   | * *   | * * | * * | * * | * * | * * | * * | * * | * * |
| *Enalapril*                  |       | $                                     | 1,555      |       | *18*       | *%* | $ | 1,248 |   | *14* | *%* | $ | 307 |   | *25* | *%* |
| *Codeisan*                   |       | 1,511                                 |       | *18*       | *%*        | 1,230 |   | *13* | *%* | 281 |   | *23* | *%* |
| *Omeprazole*                 |       | 1,180                                 |       | *14*       | *%*        | 3,193 |   | *35* | *%* | (2,013 | ) | *-63* | *%* |
| *All other branded products* |       | 4,315                                 |       | *50*       | *%*        | 3,420 |   | *38* | *%* | 895 |   | *26* | *%* |
| *Total branded sales*        |       | $                                     | 8,561      |       | *100*      | *%* | $ | 9,091 |   | *100* | *%* | $ | (530 | ) | *-6* | *%* |

 

Sales of ourbranded pharmaceutical products decreased by approximately 6% in U.S. Dollarscompared to the prior year, and they accounted for 24% of total revenues duringthe six months ended June 30, 2004 compared to 29% of total revenues during thesix months ended June 30, 2003.  Anincrease in the weighted average value of the Euro, in relation to the U.S. Dollar, had the effect of increasingbranded net product sales by approximately $862,000 in the first half of 2004.Price reductions continued to negatively impact our branded product sales. Mostsignificantly, sales of our branded omeprazole and simvastatin productsdecreased by

 

27

----

 

approximately $2,013,000 and$368,000, respectively, from the same period in the prior year, as a result ofprice reductions effected in December 2003. Our branded omeprazole, Belmazol,for example, experienced the most severe of the price reductions, suffering onaverage a 61% price cut. Even in the face of these price cuts and stronggeneric competition, we were successful in maintaining market share and soldapproximately the same number of units of Belmazol in the first half of 2004 asin the comparable period of the prior year. Sales of our branded enalapril,which experienced a 62% increase in unit volume compared to the same period ofthe prior year, increased 25% from the prior year in spite of price cuts, andnow accounts for 18% of our year to date branded product sales. Strong sales ofour cough and cold medicine, Codeisan, and the launch of our branded version ofparoxetine in May of 2003 also helped to mitigate the impact of price cuts. Whilewe expect to continue to develop, acquire, and launch new branded products, ourfocus on generics and sales outside of Spain are expected to increase thoserevenues at a significantly higher pace than that of our branded products.

 

*GenericPharmaceutical Products*

 
| ** **                   | ** ** | **For the Six Months Ended June 30,** | ** ** | **Change** | ** ** |
|------------------------------|------------|---------------------------------------|------------|------------|------------|
| **(in  thousands)**          | ** ** | **2004**                              | ** ** | **%**      | ** ** | **2003** | ** ** | **%** | ** ** | **$** | ** ** | **%** | ** ** |
| *Generic Product Sales:*     | * *   | * *                              | * *   | * *   | * *   | * * | * * | * * | * * | * * | * * | * * | * * |
| *Omeprazole*                 |       | $                                     | 6,492      |       | *48*       | *%* | $ | 6,582 |   | *51* | *%* | $ | (90 | ) | *-1* | *%* |
| *Simvastatin*                |       | 1,641                                 |       | *12*       | *%*        | 1,924 |   | *15* | *%* | (283 | ) | *-15* | *%* |
| *Paroxetine*                 |       | 1,584                                 |       | *12*       | *%*        | 207 |   | *2* | *%* | 1,377 |   | *665* | *%* |
| *Pentoxifylline*             |       | 1,278                                 |       | *9*        | *%*        | 973 |   | *8* | *%* | 305 |   | *31* | *%* |
| *Trimetazidine*              |       | 927                                   |       | *7*        | *%*        | 226 |   | *2* | *%* | 701 |   | *310* | *%* |
| *All other generic products* |       | 1,666                                 |       | *12*       | *%*        | 2,844 |   | *22* | *%* | (1,178 | ) | *-41* | *%* |
| *Total generic sales*        |       | $                                     | 13,588     |       | *100*      | *%* | $ | 12,756 |   | *100* | *%* | $ | 832 |   | *7* | *%* |

 

Sales of ourgeneric pharmaceutical products increased by 7% during the six months endedJune 30, 2004 compared to the six months ended June 30, 2003.  An increase in the weighted average value ofthe Euro, in relation to the U.S.Dollar, had the effect of increasing generic product sales byapproximately $1,368,000 in the first half of 2004.  Consistent sales volume of our genericomeprazole, accounted for 48% of our generic pharmaceutical revenues in the sixmonths ended June 30, 2004, compared to 51% of generic revenues in thecomparable period of the prior year, in spite of price reductions.  However, sales of our generic simvastatinwhich experienced a 22% increase in unit volume, decreased by approximately15%, when expressed in U.S. Dollars as a result of price reductions.  Our generic paroxetine, which was launched inMay of 2003, added approximately $1,377,000 to our generic sales over the prioryear, positioning it third behind our generic omeprazole and simvastatin productsin the six months ended June 30, 2004. Sales of our generic pentoxifyllineincreased by approximately $305,000, or approximately 31% from the comparableperiod of the prior year, while sales of our generic trimetazidine increasedapproximately $701,000.  Trimetazidinehas quickly become a major contributor to our generic pharmaceutical sales inthe first half of 2004. We expect to continue to increase our generic drugportfolio and increase our generic drug sales in Spain as products come offpatent in the future.

