** **

**UNITED STATES SECURITIES AND EXCHANGE COMMISSION**

 

**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 quarterlyperiod ended March 31, 2004**

 

**OR**

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

 

**For the transitionperiod from                                                    to**

 

**Commission File Number  1-10581**

** **

**BENTLEY PHARMACEUTICALS, INC.**

(Exact name of registrant as specified in its charter)

 

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

 

**Bentley Park,2 Holland Way, Exeter, New Hampshire 03833**

(Current Address of Principal Executive Offices)

 

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

 

Indicate by check mark whetherthe registrant (1) has filed all reports required to be filed by Section 13 or15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (orfor such shorter period that the registrant was required to file such reports),and (2) has been subject to such filing requirements for the past 90 days.      YES  ý    NO  o

 

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

 

The number of shares of theregistrant’s common stock outstanding as of May 7, 2004 was 20,600,909.

 

 

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**BENTLEYPHARMACEUTICALS, INC. AND SUBSIDIARIES**

**FORM 10-Q FOR THEQUARTER ENDED MARCH 31, 2004**

**INDEX**

 
|     |                            | **PAGE**                                                                                                                          |
|----------|---------------------------------|-----------------------------------------------------------------------------------------------------------------------------------|
| Part I.  | UNAUDITED FINANCIAL INFORMATION |                                                                                                                              |
|     |                            |                                                                                                                              |   |
|     | Item 1.                         | Condensed Consolidated Financial  Statements:                                                                                     |   |
|     |                            |                                                                                                                              |   |
|     |                            | Consolidated  Balance Sheets as of March 31, 2004 and December 31, 2003                                                           | 3 |
|     |                            |                                                                                                                              |   |
|     |                            | Consolidated  Income Statements and Statements of Comprehensive (Loss) Income for the three  months ended March 31, 2004 and 2003 | 4 |
|     |                            |                                                                                                                              |   |
|     |                            | Consolidated  Statement of Changes in Stockholders’ Equity for the three months ended March  31, 2004                        | 5 |
|     |                            |                                                                                                                              |   |
|     |                            | Consolidated  Statements of Cash Flows for the three months ended March 31, 2004 and 2003                                         | 6 |
|     |                            |                                                                                                                              |   |
|     |                            | Notes  to Consolidated Financial Statements                                                                                       | 8 |
|     |                            |                                                                                                                              |   |
|     | Item 2.                         | Management’s  Discussion and Analysis of Financial Condition and Results of Operations                                       | 15 |
|     |                            |                                                                                                                              |   |
|     | Item 3.                         | Quantitative  and Qualitative Disclosures About Market Risk                                                                       | 27 |
|     |                            |                                                                                                                              |   |
|     | Item 4.                         | Controls  and Procedures                                                                                                          | 28 |
|     |                            |                                                                                                                              |   |
| Part II. | OTHER INFORMATION               |                                                                                                                              |
|     |                            |                                                                                                                              |   |
|     | Item 1.                         | Legal  Proceedings                                                                                                                | 29 |
|     |                            |                                                                                                                              |   |
|     | Item 6.                         | Exhibits  and Reports on Form 8-K                                                                                                 | 30 |

 

2

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**BENTLEYPHARMACEUTICALS, INC. AND SUBSIDIARIES**

**CONSOLIDATEDBALANCE SHEETS**

 

*(in thousands, except per share data)*

* *
|                                                                                                        |   | **March 31,  2004** |    | **December  31,  2003** |   |
|-------------------------------------------------------------------------------------------------------------|--------|---------------------|---------|-------------------------|--------|
| **ASSETS**                                                                                                  |   |                |    |                    |   |
| Current assets:                                                                                             |   |                |    |                    |   |
| Cash and cash equivalents                                                                                   |   | $                   | 37,812  |                    | $      | 39,393 |   |
| Marketable securities                                                                                       |   | 1,218               |    | 1,252                   |   |
| Receivables, net                                                                                            |   | 18,885              |    | 18,036                  |   |
| Inventories, net                                                                                            |   | 7,439               |    | 7,106                   |   |
| Deferred taxes                                                                                              |   | 207                 |    | 213                     |   |
| Prepaid expenses and other                                                                                  |   | 1,600               |    | 899                     |   |
| Total current assets                                                                                        |   | 67,161              |    | 66,899                  |   |
| Non-current assets:                                                                                         |   |                |    |                    |   |
| Fixed assets, net                                                                                           |   | 19,637              |    | 18,566                  |   |
| Drug licenses and related costs, net                                                                        |   | 13,536              |    | 13,818                  |   |
| Restricted cash                                                                                             |   | 1,000               |    | 1,000                   |   |
| Other                                                                                                       |   | 169                 |    | 180                     |   |
| Total non-current assets                                                                                    |   | 34,342              |    | 33,564                  |   |
|                                                                                                        |   | $                   | 101,503 |                    | $      | 100,463 |   |
|                                                                                                        |   |                |    |                    |   |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                               |   |                |    |                    |   |
| Current liabilities:                                                                                        |   |                |    |                    |   |
| Accounts payable                                                                                            |   | $                   | 11,223  |                    | $      | 10,154 |   |
| Accrued expenses                                                                                            |   | 7,774               |    | 7,103                   |   |
| Short-term borrowings                                                                                       |   | 1,355               |    | 1,915                   |   |
| Current portion of long-term debt                                                                           |   | —              |    | 70                      |   |
| Deferred income                                                                                             |   | 2,272               |    | 1,956                   |   |
| Total current liabilities                                                                                   |   | 22,624              |    | 21,198                  |   |
| Non-current liabilities:                                                                                    |   |                |    |                    |   |
| Deferred taxes                                                                                              |   | 2,478               |    | 2,555                   |   |
| Long-term debt                                                                                              |   | 358                 |    | 369                     |   |
| Other                                                                                                       |   | 76                  |    | 176                     |   |
| Total non-current liabilities                                                                               |   | 2,912               |    | 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, 20,600 and 20,573 shares |   | 412                 |    | 412                     |   |
| Stock purchase warrants (to purchase 420  and 420 shares of common stock)                                   |   | 333                 |    | 333                     |   |
| Additional paid-in capital                                                                                  |   | 137,072             |    | 136,850                 |   |
| Accumulated deficit                                                                                         |   | (65,790             | )       | (66,599                 | )      |
| Accumulated other comprehensive income                                                                      |   | 3,940               |    | 5,169                   |   |
| Total stockholders’ equity                                                                             |   | 75,967              |    | 76,165                  |   |
|                                                                                                        |   | $                   | 101,503 |                    | $      | 100,463 |   |

 

*The accompanying Notes to CondensedConsolidated Financial Statements are an integral part of these financialstatements.*

 

3

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**BENTLEYPHARMACEUTICALS, INC. AND SUBSIDIARIES**

**CONSOLIDATEDINCOME STATEMENTS**

**ANDSTATEMENTS OF COMPREHENSIVE (LOSS) INCOME**

 