 

*ContractManufacturing*

 
| ** **               | ** ** | **For the Six Months Ended June 30,** | ** ** | **Change** | ** ** |
|--------------------------|------------|---------------------------------------|------------|------------|------------|
| **(in  thousands)**      | ** ** | **2004**                              | ** ** | **2003**   | ** ** | **$** | ** ** | **%** | ** ** |
|                     |       |                                  |       |       |       |   |   |   |   |
| *Contract manufacturing* | * *   | *$*                                   | *4,837*    | * *   | *$*        | *5,094* | * * | *$* | *(257* | *)* | *-5* | *%* |
|                          |            |                                       |            |            |            |  |  |  |  |  |  |  |

 

28

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Revenues generatedfrom contract manufacturing represented 14% of total revenues in the six monthsended June 30, 2004, compared to 16% of total revenues in the six months endedJune 30, 2003. An increase in the weighted average value of the Euro, in relation to the U.S. Dollar, had theeffect of increasing contract manufacturing sales by approximately$487,000 in the first half of 2004.

 

*SalesOutside of Spain*

 
| ** **               | ** ** | **For the Six Months Ended June 30,** | ** ** | **Change** | ** ** |
|--------------------------|------------|---------------------------------------|------------|------------|------------|
| **(in  thousands)**      | ** ** | **2004**                              | ** ** | **2003**   | ** ** | **$** | ** ** | **%** | ** ** |
|                     |       |                                  |       |       |       |   |   |   |   |
| *Sales outside of Spain* | * *   | *$*                                   | *6,762*    | * *   | *$*        | *3,890* | * * | *$* | *2,872* | * * | *74* | *%* |
|                          |            |                                       |            |            |            |  |  |  |  |  |  |  |

 

Sales underour supply agreements increased 74% from 12% of total revenues in the sixmonths ended June 30, 2003 to 19% of total revenues in the six months endedJune 30, 2004.  The $2,872,000 increaseis attributable to increased demand for products that we are able tomanufacture at relatively low costs and sell to customers in other countriesaround the world as they search to find low cost manufacturing alternatives toremain competitive in their respective markets. An increase in the weightedaverage value of the Euro, in relationto the U.S. Dollar, had the effect of increasing sales outside of Spainby approximately $681,000 during the six months ended June 30, 2004.

 

*Licensing and Collaboration Revenues.*   Licensing and collaboration revenuesaccounted for 5% of total revenues in the six months ended June 30, 2004.  These revenues include royalties totaling$1,198,000 (compared to $208,000 in the first half of the prior year) from thecommercialization and continuing sales of Testim. Licensing and collaborationrevenues in the first half of the prior year included a one-time milestonepayment of $500,000.  We have alsorecognized revenues totaling $561,000 during the six months ended June 30,2004, related to product licensing activities in Europe.

 

*GrossProfit.*    Grossprofit increased by approximately $378,000, or 2%, in the six months ended June30, 2004 when compared to the six months ended June 30, 2003, while our grossmargins on net product sales have decreased from 58% in the six months endedJune 30, 2003 to 51% in the six months ended June 30, 2004 (52% gross marginson sales of pharmaceutical products, excluding sales of active pharmaceuticalingredients). Product returns in in the six months ended June 30, 2004 totaled$2,262,000, reducing revenues by this amount during the six months ended June30, 2004.

 

*Selling andMarketing Expenses*

 
| ** **              | ** ** | **For the Six Months Ended June 30,** | ** ** | **Change** | ** ** |
|-------------------------|------------|---------------------------------------|------------|------------|------------|
| **(in  thousands)**     | ** ** | **2004**                              | ** ** | **2003**   | ** ** | **$** | ** ** | **%** | ** ** |
| *Selling and marketing* | * *   | *$*                                   | *7,721*    | * *   | *$*        | *6,979* | * * | *$* | *742* | * * | *11* | *%* |
|                         |            |                                       |            |            |            |  |  |  |  |  |  |  |

 

Selling andmarketing expenses for the six months ended June 30, 2004 increased 11% fromthe same period in the prior year. Theweighted average value of the Euro, in relation to the U.S. Dollar, had theeffect of increasing selling and marketing expenses by approximately $766,000in the six months ended June 30, 2004, indicating that selling and marketingexpenses actually decreased in local currency. Selling and marketing expensesas a percentage of net product sales in the six months ended June 30, 2004remained consistent with the same period of the prior year at 23%.

 

29

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*General andAdministrative Expenses*

 
| ** **                   | ** ** | **For the Six Months Ended June 30,** | ** ** | **Change** | ** ** |
|------------------------------|------------|---------------------------------------|------------|------------|------------|
| **(in  thousands)**          | ** ** | **2004**                              | ** ** | **2003**   | ** ** | **$** | ** ** | **%** | ** ** |
| *General and administrative* | * *   | *$*                                   | *4,451*    | * *   | *$*        | *3,345* | * * | *$* | *1,106* | * * | *33* | *%* |
|                              |            |                                       |            |            |            |  |  |  |  |  |  |  |

 

General and administrative expenses for thesix months ended June 30, 2004 increased 33% from the same period in the prioryear.  The $1,106,000 increase was theresult of increased general and administrative activities required to supportour continued growth and prepare for our anticipated future growth. Theseexpenditures include increased costs in the current year for additionalemployees, outside services, insurance and other costs to support the growth ofour organization. General and administrative expenses as a percent of totalrevenues increased to approximately 12% in the six months ended June 30, 2004,compared to approximately 11% of total revenues in the six months ended June30, 2003.  General and administrativeexpenses would have been approximately $272,000 lower, absent the increase inthe weighted average value of the Euro, in relation to the U.S. Dollar, in thesix months ended June 30, 2004. This foreign currency impact accounted foralmost 25% of the increase in general and administrative expenses when comparedto the first half of the prior year.

 

*Researchand Development Expenses*

 
| ** **                 | ** ** | **For the Six Months Ended June 30,** | ** ** | **Change** | ** ** |
|----------------------------|------------|---------------------------------------|------------|------------|------------|
| **(in  thousands)**        | ** ** | **2004**                              | ** ** | **2003**   | ** ** | **$** | ** ** | **%** | ** ** |
| *Research and development* | * *   | *$*                                   | *1,941*    | * *   | *$*        | *1,897* | * * | *$* | *44* | * * | *2* | *%* |
|                            |            |                                       |            |            |            |  |  |  |  |  |  |  |

 

Research and development expenses for the six months ended June 30, 2004 increased 2%from the same period in the prior year. In the first quarter of 2004, wecompleted and reported the results of a Phase I intranasal insulin trial. We recently commenced Phase II studies ofour clinical program for the intranasal delivery of insulin. In addition, we have initiated certainclinical programs to support the eventual distribution of certain of our Spanishgeneric pharmaceutical products in other countries, including the U.S., and arein the planning stages of certain other clinical programs. We expect tocontinue to incur costs to conduct clinical trials and support the requiredregulatory submissions for our clinical programs. We also incur costs relatedto pre-clinical programs for product formulation and testing efforts beingperformed in the laboratory in our U.S. headquarters and at our facilities inSpain. We are using our U.S. laboratory to develop potential productapplications using our drug delivery technologies. The expenditures in researchand development reflect our focus on projects that are necessary for expansionof our portfolio of marketed products and clinical trials involving our drugdelivery technologies. Someof our cost estimates for our research and development programs arepreliminary, and the specific timing is not known; however, based upon our mostrecent information, we estimate that our research and development expenses forthe year ending December 31, 2004 could be approximately $500,000 to $1,000,000higher than in the year ended December 31, 2003.

 

30

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*OtherIncome (Expenses)*

 
| ** **                | ** ** | **For the Six Months Ended June 30,** | ** ** | **Change** | ** ** |
|---------------------------|------------|---------------------------------------|------------|------------|------------|
| **(in  thousands)**       | ** ** | **2004**                              | ** ** | **2003**   | ** ** | **$** | ** ** | **%** | ** ** |
| *Other income (expenses)* | * *   | *$*                                   | *1,405*    | * *   | *$*        | *47* | * * | *$* | *1,358* | * * | * * | *** |
|                           |            |                                       |            |            |            |  |  |  |  |  |  |  |

 

----

****                **Not meaningful*

 

Other income(expenses) for the six months ended June 30, 2004 increased by $1,358,000 fromthe same period in the prior year. The increase is primarily due to thereversal of previously accrued tax assessments totaling $1,467,000, partiallyoffset by interest and penalties totaling $193,000 associated with thesettlement of the tax audit of our Spanish subsidiary (see *Provisionfor Income Taxes*). We recorded a pre-tax benefit totaling $1,467,000($954,000 after taxes) as a component of other income and expenses as theresult of the reversal of previously accrued pharmaceutical tax assessments inSpain. These assessments had been accrued to be paid to the Spanish governmentas a vehicle to help reduce the impact of the rising health care costs inSpain. Due to recent changes in the pharmaceutical industry in Spain and achange in the Spanish political environment, these liabilities no longer exist.Accordingly, these accruals were reversed during the quarter ended June 30,2004.

 

*Provisionfor Income Taxes*

 
| ** **                                   | ** ** | **For the Six Months Ended June 30, 2004** | ** ** |
|----------------------------------------------|------------|--------------------------------------------|------------|
| **(in  thousands)**                          | ** ** | **Spain**                                  | ** ** | **U.S.** | ** ** | **Consolidated** | ** ** |
|                                         |       |                                       |       |   |   |   |   |
| *Income (loss) before income taxes*          | * *   | *$*                                        | *7,140*    | * * | *$* | *(1,481* | *)* | *$* | *5,659* | * * |
| * *                                     | * *   | * *                                   | * *   | * * | * * | * * | * * |
| *Provision (benefit) for income taxes*       | * *   | *2,757*                                    | * *   | *504* | * * | *3,261* | * * |
| *Tax liability, 1998 - 2000 audit*           | * *   | *604*                                      | * *   | *—* | * * | *604* | * * |
| * *                                     | * *   | * *                                   | * *   | * * | * * | * * | * * |
| *Total provision (benefit) for income taxes* | * *   | *3,361*                                    | * *   | *504* | * * | *3,865* | * * |
| *Valuation allowance*                        | * *   | *—*                                   | * *   | *(504* | *)* | *(504* | *)* |
| * *                                     | * *   | * *                                   | * *   | * * | * * | * * | * * |
| *Net provision for income taxes*             | * *   | *3,361*                                    | * *   | *—* | * * | *3,361* | * * |
| * *                                     | * *   | * *                                   | * *   | * * | * * | * * | * * |
| *Net income (loss)*                          | * *   | *$*                                        | *3,779*    | * * | *$* | *(1,481* | *)* | *$* | *2,298* | * * |
| * *                                     | * *   | * *                                   | * *   | * * | * * | * * | * * |
| *Effective tax rate*                         | * *   | *47*                                       | *%*        | *0* | *%* | *59* | *%* |