*(in thousands, except per share data)*

 
|                                        |   | **For the  Three Months Ended March 31,** |   |
|---------------------------------------------|--------|-------------------------------------------|--------|
|                                        |   | **2004**                                  |   | **2003** |   |
| Revenues:                                   |   |                                      |   |   |   |
| Net product sales                           |   | $                                         | 16,606 |   | $ | 14,235 |   |
| Licensing and collaboration revenues        |   | 696                                       |   | 753 |   |
| Total revenues                              |   | 17,302                                    |   | 14,988 |   |
|                                        |   |                                      |   |   |   |
| Cost of net product sales                   |   | 8,196                                     |   | 6,121 |   |
|                                        |   |                                      |   |   |   |
| Gross profit                                |   | 9,106                                     |   | 8,867 |   |
|                                        |   |                                      |   |   |   |
| Operating expenses:                         |   |                                      |   |   |   |
| Selling and marketing                       |   | 3,870                                     |   | 3,353 |   |
| General and administrative                  |   | 2,162                                     |   | 1,559 |   |
| Research and development                    |   | 995                                       |   | 1,018 |   |
| Depreciation and amortization               |   | 406                                       |   | 283 |   |
|                                        |   |                                      |   |   |   |
| Total operating expenses                    |   | 7,433                                     |   | 6,213 |   |
|                                        |   |                                      |   |   |   |
| Income from operations                      |   | 1,673                                     |   | 2,654 |   |
|                                        |   |                                      |   |   |   |
| Other income (expenses):                    |   |                                      |   |   |   |
| Interest income                             |   | 110                                       |   | 83 |   |
| Interest expense                            |   | (53                                       | )      | (54 | ) |
|                                        |   |                                      |   |   |   |
| Income before income taxes                  |   | 1,730                                     |   | 2,683 |   |
|                                        |   |                                      |   |   |   |
| Provision for income taxes                  |   | 921                                       |   | 1,151 |   |
|                                        |   |                                      |   |   |   |
| Net income                                  |   | $                                         | 809    |   | $ | 1,532 |   |
|                                        |   |                                      |   |   |   |
| Net income per common share:                |   |                                      |   |   |   |
| Basic                                       |   | $                                         | 0.04   |   | $ | 0.09 |   |
| Diluted                                     |   | $                                         | 0.04   |   | $ | 0.08 |   |
|                                        |   |                                      |   |   |   |
| Weighted average common shares outstanding: |   |                                      |   |   |   |
| Basic                                       |   | 20,597                                    |   | 17,455 |   |
| Diluted                                     |   | 22,784                                    |   | 20,350 |   |
|                                        |   |                                      |   |   |   |
| Net income                                  |   | $                                         | 809    |   | $ | 1,532 |   |
| Other comprehensive (loss) income:          |   |                                      |   |   |   |
| Foreign currency translation (losses) gains |   | (1,229                                    | )      | 680 |   |
| Comprehensive (loss) income                 |   | $                                         | (420   | ) | $ | 2,212 |   |

 

*The accompanying Notes to CondensedConsolidated Financial Statements are an integral part of these financialstatements.*

 

4

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**BENTLEYPHARMACEUTICALS, INC. AND SUBSIDIARIES**

**CONSOLIDATEDSTATEMENTS OF CHANGES IN STOCKHOLDERS’ 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               |   | 20                                |   | —     |   | —                        |   | 122                              |   | —                   |    | —                                        |   | 122       |   |
| Equity based compensation               |   | 7                                 |   | —     |   | —                        |   | 100                              |   | —                   |    | —                                        |   | 100       |   |
| Foreign currency translation adjustment |   | —                            |   | —     |   | —                        |   | —                           |   | —                   |    | (1,229                                        | )      | (1,229    | )      |
| Net income                              |   | —                            |   | —     |   | —                        |   | —                           |   | 809                      |    | —                                        |   | 809       |   |
| Balance at March 31, 2004               |   | 20,600                            |   | $          | 412    |                          | $      | 333                              |   | $                        | 137,072 |                                          | $      | (65,790   | )      | $ | 3,940 |   | $ | 75,967 |   |
|                                         |        |                                   |        |            |        |                               |        |                                  |        |                          |         |                                               |        |           |        |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

*The accompanying Notes to CondensedConsolidated Financial Statements are an integral part of these financialstatements.*

 

5

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**BENTLEYPHARMACEUTICALS, INC. AND SUBSIDIARIES**

**CONSOLIDATEDSTATEMENTS OF CASH FLOWS**

 
|                                                                               |   | **For the  Three Months Ended March 31,** |   |
|------------------------------------------------------------------------------------|--------|-------------------------------------------|--------|
|                                                                               |   | **2004**                                  |   | **2003** |   |
|                                                                               |   |                                      |   |   |   |
| Cash flows from operating activities:                                              |   |                                      |   |   |   |
| Net income                                                                         |   | $                                         | 809    |   | $ | 1,532 |   |
| Adjustments to reconcile net income to net  cash provided by operating activities: |   |                                      |   |   |   |
| Depreciation and amortization                                                      |   | 829                                       |   | 500 |   |
| Forgiveness of related party loans                                                 |   | —                                    |   | 75 |   |
| Equity-based compensation expense                                                  |   | 60                                        |   | 141 |   |
| Other non-cash items                                                               |   | (55                                       | )      | (152 | ) |
| (Increase) decrease in assets and increase  (decrease) in liabilities:             |   |                                      |   |   |   |
| Receivables                                                                        |   | (1,438                                    | )      | (1,248 | ) |
| Inventories                                                                        |   | (565                                      | )      | 599 |   |
| Prepaid expenses and other current assets                                          |   | (809                                      | )      | (52 | ) |
| Other assets                                                                       |   | 6                                         |   | (42 | ) |
| Accounts payable and accrued expenses                                              |   | 2,387                                     |   | 131 |   |
| Deferred income                                                                    |   | 318                                       |   | 551 |   |
| Other liabilities                                                                  |   | (100                                      | )      | (5 | ) |
|                                                                               |   |                                      |   |   |   |
| Net cash provided by operating activities                                          |   | 1,442                                     |   | 2,030 |   |
|                                                                               |   |                                      |   |   |   |
| Cash flows from investing activities:                                              |   |                                      |   |   |   |
| Proceeds from sale of investments                                                  |   | 80,450                                    |   | 56,800 |   |
| Purchase of investments                                                            |   | (80,395                                   | )      | (56,763 | ) |
| Additions to fixed assets                                                          |   | (2,096                                    | )      | (2,268 | ) |
| Additions to drug licenses and related  costs                                      |   | (268                                      | )      | (386 | ) |
|                                                                               |   |                                      |   |   |   |
| Net cash used in investing activities                                              |   | (2,309                                    | )      | (2,617 | ) |
|                                                                                    |        |                                           |        |  |  |  |  |

 

(Continuedon following page)

 

*The accompanying Notes to CondensedConsolidated Financial Statements are an integral part of these financialstatements.*

 

6

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**BENTLEYPHARMACEUTICALS, INC. AND SUBSIDIARIES**

**CONSOLIDATEDSTATEMENTS OF CASH FLOWS (concluded)**

 

*(in thousands)*

 
|                                                                                               |   | **For the  Three Months Ended March 31,** |   |
|----------------------------------------------------------------------------------------------------|--------|-------------------------------------------|--------|
|                                                                                               |   | **2004**                                  |   | **2003** |   |
|                                                                                               |   |                                      |   |   |   |
| Cash flows from financing activities:                                                              |   |                                      |   |   |   |
| Proceeds from exercise of stock options                                                            |   | $                                         | 122    |   | $ | 30 |   |
| Repayment of borrowings                                                                            |   | (594                                      | )      | (895 | ) |
| Proceeds from borrowings                                                                           |   | 84                                        |   | 720 |   |
|                                                                                               |   |                                      |   |   |   |
| Net cash used in financing activities                                                              |   | (388                                      | )      | (145 | ) |
|                                                                                               |   |                                      |   |   |   |
| Effect of exchange rate changes on cash                                                            |   | (326                                      | )      | 193 |   |
|                                                                                               |   |                                      |   |   |   |
| Net decrease in cash and cash equivalents                                                          |   | (1,581                                    | )      | (539 | ) |
|                                                                                               |   |                                      |   |   |   |
| Cash and cash equivalents at beginning of  period                                                  |   | 39,393                                    |   | 26,581 |   |
|                                                                                               |   |                                      |   |   |   |
| Cash and cash equivalents at end of period                                                         |   | $                                         | 37,812 |   | $ | 26,042 |   |
|                                                                                               |   |                                      |   |   |   |
| **Supplemental Disclosures of Cash Flow Information**                                              |   |                                      |   |   |   |
| The Company paid cash during the period for*:*                                                     |   |                                      |   |   |   |
|                                                                                               |   |                                      |   |   |   |
| Interest                                                                                           |   | $                                         | 46     |   | $ | 42 |   |
|                                                                                               |   |                                      |   |   |   |
| **Supplemental Disclosures of Non-Cash Financing and  Investing Activities**                       |   |                                      |   |   |   |
| The Company has issued or is obligated to issue Common Stock in  exchange for services as follows: |   |                                      |   |   |   |
|                                                                                               |   |                                      |   |   |   |
| Shares                                                                                             |   | 7                                         |   | 49 |   |
| Amount                                                                                             |   | $                                         | 101    |   | $ | 391 |   |
|                                                                                               |   |                                      |   |   |   |
| Included in accounts payable at period-end are fixed asset and drug  license purchases totaling    |   | $                                         | 1,619  |   | $ | 910 |   |

 

*The accompanying Notes to CondensedConsolidated Financial Statements are an integral part of these financialstatements.*

 

7

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**BENTLEY PHARMACEUTICALS,INC. AND SUBSIDIARIES**

 

**NOTES TOCONSOLIDATED FINANCIAL STATEMENTS**

 

HISTORY AND OPERATIONS:

 

Bentley Pharmaceuticals, Inc. andSubsidiaries (which may be referred to as *Bentley Pharmaceuticals*, *Bentley*,*theCompany*, *we*, *us* or *our*) is a U.S.-based internationalspecialty pharmaceutical company, incorporated in the State 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. and international patents and other proprietary rights totechnologies that facilitate the absorption of drugs.  Our pharmaceutical product sales and licensing activities arebased in Spain, where we have a significant commercial presence and manufactureand market approximately 100 pharmaceutical products through three wholly-ownedSpanish subsidiaries, Laboratorios Belmac, Laboratorios Davur and LaboratoriosRimafar. These products represent various dosage strengths and productformulations of more than 30 chemical entities in four primary therapeuticareas: cardiovascular, gastrointestinal, neurological and infectious diseases.We continually add to our product portfolio in response to increasing marketdemand for generic and branded therapeutic agents and divest portfolio productsthat we consider to be redundant or that have become non-strategic.  Although most of our sales of these productsare currently in the Spanish market, we have recently focused on increasing oursales in other European countries and other geographic regions through strategicalliances with companies in these countries. We have a strategic alliance withTeva Pharmaceutical Industries Ltd. granting us the right to register andmarket in Spain more than 75 of Teva’s pharmaceutical products through oursales force of approximately 150 full-time personnel located in major citiesthroughout Spain.  In addition, ourSpanish manufacturing facility produces pharmaceutical products which aremarketed by pharmaceutical 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. Subsequent to March 31, 2004, we purchased an FDA approvedmanufacturing facility, located in Spain, which specializes in themanufacture of several active pharmaceutical ingredients (API).  We will manufacture and market theseproducts through our newly formed subsidiary, Bentley API.

 

We develop products which incorporate our drug delivery technologiesand have licensed applications of our proprietary CPE-215® drug deliverytechnology to Auxilium Pharmaceuticals, Inc., which launched TestimTM, the firstproduct incorporating our drug delivery technology, in February 2003.  Testim is a gel indicated for testosteronereplacement therapy which restores serum testosterone levels in men and therebyimproves symptoms of health problems associated with low testosterone levels(hypogonadism), including loss of muscle mass and a decrease in sexual desire,sexual motivation and frequency of spontaneous erections. We are in discussionswith other pharmaceutical and biotechnology companies to form additionalstrategic alliances to facilitate the development and commercialization ofother products using our drug delivery technologies, including productcandidates that deliver insulin to diabetic patients intranasally and treatnail fungus infections topically.

 

8

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BASIS OF CONSOLIDATED FINANCIAL STATEMENTS:

 

The consolidated financialstatements of Bentley Pharmaceuticals as of March 31, 2004 and for the threemonths ended March 31, 2004 and 2003, included herein, have been prepared byus, without audit, pursuant to the rules and regulations of the Securities andExchange Commission.  Certaininformation and footnote disclosures normally included in financial statementsprepared in accordance with accounting principles generally accepted in theUnited States of America have been condensed or omitted insofar as suchinformation was disclosed in our consolidated financial statements for the yearended December 31, 2003.  Theseconsolidated financial statements should be read in conjunction with thesummary of significant accounting policies and the audited consolidatedfinancial statements and notes thereto included in our Annual Report on Form10-K for the year ended December 31, 2003.

 

In the opinion of management,the accompanying unaudited consolidated financial statements as of March 31,2004 and for the three months ended March 31, 2004 and 2003 are presented on abasis consistent with the audited consolidated financial statements for theyear ended December 31, 2003 and contain all adjustments, consisting only ofnormal recurring adjustments, necessary to present fairly Bentley’s financialposition as of March 31, 2004 and the results of our operations and our cashflows for the three months ended March 31, 2004 and 2003.  The results of operations for the threemonths ended March 31, 2004 should not necessarily be considered indicative ofthe results to be expected for the full year ending December 31, 2004.