 

A tax review of our Spanish subsidiary, Laboratorios Belmac S.A., bythe Spanish tax authorities for the tax years 1998, 1999 and 2000, which hadcommenced over a year ago, was completed in the quarter ended June 30,2004.  As a result of this audit, oursubsidiary has been assessed an additional tax liability of approximately$604,000, which has been recorded as a component of *provisionfor income taxes*, and approximately $193,000 for related interestand penalties, which have been recorded as components of *other incomeand expenses*, in the consolidated income statements for the threeand six months ended June 30, 2004.

 

We haverecorded provisions for foreign income taxes totaling $3,361,000 ($2,757,000income tax expense on operations plus $604,000 recorded as a result of the taxaudit of our Spanish subsidiary) and $2,956,000 for the six months ended June30, 2004 and 2003, respectively. The effective tax rate in Spain for the sixmonths ended June 30, 2004 is 47%; however, when the $604,000 tax auditsettlement related to prior years is excluded, the effective tax rate is 39%compared to 40% in the comparable six month period of the prior year. Theprovision for foreign income taxes would have been approximately $342,000 lowerthan reported, absent the increase in the weighted average value of the Euro,in relation to the U.S. Dollar, during the six months ended June 30, 2004.

 

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We generatedadditional U.S. federal net operating loss carry-forwards in the six monthsended June 30, 2004 and 2003 as a result of U.S. pre-tax losses of ($1,481,000)and ($1,465,000), respectively. As future domestic operating profits cannot bereasonably assured, no tax benefit has been recorded for U.S. losses.Accordingly, we have established a valuation allowance equal to the full amountof the U.S. deferred tax assets.

 

Should we determine that it is more likely than not that we willrealize certain of our net deferred tax assets for which we have previouslyprovided a valuation allowance, an adjustment would be required to reduce theexisting valuation allowance. In addition, we operate within multiple taxingjurisdictions and are subject to audit in those jurisdictions. These audits caninvolve complex issues, which may require an extended period of time forresolution. During the quarter ended June 30, 2004, we identified certain taxcontingencies that we have determined are probable and reasonably estimable.Consequently, we have included a charge totaling $188,000 in the *provision for income taxes* for the quarter ended June 30,2004 related to these contingencies. No other potential tax contingencies were consideredprobable and/or reasonably estimable by Bentley at period end. However, there is thepossibility that the ultimate resolution of such potential contingencies couldhave an adverse effect on our results of operations.

 

*Net Income*

 
| ** **                                    | ** ** | **For the Six Months Ended June 30,** | ** ** | **Change** | ** ** |
|-----------------------------------------------|------------|---------------------------------------|------------|------------|------------|
| **(in  thousands, except per share data)**    | ** ** | **2004**                              | ** ** | **2003**   | ** ** | **$** | ** ** | **%** | ** ** |
|                                          |       |                                  |       |       |       |   |   |   |   |
| *Net income*                                  | * *   | *$*                                   | *2,298*    | * *   | *$*        | *3,061* | * * | *$* | *(763* | *)* | *-25* | *%* |
| * *                                      | * *   | * *                              | * *   | * *   | * *   | * * | * * | * * | * * |
| *Net income per common share:*                | * *   | * *                              | * *   | * *   | * *   | * * | * * | * * | * * |
| *Basic*                                       | * *   | *$*                                   | *0.11*     | * *   | *$*        | *0.17* | * * | *$* | *(0.06* | *)* | *-35* | *%* |
| *Diluted*                                     | * *   | *$*                                   | *0.10*     | * *   | *$*        | *0.15* | * * | *$* | *(0.05* | *)* | *-33* | *%* |
| * *                                      | * *   | * *                              | * *   | * *   | * *   | * * | * * | * * | * * |
| *Weighted average common shares outstanding:* | * *   | * *                              | * *   | * *   | * *   | * * | * * | * * | * * |
| *Basic*                                       | * *   | *20,620*                              | * *   | *17,495*   | * *   | *3,125* | * * | *18* | *%* |
| *Diluted*                                     | * *   | *22,787*                              | * *   | *20,617*   | * *   | *2,170* | * * | *11* | *%* |

* *

We reported income from operations of $4,254,000in the six months ended June 30, 2004 compared to $5,970,000 (which included anon-recurring one-time milestone revenue payment of $500,000) in the six monthsended June 30, 2003. The combination of income from operations of $4,254,000and the non-operating items, primarily the provision for income taxes of$3,361,000 and the reversal of previously accrued tax assessmentstotaling $1,467,000 resulted in net income of$2,298,000, or $0.11 per basic common share ($0.10 per diluted common share) on20,620,000 weighted average basic common shares outstanding (22,787,000weighted average diluted common shares outstanding) in the first half of 2004,compared to net income of $3,061,000, or $0.17 per basic common share ($0.15per diluted common share) on 17,495,000 weighted average basic common sharesoutstanding (20,617,000 weighted average diluted common shares outstanding) inthe first half of 2003. Net income in the future could be negatively impactedas a result of the lower selling prices in Spain and anticipated increases inresearch and development programs that are expected to benefit future periods.However, as previously discussed, our broad-based growth strategy shouldmitigate the impact of these developments over time.