 

CASH AND CASH EQUIVALENTS ANDRESTRICTED CASH:

 

Included in *cash and cash equivalents* atMarch 31, 2004 and December 31, 2003 are approximately $34,344,000 and$29,156,000, respectively, of short-term investments considered to be cashequivalents, as the remaining maturity dates of such investments were threemonths or less when purchased.

 

The Company acquired intellectual property during the year endedDecember 31, 2003 for $1,000,000 plus future royalties on sales and licensingincome. In connection with the acquisition, the Company obtained a renewable,irrevocable letter of credit in the amount of $1,000,000 in favor of the sellerto guarantee future royalty payments. The $1,000,000 used to secure the letterof credit has been classified as *restricted cash* in the ConsolidatedBalance Sheets as of March 31, 2004 and December 31, 2003.

 

MARKETABLESECURITIES:

 

The Company hasinvestments in securities, with maturities of greater than three months whenpurchased, which are classified as available-for-sale, totaling $1,218,000 asof March 31, 2004, compared to $1,252,000 as of December 31, 2003. The Company’s investments are carried atamortized cost which approximates fair value due to the short-term nature ofthese investments.  Accordingly, nounrealized gains or losses have been recognized on these investments. Shouldthe fair values differ significantly from the amortized costs, unrealized gainsor losses would be included 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):

 
|                                     |   | **March 31,  2004** |   | **December 31, 2003** |   |
|------------------------------------------|--------|---------------------|--------|-----------------------|--------|
| Raw materials                            |   | $                   | 5,233  |                  | $      | 5,351 |   |
| Finished goods                           |   | 2,278               |   | 1,829                 |   |
|                                     |   | 7,511               |   | 7,180                 |   |
| Less allowance for slow moving inventory |   | (72                 | )      | (74                   | )      |
|                                     |   | $                   | 7,439  |                  | $      | 7,106 |   |

 

FIXEDASSETS:

 

Fixed assets consist of the following (inthousands):

** **
|                          |   | **March 31,  2004** |   | **December 31, 2003** |   |
|-------------------------------|--------|---------------------|--------|-----------------------|--------|
| Land                          |   | $                   | 1,867  |                  | $      | 1,900 |   |
| Buildings                     |   | 8,879               |   | 9,085                 |   |
| Equipment                     |   | 12,666              |   | 10,953                |   |
| Furniture and fixtures        |   | 1,465               |   | 1,497                 |   |
| Leasehold improvements        |   | 44                  |   | 43                    |   |
|                          |   | 24,921              |   | 23,478                |   |
| Less accumulated depreciation |   | (5,284              | )      | (4,912                | )      |
|                          |   | $                   | 19,637 |                  | $      | 18,566 |   |

 

In order to support the Company’s growth inEurope, we are adding additional capacity to our manufacturing facility througha series of improvements. During the three months ended March 31, 2004, theCompany invested approximately $1,663,000 for machinery and equipment,including new high speed manufacturing and packaging equipment.

 

Subsequent to March 31, 2004, we purchased an FDA approved manufacturing facility,located in Spain which specializes in the manufacture of several activepharmaceutical ingredients, including methocarbamal (30 tons per annum), silversulfadiazine (7 tons per annum), nimodipine, guaifenesin and ambroxol, forapproximately $3,300,000. We will manufacture and market these products throughour newly formed subsidiary, Bentley API.  The 20,000 square foot facility is currentlyFDA approved for one product, which it sells to several customers in the UnitedStates.  FDA approvals for additionalproducts manufactured in the facility are currently pending.  The facility is also certified for EuropeanUnion production of API.

 

Depreciation expense of approximately$129,000 and $65,000 has been charged to operations as a component of *depreciation and amortization expense* inthe Consolidated Income Statements for the three months ended March 31, 2004and 2003, respectively. We have included depreciation totaling approximately$423,000 and $217,000 in *cost of net productsales* during the three months ended March 31, 2004 and 2003,respectively.

 

STOCKHOLDERS’EQUITY:

 

A substantial amount of our business isconducted in Europe and is therefore influenced by fluctuations in the U.S.Dollar’s value against other currencies, specifically the Euro. The exchangerate at March 31, 2004 and December 31, 2003 was .82 Euros and .80 Eurosper U.S. Dollar, respectively. The weighted average exchange rate for the threemonths ended March 31, 2004 and

 

10

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2003 was..81 Euros and .93 Euros per U.S. Dollar, respectively. The effect of foreigncurrency fluctuations on long lived assets for the three months endedMarch 31, 2004 was a decrease of $1,229,000 and the cumulative historicaleffect was an increase of $3,940,000, as reflected in our Consolidated BalanceSheets as *accumulated other**comprehensive income*. Although exchangerates 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, the Euro. However, the carryingvalue of assets and liabilities can be materially impacted by foreign currencytranslation, as can the translated amounts of revenues and expenses.

 

During the three months ended March 31,2004, we issued 20,000 shares of Common Stock upon exercise of employee stockoptions, and approximately 8,000 shares of Common Stock as equity-basedcompensation in lieu of cash contributions to the Company-sponsored 401(k)retirement savings plan.  Also duringthe three months ended March 31, 2004 we awarded our employees stock options topurchase approximately 403,000 shares of Common Stock.

 

LICENSINGAND COLLABORATION REVENUES:

 

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 paymentto us 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 three months ended March 31, 2004 and 2003, we recognizedroyalty revenues of $554,000 and $50,000, respectively, based on an estimate ofprescriptions filled.  The differencebetween the total amount earned from Auxilium under the royalty arrangement andthe amount recognized as *licensing and collaboration revenues* isrecorded as a component of *deferred income* in the ConsolidatedBalance Sheets.  As of March 31, 2004and December 31, 2003, deferred income from Testim royalties totaled $681,000and $634,000, respectively.  We willcontinue to use available market information to determine the amount and timingof royalty revenue recognition. Auxilium has recently filed an initial public offering with the SEC andhas indicated in that filing, that approximately 30% of the proceeds from itsoffering of stock will be dedicated to furthering the commericialization ofTestim.

 

# **PROVISION FOR INCOME TAXES:**

 

As a result of reporting taxable income in Spain, we recordedprovisions for foreign income taxes totaling $921,000 and $1,151,000 for thethree months ended March 31, 2004 and 2003, respectively. These amountsrepresent 37% and 36% of the pre-tax income reported in Spain of $2,482,000 and$3,172,000 for the three months ended March 31, 2004 and 2003, respectively. Notax benefit has been recorded for U.S. losses, which totaled ($752,000) and($489,000) for the three months ended March 31, 2004 and 2003, respectively, asfuture domestic operating profits cannot be reasonably assured. Accordingly, wehave established a valuation allowance equal to the full amount of the U.S.deferred tax assets. The provisions for income taxes differ from the amountscomputed by applying the U.S. federal income tax rate of 34% to pretax income,primarily as a result of the increase in the valuation allowance to offset U.S.deferred tax assets, certain nondeductible expenses in Spain and the higherstatutory income tax rate of 35% in Spain.

 

11

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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. We are currently undergoing a tax review of our Spanish subsidiary,Laboratorios Belmac S.A., by the Spanish tax authorities.  Certain tax contingencies exist and whenprobable and reasonably estimable, are provided for in the ConsolidatedFinancial Statements. Accordingly, as of March 31, 2004, since thesecontingencies are not considered probable or reasonably estimable, no amountshave been provided for these contingencies. However, there is the possibilitythat the ultimate resolution of such issues could have an adverse effect on ourresults of operations.

 

BASIC AND DILUTED NET INCOMEPER COMMON SHARE:

 

Basic and diluted net incomeper common share is based on the weighted average number of shares of commonstock outstanding during each period. The dilutive effect of our outstandingstock options and stock purchase warrants, as calculated using the treasurystock method, were considered in the net income per share calculations for thethree months ended March 31, 2004 and 2003.

 

The following is areconciliation between basic and diluted net income per common share for thethree months ended March 31, 2004 and 2003. Dilutive securities issuable for the three months ended March 31, 2004include approximately 2,187,000 shares issuable as a result of various stockoptions and warrants that are outstanding and exercisable.  Dilutive securities issuable for the threemonths ended March 31, 2003 included approximately 1,168,000 shares that wereissuable as a result of Class B Warrants and approximately 1,727,000 sharesthat were issuable as a result of various stock options and other warrants thatwere outstanding at that time.

 

(in thousands, except per sharedata)

 

For the Three Months EndedMarch 31, 2004:

 
|                                       |   | **Basic EPS** |   | **Effect of  Dilutive  Securities** |   | **Diluted  EPS** |   |
|--------------------------------------------|--------|---------------|--------|-------------------------------------|--------|------------------|--------|
| Net Income                                 |   | $             | 809    |                                | $      | —           |   | $ | 809 |   |
| Weighted Average Common Shares Outstanding |   | 20,597        |   | 2,187                               |   | 22,784           |   |
| Net Income Per Common Share                |   | $             | 0.04   |                                | $      | —           |   | $ | 0.04 |   |

 

For the Three Months Ended March 31, 2003:

 
|                                       |   | **Basic EPS** |   | **Effect of  Dilutive  Securities** |   | **Diluted  EPS** |   |
|--------------------------------------------|--------|---------------|--------|-------------------------------------|--------|------------------|--------|
| Net Income                                 |   | $             | 1,532  |                                | $      | —           |   | $ | 1,532 |   |
| Weighted Average Common Shares Outstanding |   | 17,455        |   | 2,895                               |   | 20,350           |   |
| Net Income Per Common Share                |   | $             | 0.09   |                                | $      | (0.01            | )      | $ | 0.08 |   |

 

Excluded from the diluted EPS presentation, because their exerciseprices were greater than the average fair value of the Common Stock in therespective periods, were warrants and options to purchase an aggregate of642,000 and 1,011,000 shares of Common Stock, for the three months ended March31, 2004 and 2003, respectively.

 

12

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STOCK BASED COMPENSATION:

 

We have stock-based employee compensationplans that are described more fully in Note 11 of the Notes to ConsolidatedFinancial Statements included in the Annual Report on Form 10-K for the yearended December 31, 2003.  We account forthese plans under the recognition and measurement principles of AccountingPrinciples 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 (*theCompensation Committee*), the Company grants shares of its CommonStock to employees in lieu of cash compensation. Related stock-based employeecompensation costs are reflected in the Consolidated Income Statements andStatements of Cash Flows.

 

General and administrative expenses for thethree months ended March 31, 2004 and 2003 include $32,000 and $70,000,respectively, of non-cash equity-based compensation. Research and developmentexpenses for the three months ended March 31, 2004 and 2003 include$28,000 and $71,000, respectively, of non-cash equity-based compensation.

 

The following table illustrates the effect on net income per share ifwe had applied the fair value recognition provisions of Statement of Financial Accounting Standards (“SFAS”) No. 123, *Accountingfor Stock-Based Compensation*, to stock-based employee compensation.

 

|                                                                                                       |   | **For the  Three Months Ended  March 31,** |   |
|------------------------------------------------------------------------------------------------------------|--------|--------------------------------------------|--------|
|                                                                                                       |   | **2004**                                   |   | **2003** |   |
|                                                                                                       |   |                                       |   |   |   |
| Net income, as reported                                                                                    |   | $                                          | 809    |   | $ | 1,532 |   |
|                                                                                                       |   |                                       |   |   |   |
| Add: Stock-based employee compensation  expense included in reported net income                            |   | 60                                         |   | 141 |   |
|                                                                                                       |   |                                       |   |   |   |
| Deduct: Total stock-based employee  compensation expense determined under fair value method for all awards |   | (601                                       | )      | (512 | ) |
|                                                                                                       |   |                                       |   |   |   |
| Pro forma net income                                                                                       |   | $                                          | 268    |   | $ | 1,161 |   |
|                                                                                                       |   |                                       |   |   |   |
| Net income per common share:                                                                               |   |                                       |   |   |   |
| Basic - as reported                                                                                        |   | $                                          | 0.04   |   | $ | 0.09 |   |
| Basic - pro forma                                                                                          |   | $                                          | 0.01   |   | $ | 0.07 |   |
|                                                                                                       |   |                                       |   |   |   |
| Diluted - as reported                                                                                      |   | $                                          | 0.04   |   | $ | 0.08 |   |
| Diluted - pro forma                                                                                        |   | $                                          | 0.01   |   | $ | 0.06 |   |

 

13

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The preceding pro forma results were calculated using the Black-Scholesoption pricing model with the following weighted average assumptions (resultsmay vary depending on the assumptions applied within the model):

 

|                          |   | **For the  Three Months Ended  March 31,** |   |
|-------------------------------|--------|--------------------------------------------|--------|
|                          |   | **2004**                                   |   | **2003** |   |
|                          |   |                                       |   |   |   |
| Risk-free interest rate       |   | 3.2%                                       |   | 3.1% |   |
| Dividend yield                |   | 0.0%                                       |   | 0.0% |   |
| Expected life                 |   | 5 years                                    |   | 5 years |   |
| Volatility                    |   | 49.3%                                      |   | 50.6% |   |
| Fair value of options granted |   | $5.51                                      |   | $3.87 |   |

 

Stock or other equity-based compensation fornon-employees is accounted for under the fair value method as required by SFASNo. 123 and Emerging Issues Task Force (“EITF”) Issue No. 96-18, *Accounting for Equity Instruments ThatAre Issued to Other Than Employees for Acquiring, or in Conjunction withSelling, Goods or Services* and other related interpretations.

 

RECLASSIFICATIONS:

 

Certain prior period amounts have been reclassified to conform with thecurrent period’s presentation.  Suchreclassifications are not material to the Consolidated Financial Statements.