 

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**LIQUIDITY AND CAPITAL RESOURCES:**

 

Total assets increased from $100,463,000 at December 31, 2003 to$109,787,000 at June 30, 2004, while stockholders’ equity increased from$76,165,000 at December 31, 2003 to $78,657,000 at June 30, 2004. Theincrease in stockholders’ equity primarily reflects net income for the sixmonths of $2,298,000 and net proceeds from the exercise of stock options ofapproximately $1,600,000, partially offset by the negative impact of thefluctuation of the Euro/U.S. dollar exchange rate, which totaled $1,538,000 inthe six month period ended June 30, 2004.

 

Cash, cash equivalents and marketable securities decreased by 11% or$4,437,000 from $40,645,000 at December 31, 2003 to $36,208,000 at June30, 2004. The decrease was primarily attributed to the cash acquisition of anactive pharmaceutical ingredient manufacturing facility for approximately$3,300,000 and additions to other fixed assets totaling $3,476,000, which werepartially offset by operating activities and proceeds from exercises of stockoptions totaling approximately $3,170,000. Cash and cash equivalents at June 30, 2004 include approximately$4,604,000 of short-term liquid investments considered to be cash equivalents.

 

Receivables increased by 32% from $18,036,000 at December 31, 2003to $23,772,000 at June 30, 2004. Receivables increased by approximately$4,882,000 in local currency, but fluctuations in foreign currency exchangerates increased receivables reported in U.S. dollars by approximately$854,000.  Receivables are comprised oftrade receivables totaling $21,545,000, VAT receivables totaling $2,096,000 andother receivables totaling $131,000. Receivables from one international customer total $6,281,000 at June 30,2004 and are secured by an irrevocable letter of credit to secure payment.  We have not experienced any materialdelinquencies on our receivables that have had a material effect on ourfinancial position, results of operations or cash flows.

 

Inventories increased by approximately $2,499,000 from $7,106,000 atDecember 31, 2003 to $9,605,000 at June 30, 2004, primarily as a result ofincreased production during the quarter required to meet anticipated salesdemand and purchases of raw materials to facilitate product testing, launchesand manufacturing demand. Inventory increased by approximately $2,127,000 inlocal currency, and fluctuations in foreign currency exchange rates increasedinventories reported in U.S. dollars by approximately $372,000.

 

The combined total of accounts payable and accrued expenses increasedfrom $17,257,000 at December 31, 2003 to $23,304,000 at June 30, 2004. The$6,047,000 increase was primarily attributed to an increase in accounts payableof $3,162,000 for inventory purchases, an increase in income taxes payable ofapproximately $1,516,000 and a $1,986,000 increase in co-marketing costspayable while fluctuations in foreign currency exchange rates increasedaccounts payable and accrued expenses reported in U.S. dollars by approximately$713,000.

 

Short-term borrowings and current portion of long-term debt decreasedfrom $1,985,000 at December 31, 2003 to $1,871,000 at June 30, 2004,primarily as a result of payment of the current portion of long-term debt andthe effect of fluctuations in foreign currency exchange rates. The weightedaverage interest rate on our short-term borrowings at June 30, 2004 was 3.7%.

 

Operatingactivities for the six months ended June 30, 2004 provided net cash of$1,567,000. Our future operating cash flows could be negatively impacted as aresult of government regulations that impact pharmaceutical pricing in Spainand anticipated increases in research and development spending for programsthat are expected to benefit future periods. However, as previously discussed,our broad-based growth strategy should mitigate the impact of thesedevelopments.

 

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Investingactivities, primarily capital expenditures to: (i) acquire an active pharmaceutical ingredient manufacturing facilityin Spain; (ii) increase the capacity of our other manufacturing facility inSpain; and (iii) increase our manufacturing and packaging capabilities, alongwith additions to drug licenses and related costs, partially offset by proceedsfrom investment maturities, used net cash of $6,453,000 during the six monthsended June 30, 2004.

 

Financingactivities during the six months ended June 30, 2004 provided cash totaling$1,553,000, and included proceeds from the exercise of stock options totalingapproximately $1,600,000. These proceeds were partially offset by netrepayments of borrowings of approximately $50,000

 

Our licensee, Auxilium Pharmaceuticals, Inc.,launched its testosterone replacement gel, Testim, which utilizes our patentedCPE-215 drug delivery technology, during the first quarter of 2003.  Auxilium paid a $500,000 milestone payment tous during the first quarter of 2003, which we recorded as *licensingand collaboration revenues* in the Consolidated Income Statement forthe three months ended March 31, 2003. In connection with the Testim product launch, we began earning royaltyrevenues on a percentage of Testim sales as defined in the licensing agreementwith Auxilium.  Royalty revenues onTestim product sales are recognized based on an estimate of Auxilium’ssell-through of the Testim product based on prescriptions filled, until suchtime that returns from wholesalers and pharmacies can be reasonablyestimated.   For the six months endedJune 30, 2004 and 2003, we recognized royalty revenues of $1,198,000 and$208,000, respectively, based on an estimate of prescriptions filled.  The difference between the total amountearned from Auxilium under the royalty arrangement and the amount recognized asa component of *licensing and collaborationrevenues* is recorded as a component of *deferredincome* in the Consolidated Balance Sheets.  As of June 30, 2004 and December 31, 2003,deferred income from Testim royalties totaled $995,000 and $634,000,respectively.  We will continue to useavailable market information to determine the amount and timing of royaltyrevenue recognition.

 

*Seasonality.*  In the past, we have experienced lower salesin the third calendar quarter and higher sales in the fourth calendar quarterdue to seasonality.  As we market morepharmaceutical products whose sales are seasonal, seasonality of sales maybecome more significant.

 

*Effect ofInflation and Changing Prices.*  Neither inflation nor changing prices hasmaterially impacted our revenues or income from operations for the periodspresented.

 

*Liquidity*.  We plan to continue making improvements toour manufacturing facilities during the balance of 2004 to accommodate ourcontinuing growth.  As previouslydiscussed, in April of 2004, we purchaseda manufacturing facility located in Spain, for approximately $3,300,000,which specializes in the manufacture of several active pharmaceuticalingredients. We estimate that capital investments of approximately $2,500,000for the purchase of new manufacturing equipment will be required in the balanceof 2004 to expand that facility.  We alsoplan to continue improving and expanding our other manufacturing facility inSpain and plan to purchase new equipment to support our research anddevelopment activities in the U.S. We expect to invest an additional $3,500,000in capital improvements and additions for these items during the balance of2004. As mentioned above, we have cash, cash equivalents and short-term liquidinvestments totaling approximately $36,208,000 as of June 30, 2004, which webelieve will be sufficient to fund our operations for the foreseeable future.Even though we are generating positive cash flow from operations,(approximately $1,567,000 in the six months ended June 30, 2004), there can beno assurance that changes in our research and development plans, capitalexpenditures and/or acquisitions, or other events affecting our net productsales or operating expenses will not result in the earlier depletion of ourfunds.  We continue to explorealternative sources for financing our business activities. In

 

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appropriate situations, whichwill be strategically determined, we may seek financial assistance from othersources, including contribution by others to joint ventures and othercollaborative or licensing arrangements for the development, testing,manufacturing and marketing of products under development.

 

**CriticalAccounting Policies and Estimates**

 

Oursignificant accounting policies are more fully described in Note 2 to ourconsolidated financial statements in our Annual Report on Form 10-K for theyear ended December 31, 2003. Certain of our accounting policies areparticularly important to the portrayal of our financial position, results ofoperations and cash flows and require the application of significant judgmentby our management; as a result they are subject to an inherent degree ofuncertainty. In applying those policies, our management uses its judgment todetermine the appropriate assumptions to be used in the determination ofcertain estimates. Those estimates are based on our historical experience,terms of existing contracts, our observance of trends in the industry,information provided by our customers and information available from otheroutside sources, as appropriate.

 

**ImportantFactors That May Affect Future Results**

 

This QuarterlyReport on Form 10-Q contains forward-looking statements. These forward-lookingstatements appear principally in the section entitled “Management’s Discussionand Analysis of Financial Condition and Results of Operations.” Forward-lookingstatements may appear in other sections of this report, as well. Generally, theforward-looking statements in this report include such words as “expect,” “believe,”“continue,” “anticipate,” “estimate,” “may,” “will,” “could,” “opportunity,”“future,” “project,” and similar expressions.

 

Theforward-looking statements include statements about our:

•                  Strategic plans;

•                  Sales growth;

•                  Anticipatedsources of future revenues;

•                  Anticipated 2004expenses, margins and operating performance;

•                  Expected launchof new products;

•                  Anticipatedexpenses and spending;

•                  Commencing andcontinuing clinical trials;

•                  The sufficiencyof capital to fund our operations.

 

These forward-lookingstatements are based on our current expectations, beliefs, assumptions,estimates, forecasts and projections for our business and the industry andmarkets in which we compete. These statements are not guarantees of futureperformance and involve certain risks, uncertainties and assumptions that aredifficult to predict. Therefore, actual outcomes and results may differmaterially from what is expressed in such forward-looking statements. Wecaution investors not to place undue reliance on the forward-looking statementscontained in this report. These statements speak only as of the date of thisreport, and we do not undertake any obligation to update or revise them, exceptas required by law.  The followingfactors, among others, create risks and uncertainties that could affect ourfuture or other performance:  expandinggeneric and branded drug operations, changes in third-party reimbursement andgovernment mandates which impact pharmaceutical pricing, development andcommercialization of our products, relationships with our strategic partners,uncertainty of clinical trial results, regulatory approval process,unpredictability of

 

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patent protection,technological changes, the effects of economic conditions, risks associatedwith international operations, competition from other manufacturers of genericand proprietary pharmaceuticals, and difficulties in managing our growth andthe other risk factors contained in the section entitled “Risk Factors” in ourAnnual Report on Form 10-K filed for the year ended December 31, 2003.  As a result of these and other factors, wemay experience material fluctuations in our future operating results, whichcould materially affect our business, financial position, and stock price.