 

NEW ACCOUNTING PRONOUNCEMENTS:

 

In November 2002, the EITFreleased Issue No. 00-21, *Accounting for Revenue Arrangements with MultipleDeliverables*, which addresses certain aspects of the accounting by avendor for arrangements under which it will perform multiple revenue-generatingactivities. EITF Issue No. 00-21 establishes three principles: revenuearrangements with multiple deliverables should be evaluated to determine ifseparate units of accounting exist; arrangement consideration should beallocated among the separate units of accounting based on their relative fairvalues; and revenue recognition criteria should be considered individually foreach separate unit of accounting. EITF Issue No. 00-21 is effective for allrevenue arrangements entered into in fiscal periods beginning after June 15,2003. The adoption of EITF Issue No. 00-21 in our third quarter of 2003 did nothave a material effect on our financial position, results of operations or cashflows for the year ended December 31, 2003. However, the adoption of EITF Issue No. 00-21 requires the deferral andrecognition over extended periods, of certain up-front fees, even if such feesor payments are non-refundable, associated with our multiple elementcollaboration and license agreements and of our marketing, distribution andsupply agreements and may have an impact on future periods.

 

 

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# **Item 2.**                     Management’s Discussion andAnalysis of Financial Condition and Results of Operations

 

You shouldread the following discussion and analysis together with all financial andnon-financial information appearing elsewhere in this report and with ourconsolidated financial statements and related notes included in our AnnualReport on Form 10-K for the year ended December 31, 2003, which has beenpreviously filed with the SEC. In addition to historical information, thefollowing discussion and other parts of this report contain forward-lookinginformation that involves risks and uncertainties.  Our actual results could differ materially from those anticipatedby such forward-looking information due to competitive factors and other risksdiscussed below under the caption “Important Factors That May Affect FutureResults”.

 

**RESULTS OFOPERATIONS:**

 

**Three Months Ended March 31, 2004 versusThree Months Ended March 31, 2003**

 

*Revenues*

 

|                                   |   | **For the  Three Months Ended March 31,** |     | **Change** |     |
|----------------------------------------|--------|-------------------------------------------|----------|------------|----------|
| **(in  thousands)**                    |   | **2004**                                  |     | **%**      |     | **2003** |   | **%** |   | **$** |   | **%** |   |
| *Revenues:*                            |   |                                      | * * |       | * * |   | * * |   | * * |   | * * |   | * * |
| *Net product sales*                    |   | *$*                                       | *16,606* | * *   | *96%*    |   | *$* | *14,235* | * * | *95%* |   | *$* | *2,371* | * * | *17%* |   |
| *Licensing and collaboration revenues* |   | *696*                                     | * * | *4%*       |     | *753* | * * | *5%* |   | *(57* | *)* | *-8%* |   |
| *Total revenues*                       |   | *$*                                       | *17,302* | * *   | *100%*   |   | *$* | *14,988* | * * | *100%* |   | *$* | *2,314* | * * | *15%* |   |

 

Total revenues for the three months ended March 31, 2004 increased 15%from the same period in the prior year. However, our total revenues increasedapproximately 1% when expressed in constant currency. An increase in theweighted average value of the Euro, in relation to the U.S. Dollar, had the effect ofincreasing revenues by approximately $2,143,000, offsetting the impactof recent price reductions in Spain during the first quarter of 2004. Inaddition to the favorable impact of exchange rate fluctuation, the increasereflects the continued growth of our Spanish operations despite recent pricereductions (the Company shipped approximately 25% more units of product in thefirst quarter of 2004 than in the first quarter of 2003) and, to a lesserdegree, the advancement of our proprietary drug delivery programs in the U.S.,as evidenced by the growing royalty stream from sales of Testim, the firstmarketed product incorporating our CPE-215 drug delivery technology, which waslaunched by our licensee in February 2003.

 

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). See a summaryof our revenues by sales channel and top-selling product lines below:

 

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For the threemonths ended March 31, 2004:

 
|                           |   | **Sales  Within Spain** |     |                  |     |                           |     |                |     |
|--------------------------------|--------|-------------------------|----------|-----------------------|----------|--------------------------------|----------|---------------------|----------|
| ***(in thousands)***           |   | **Branded  Products**   |     | **Generic  Products** |     | **Contract  Manu-  facturing** |     | **Other  Revenues** |     | **Total** |   | **% of Total  Revenues** |   |
| **Product  Line**              |
|                           |   |                    |     |                  |     |                           |     |                |     |   |   |   |   |
| *Omeprazole*                   |   | *$*                     | *533*    | * *              | *$*      | *3,288*                        | * * | *$*                 | *—* | * * | *$* | *—* | * * | *$* | *3,821* | * * | *22* | *%* |
| *Paroxetine*                   |   | *250*                   | * * | *820*                 | * * | *—*                       | * * | *—*            | * * | *1,070* | * * | *6* | *%* |
| *Simvastatin*                  |   | *239*                   | * * | *773*                 | * * | *—*                       | * * | *—*            | * * | *1,012* | * * | *6* | *%* |
| *Codeisan*                     |   | *903*                   | * * | *-*                   | * * | *—*                       | * * | *—*            | * * | *903* | * * | *5* | *%* |
| *Enalapril*                    |   | *662*                   | * * | *209*                 | * * | *—*                       | * * | *—*            | * * | *871* | * * | *5* | *%* |
| *All other products*           |   | *1,704*                 | * * | *1,693*               | * * | *—*                       | * * | *—*            | * * | *3,397* | * * | *20* | *%* |
| *Contract manufacturing*       |   | *—*                | * * | *—*              | * * | *2,534*                        | * * | *—*            | * * | *2,534* | * * | *15* | *%* |
| *Sales outside of Spain*       |   | *—*                | * * | *—*              | * * | *—*                       | * * | *2,998*             | * * | *2,998* | * * | *17* | *%* |
| *Licensing and collaborations* |   | *—*                | * * | *—*              | * * | *—*                       | * * | *696*               | * * | *696* | * * | *4* | *%* |
| *Total Revenues*               |   | *$*                     | *4,291*  | * *              | *$*      | *6,783*                        | * * | *$*                 | *2,534*  | * * | *$* | *3,694* | * * | *$* | *17,302* | * * | *100* | *%* |
| *% of Total Revenues*          |   | *25%*                   |     | *39%*                 |     | *15%*                          |     | *21%*               |     | *100%* |   |   |   |

 

For the threemonths ended March 31, 2003:

 
|                           |   | **Sales  Within Spain** |     |                  |     |                           |     |                |     |
|--------------------------------|--------|-------------------------|----------|-----------------------|----------|--------------------------------|----------|---------------------|----------|
| ***(in thousands)***           |   | **Branded  Products**   |     | **Generic  Products** |     | **Contract  Manu-  facturing** |     | **Other  Revenues** |     | **Total** |   | **% of Total  Revenues** |   |
| **Product  Line**              |
|                           |   |                    |     |                  |     |                           |     |                |     |   |   |   |   |
| *Omeprazole*                   |   | *$*                     | *1,499*  | * *              | *$*      | *3,151*                        | * * | *$*                 | *—* | * * | *$* | *—* | * * | *$* | *4,650* | * * | *31* | *%* |
| *Paroxetine*                   |   | *—*                | * * | *—*              | * * | *—*                       | * * | *—*            | * * | *—* | * * | *0* | *%* |
| *Simvastatin*                  |   | *372*                   | * * | *796*                 | * * | *—*                       | * * | *—*            | * * | *1,168* | * * | *8* | *%* |
| *Codeisan*                     |   | *706*                   | * * | *—*              | * * | *—*                       | * * | *—*            | * * | *706* | * * | *5* | *%* |
| *Enalapril*                    |   | *505*                   | * * | *457*                 | * * | *—*                       | * * | *—*            | * * | *962* | * * | *6* | *%* |
| *All other products*           |   | *1,225*                 | * * | *1,497*               | * * | *—*                       | * * | *—*            | * * | *2,722* | * * | *18* | *%* |
| *Contract manufacturing*       |   | *—*                | * * | *—*              | * * | *2,486*                        | * * | *—*            | * * | *2,486* | * * | *17* | *%* |
| *Sales outside of Spain*       |   | *—*                | * * | *—*              | * * | *—*                       | * * | *1,541*             | * * | *1,541* | * * | *10* | *%* |
| *Licensing and collaborations* |   | *—*                | * * | *—*              | * * | *—*                       | * * | *753*               | * * | *753* | * * | *5* | *%* |
| *Total Revenues*               |   | *$*                     | *4,307*  | * *              | *$*      | *5,901*                        | * * | *$*                 | *2,486*  | * * | *$* | *2,294* | * * | *$* | *14,988* | * * | *100* | *%* |
| *% of Total Revenues*          |   | *29%*                   |     | *39%*                 |     | *17%*                          |     | *15%*               |     | *100%* |   |   | * * |

 

*Spanish Operations.*    The core of our Spanish operations hasbeen the efficient manufacturing and domestic marketing of branded and genericpharmaceutical products.  Historically,our pharmaceutical products were sold only within Spain.  However, the execution of our long-termstrategic plan over the past eight years has created an opportunity for ourSpanish operations to expand beyond the borders of Spain and into otherEuropean countries and other countries outside of Europe.First quarter 2004 product sales have beenfueled by the introduction of our paroxetine product line, which was launchedin May of 2003.  Our paroxetine productline generated net sales of $1,070,000, representing 6% of our total revenuesduring the three months ended March 31, 2004. Revenues from our paroxetine products were second only to our omeprazoleproducts in the first quarter of 2004, which in spite of recently reducedselling prices, comprised 22% of our total revenues in the first quarter of2004, compared to 31% in the same quarter of the prior year.

 

16

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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 risinghealthcare costs. In further efforts to reduce healthcare costs, the Ministryof Health had contemplated new laws and regulations that would significantlyreduce the market 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 revenues in theyear ended December 31, 2003. These new prices were required to take effect onDecember 26, 2003.  However, we, and some other pharmaceutical companiesin Spain, strategically implemented the new prices on December 1, 2003.

 

Although the law required laboratories to begin selling at the newprices in December 2003, pharmacies in Spain were able to continue to sell atthe old higher prices until January 31, 2004. This transition period was an attempt to reduce returns of the higherpriced products by allowing the higher priced products to pass through thedistribution channel to the end users. On average, our customers maintain a stock of approximately one to twomonths' supply of our products.  As webegan selling at the new lower prices on December 1, 2003, we expected themajority of our products that were labeled and stamped at the old higher pricesto have cleared the distribution channel by January 31, 2004. We experienced anunforeseen level of returns totaling approximately $1,800,000 between midFebruary and mid March.  A majority ofthe products returned were either expired, nearing expiration or otherwise notresalable and consequently were destroyed. As these product returns exceeded our allowance for estimated salesreturns, they 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.  Consequently ourgross margins on net product sales were negatively impacted by four percentagepoints which contributed to a temporary decline in our margins to 51% for thethree months ended March 31, 2004 compared to 57% for the three months endedMarch 31, 2003.  Price reductions andproduct mix constitute the additional decrease of two percentage points in thefirst quarter.  We expect our grossmargins on product sales to be approximately 54% to 56% in the second quarter.

 

We have implemented several initiatives to mitigate the decline inmargins. We expect to continue to increase our future sales volume throughour pipeline of approximately 100 products, consisting of approximately 20chemical entities that are not affected by the new pricing regulations.  In addition, we have modified our pricingstructure in efforts to increase our sales volume and market share throughoutSpain. We will continue to focus on acquiring, developing and launching newproducts that will improve our product mix. We will also continue our effortsto increase our sales outside of Spain through additional registration,marketing, and supply agreements. Over the past several years we have madesignificant investments in renovating and increasing capacity in ourmanufacturing facility, as well as investments in new high speed, high volumeequipment. Those investments are enabling us to manufacture and package largerquantities of products more efficiently and cost effectively. We anticipate that our gross margins will beginto gradually increase in the next few quarters as we continue to implement ourstrategy and benefit from economies of scale. See additional discussion aboutour gross margins below under the caption *Gross Profit*.

 

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*Branded Pharmaceutical Products*

 
|                         |   | **For the  Three Months Ended March 31,** |     | **Change** |     |
|------------------------------|--------|-------------------------------------------|----------|------------|----------|
| **(in  thousands)**          |   | **2004**                                  |     | **%**      |     | **2003** |   | **%** |   | **$** |   | **%** |   |
| *Branded Product Sales:*     |   |                                      | * * |       | * * |   | * * |   | * * |   |   |   | * * |
| *Paroxetine*                 |   | $                                         | 250      | * *   | *6%*     |   | $ | — | * * | *** |   | $ | 250 |   | *** |   |
| *Codeisan*                   |   | 903                                       | * * | *21%*      |     | 706 | * * | *16%* |   | 197 |   | *28%* |   |
| *Enalapril*                  |   | 662                                       | * * | *15%*      |     | 505 | * * | *12%* |   | 157 |   | *31%* |   |
| *Simvastatin*                |   | 239                                       | * * | *6%*       |     | 372 | * * | *9%* |   | (133 | ) | *-36%* |   |
| *Omeprazole*                 |   | 533                                       | * * | *12%*      |     | 1,499 | * * | *35%* |   | (966 | ) | *-64%* |   |
| *All other branded products* |   | 1,704                                     | * * | *40%*      |     | 1,225 | * * | *28%* |   | 479 |   | *39%* |   |
| *Total branded sales*        |   | $                                         | 4,291    | * *   | *100%*   |   | $ | 4,307 | * * | *100%* |   | $ | (16 | ) | *0%* |   |

 

----

*  Not meaningful

 