 

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# **Item 3.  Quantitative andQualitative Disclosures About Market Risk**

 

*Foreign Currency.*  A substantial amount of our business isconducted in Europe and is therefore influenced to the extent to which thereare fluctuations in the U.S. Dollar’s value against other currencies,specifically the Euro. The exchange rates at June 30, 2004 and December31, 2003 were .83 Euros and .80 Euros per U.S. Dollar, respectively. Theweighted average exchange rates for the three months ended June 30, 2004and 2003 were .83 Euros and .88 Euros per U.S. Dollar, respectively. Theweighted average exchange rates for the six months ended June 30, 2004 and2003 were .82 Euros and .91 Euros per U.S. Dollar, respectively. The effect offoreign currency fluctuations on long lived assets for the six months endedJune 30, 2004 was a decrease of $1,538,000 and the cumulative historicaleffect was an increase of $3,631,000, as reflected in our Consolidated Balance Sheetsas *accumulated other**comprehensive income*. Although exchangerates have fluctuated significantly in recent years, we do not believe that theeffect of foreign currency fluctuation is material to our results of operationsas the expenses related to much of our foreign currency revenues are in thesame functional currency as those revenues, namely the Euro. However, thecarrying value of assets and liabilities can be materially impacted by foreigncurrency translation, as can the translated amounts of revenues and expenses.Nonetheless, we do not plan to modify our business practices at this time.

 

We have relied primarily upon financing activities to fund ouroperations in the U.S. In the event that we are required to fund U.S.operations or cash needs with funds generated in Europe, currency ratefluctuations in the future could have a significant impact on us. However, atthe present time, we do not anticipate altering our business plans andpractices to compensate for future currency fluctuations.

 

*Interest Rates.*  As of June 30, 2004, the weighted averageinterest rate on our short-term borrowings of $1,871,000 is 3.7%. A portion ofour long-term borrowings is non-interest bearing and the balance outstanding onthese borrowings at June 30, 2004 is $360,000 including imputed interest(ranging from 4.8% to 6.0%) of $75,000. The weighted average interest rate onour long-term borrowings is 5.6%. The effect of an increase in interest ratesof one percentage point (one hundred basis points) to an average of 4.7% onshort-term borrowings and to an average of 6.6% on long-term borrowings wouldhave the effect of increasing interest expense by approximately $22,000annually.

 

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# **Item 4.  Controls and Procedures**

 

BentleyPharmaceuticals maintains disclosure controls and procedures that are designedto ensure that information required to be disclosed in Bentley’s reports thatare filed with the Securities and Exchange Commission is recorded, processedand reported within the time periods required for each report and that suchinformation is reported to Bentley’s management, including its Chief ExecutiveOfficer and Chief Financial Officer, as appropriate, to allow timely decisionsregarding required disclosure.

 

As of June 30,2004, Bentley carried out an evaluation, under the supervision of, and with theparticipation of Bentley’s management, including Bentley’s Chief ExecutiveOfficer and Chief Financial Officer, of the effectiveness of the design andoperation of Bentley’s disclosure controls and procedures (as defined inExchange Act Rules 13a-15(e) and 15(d)-15(e)). Based on that evaluation,Bentley’s Chief Executive Officer and Chief Financial Officer concluded thatBentley’s disclosure controls and procedures are effective in timely alertingthem to material information relating to Bentley (including its consolidatedsubsidiaries), which is required to be included in its publicly filed reportsor submitted under the Exchange Act, and in ensuring that such information isrecorded, processed, summarized and reported within the time periods specifiedin the Securities and Exchange Commission’s rules and forms.  Although Bentley’s management continues toevaluate the internal control structure and strengthen Bentley’s controlprocedures, particularly in connection with the requirements of Section 404 ofthe Sarbanes-Oxley Act of 2002, there have been no significant changes inBentley’s internal controls or in other factors which could significantlyaffect internal controls during the quarter ended June 30, 2004.

 

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**PARTII.                OTHER INFORMATION**

 

# **Item 1.    Legal Proceedings**

 

See Item 1. Legal Proceedings in our Quarterly Report on Form 10-Q forthe quarterly period ended March 31, 2004.

 

We are party to various other legal actions that arise in the ordinarycourse of business. We do not expect that resolution of these matters willhave, individually or in the aggregate, a material adverse effect on ourfinancial position, results of operations or cash flows.

 

**Item 4.Submission of Matters to a Vote of Security Holders**

 

Our Annual Meeting of Stockholders was held on June 7, 2004 andadjourned until June 11, 2004, at which time it was concluded, for the purposeof electing two directors and consideration of proposals to amend and restateour Restated Certificate of Incorporation that would prohibit stockholderaction by written consent, amend the classified board provisions and remove theindemnification provisions.  Proxies forthe meeting were solicited pursuant to Regulation 14A of the SecuritiesExchange Act of 1934, as amended, and there was no solicitation in opposition.

 

The following members were elected to our Board of Directors:

 
| **Nominee**        | ** ** | **Term  Expiring** | ** ** | **Shares  Voted For** | ** ** | **Shares  Voted Against** | ** ** |
|--------------------|------------|--------------------|------------|-----------------------|------------|---------------------------|------------|
|               |       |               |       |                  |       |                      |       |
| F. Ross Johnson    |       | 2007               |       | 18,285,868            |       | 527,354                   |       |
| Edward J. Robinson |       | 2007               |       | 18,285,700            |       | 527,522                   |       |

 

Additionally,three of our employee directors, Messrs. Robert M. Stote, Senior Vice Presidentand Chief Medical Officer, Robert J. Gyurik, Vice President of PharmaceuticalDevelopment, and Michael D. Price, Vice President and Chief Financial Officer,each submitted letters of resignation from the Board of Directors. Theseresignations were accepted by the Chairman of the Board effective May 12, 2004concurrent with the listing of our common stock on the New York StockExchange.  There were no disagreementsinvolved with the resignations and these three officers continue to serve as ExecutiveOfficers of Bentley.  They tendered theirresignations to proactively strengthen our Corporate Governance, so that theBoard of Directors would be comprised solely of outside directors and Bentley’sChief Executive Officer.  Also, on June7, 2004, the Board of Directors designated retiring independent director,Charles L. Bolling, a Director Emeritus of Bentley.

 

The followingproposals to amend and restate our Certificate of Incorporation required theaffirmative vote of 10,300,084 shares (the holders of a majority of the sharesof our outstanding Common Stock on the Record Date of the Annual Meeting, April13, 2004). The first matter considered was a proposal to prohibit stockholderaction by written consent. This proposal was not approved by the followingvote:

 
| **Shares  Voted For** | ** ** | **Shares  Voted Against** | ** ** | **Shares  Abstaining** | ** ** |
|-----------------------|------------|---------------------------|------------|------------------------|------------|
| 8,300,972             |       | 4,442,887                 |       | 7,856,307              |       |

 

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The second matter considered was a proposal to amend the classified board provisions. This proposal also required the affirmative vote of 10,300,084 shares (the holders of a majority of the shares of our outstanding Common Stock on April 13, 2004). This proposal was not approved by the following vote:

 
| **Shares  Voted For** | ** ** | **Shares  Voted Against** | ** ** | **Shares  Abstaining** | ** ** |
|-----------------------|------------|---------------------------|------------|------------------------|------------|
| 8,203,016             |       | 4,543,537                 |       | 7,853,613              |       |

 

The final matter considered was a proposal to remove the indemnification provisions from our Restated Certificate of Incorporation. This proposal also required the affirmative vote of 10,300,084 shares (the holders of a majority of the shares of our outstanding Common Stock on April 13, 2004). This proposal was approved by the following vote:
| **Shares  Voted For** | ** ** | **Shares  Voted Against** | ** ** | **Shares  Abstaining** | ** ** |
|-----------------------|------------|---------------------------|------------|------------------------|------------|
| 17,223,372            |       | 1,644,375                 |       | 1,732,419              |       |

 

# **Item 6**.    Exhibits and Reports on Form 8-K

# ** **

(a)          Exhibits:

 

The Exhibitsfiled as part of this report are listed on the Exhibit Index immediatelypreceding the exhibits, which Exhibit Index is incorporated herein byreference.

 

(b)         Reportson Form 8-K filed during the quarter ended June 30, 2004:

 

(i)             We furnished aCurrent Report on Form 8-K dated May 5, 2004, announcing earnings for the threemonths ended March 31, 2004 and attaching a press release related thereto.(Item 12) *

 

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* This information shall not bedeemed “filed” for purposes of Section 18 of the Securities Exchange Act of1934, as amended (the “Exchange Act”), or otherwise subject to the liabilitiesof that section, nor shall it be deemed incorporated by reference in any filingmade by Bentley under the Securities Act of 1933 or the Exchange Act, except asexpressly set forth by specific reference in such filing.

 

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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 theundersigned thereunto duly authorized.

 

 
|           |   | BENTLEY PHARMACEUTICALS, INC.                                              |   |
|----------------|--------|----------------------------------------------------------------------------|--------|
|           |   | Registrant                                                                 |   |
|           |   |                                                                       |
|           |   |                                                                       |
| August 4, 2004 | By:    | /s/ James R. Murphy                                                        |   |
|           |   | James R. Murphy                                                            |
|           |   | Chairman of the Board of Directors, President and Chief  Executive Officer |   |
|           |   | (Principal Executive Officer)                                              |
|           |   |                                                                       |
|           |   |                                                                       |
| August 4, 2004 | By:    | /s/ Michael D. Price                                                       |   |
|           |   | Michael D. Price                                                           |
|           |   | Vice President, Chief Financial Officer,                                   |
|           |   | Treasurer and Secretary (Principal Financial                               |
|           |   | and Accounting Officer)                                                    |
|                |        |                                                                            |        |  |

 

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# **Exhibit Index**

 
| **Exhibit  Number** | ** ** | **Description of Exhibit**                                                                                                                                                    |
|---------------------|------------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|                |       |                                                                                                                                                                          |
| 3.1                 |       | Certificate  of Amendment of Restated Certificate of Incorporation filed with the  Secretary of State of the State of Delaware on July 23, 2004.  Filed herewith.        |
|                |       |                                                                                                                                                                          |
| 31.1                |       | Certification  of the Chief Executive Officer pursuant to 18 U.S.C. Section 1350 as adopted  pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.  Filed herewith. |
|                |       |                                                                                                                                                                          |
| 31.2                |       | Certification  of the Chief Financial Officer pursuant to 18 U.S.C. Section 1350 as adopted  pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.  Filed herewith. |
|                |       |                                                                                                                                                                          |
| 32.1                |       | Certification  of the Chief Executive Officer pursuant to 18 U.S.C. Section 1350 as adopted  pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.  Filed herewith. |
|                |       |                                                                                                                                                                          |
| 32.2                |       | Certification  of the Chief Financial Officer pursuant to 18 U.S.C. Section 1350 as adopted  pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.  Filed herewith. |

 

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