Sales of ourbranded pharmaceutical products remained relatively constant in U.S. Dollarscompared to the prior year, and they accounted for 25% of total revenues duringthe three months ended March 31, 2004 compared to 29% of total revenues duringthe three months ended March 31, 2003. An increase in the weighted average value of the Euro, in relation to theU.S. Dollar, had the effect of increasing branded net product sales byapproximately $562,000 in the first quarter of 2004.  Most significantly, sales of our branded omeprazole andsimvastatin products decreased by approximately $966,000 and $133,000,respectively, from the same quarter in the prior year as a result of the recentprice reductions. Our branded omeprazole, Belmazol, for example, experiencedthe most severe of the price reductions, suffering on average a 61% price cut.Even in the face of these price cuts and strong generic competition, we weresuccessful in maintaining market share and sold approximately the same numberof units of Belmazol in the first quarter of 2004 as in the comparable periodof the prior year. A 60% increase in unit sales of Enalapril and the launch ofour branded version of paroxetine in May of 2003 helped mitigate the impact of theprice cuts. Our branded enalapril continued to be a major contributor to ourbranded pharmaceutical revenues, even though its sales were affected by theprice reductions. While we expect to continue to develop, acquire, and launchnew branded products, our focus on generics and sales outside of Spain areexpected to increase those revenues at a significantly higher pace than that ofour branded products.

 

*Generic Pharmaceutical Products*

 
|                         |   | **For the  Three Months Ended March 31,** |     | **Change** |     |
|------------------------------|--------|-------------------------------------------|----------|------------|----------|
| **(in  thousands)**          |   | **2004**                                  |     | **%**      |     | **2003** |   | **%** |   | **$** |   | **%** |   |
| *Generic Product Sales:*     |   |                                      | * * |       | * * |   | * * |   | * * |   |   |   | * * |
| *Paroxetine*                 |   | $                                         | 820      | * *   | *12%*    |   | $ | — | * * | *** |   | $ | 820 |   | *** |   |
| *Pentoxifylline*             |   | 691                                       | * * | *10%*      |     | 446 | * * | *8%* |   | 245 |   | *55%* |   |
| *Omeprazole*                 |   | 3,288                                     | * * | *49%*      |     | 3,151 | * * | *53%* |   | 137 |   | *4%* |   |
| *Simvastatin*                |   | 773                                       | * * | *11%*      |     | 796 | * * | *13%* |   | (23 | ) | *-3%* |   |
| *All other generic products* |   | 1,211                                     | * * | *18%*      |     | 1,508 | * * | *26%* |   | (297 | ) | *-20%* |   |
| *Total generic sales*        |   | $                                         | 6,783    | * *   | *100%*   |   | $ | 5,901 | * * | *100%* |   | $ | 882 |   | *15%* |   |
|                              |        |                                           |          |            |          |  |  |  |  |  |  |  |  |  |  |  |  |

 

----

*  Not meaniningful

 

Sales of ourgeneric pharmaceutical products increased by 15% during the three months endedMarch 31, 2004 compared to the three months ended March 31, 2003.  An increase in the weighted average value ofthe Euro, inrelation to the U.S. Dollar, had the effect of increasing genericproduct sales by approximately $953,000 in the first quarter of 2004. Strongsales of our generic omeprazole accounted for 49% of our generic pharmaceuticalrevenues in the first quarter of 2004, compared to 53% of generic revenues inthe first quarter of the prior year, in spite of the recent price reductions.  Sales of our generic paroxetine, which waslaunched in May of 2003, added approximately $820,000 to our generic sales,positioning it second only to our generic omeprazole in the first quarter,accounting for 93% of the growth in generic product sales when compared to the

 

18

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comparable period of the prioryear.  Sales of our genericpentoxifylline increased by approximately $245,000, or approximately 55% fromthe same quarter in the prior year, while sales of our generic simvastatin,while higher in terms of units sold, remained relatively flat when sales areexpressed in U.S. Dollars, accounting for approximately 11% of our genericpharmaceutical sales in the first quarter of 2004. We expect to continue toincrease our generic drug portfolio and increase our generic drug sales inSpain as products come off patent in the future.

 

*Contract Manufacturing*

 
|                     |   | **For the  Three Months Ended March 31,** |    | **Change** |   |
|--------------------------|--------|-------------------------------------------|---------|------------|--------|
| **(in  thousands)**      |   | **2004**                                  |    | **2003**   |   | **$** |   | **%** |   |
|                     |   |                                      |    |       |   |   |   |   |   |
| *Contract manufacturing* |   | *$*                                       | *2,534* | * *   | *$*    | *2,486* | * * | *$* | *48* | * * | *2* | *%* |
|                          |        |                                           |         |            |        |  |  |  |  |  |  |  |

 

In addition to manufacturing our own products, our Spanishmanufacturing facility supplies branded and generic products to approximately17 entities in Spain, which market these products under their own name and withtheir own labeling.  Revenues generatedfrom contract manufacturing represented 15% of total revenues inthe three months ended March 31, 2004, compared to 17% of total revenues in thethree months ended March 31, 2003. An increase in the weighted average value ofthe Euro, inrelation to the U.S. Dollar, had the effect of increasing contractmanufacturing sales by approximately $323,000 in the first quarter of 2004. Ourincreased capacity and high speed, high volume equipment enables us tomanufacture pharmaceutical products at relatively low costs. This competitiveadvantage could lead to an increase in contract manufacturing agreementsthroughout 2004 as other pharmaceutical companies in Spain search to find lowcost alternatives to mitigate the impact of the new lower selling prices.

 

*Sales Outside of Spain*

 
|                     |   | **For the  Three Months Ended March 31,** |    | **Change** |   |
|--------------------------|--------|-------------------------------------------|---------|------------|--------|
| **(in  thousands)**      |   | **2004**                                  |    | **2003**   |   | **$** |   | **%** |   |
|                     |   |                                      |    |       |   |   |   |   |   |
| *Sales outside of Spain* |   | *$*                                       | *2,998* | * *   | *$*    | *1,541* | * * | *$* | *1,457* | * * | *95* | *%* |
|                          |        |                                           |         |            |        |  |  |  |  |  |  |  |

 

We haveentered into license and supply agreements with more than 20 entities to sell our products outside of Spain.  Sales under these supply agreementsincreased 95% from 10% of total revenues in the three months ended March 31,2003 to 17% of total revenues in the three months ended March 31, 2004.  The $1,457,000 increase is primarilyattributable to demand for products that we manufacture and sell to customersoutside of Spain.  We believe that ourhighly efficient manufacturing processes could lead to increased sales outsideof Spain as other countries around the world seek to reduce health care costsand other pharmaceutical companies outside of Spain search to find low costmanufacturing alternatives to remain competitive in their respective markets.An increase in the weighted average value of the Euro, in relation to the U.S. Dollar, had theeffect of increasing sales outside of Spain by approximately $382,000during the three months ended March 31, 2004.

 

19

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*Licensing and Collaboration Revenues.* Licensing and collaboration revenuesaccount for 4% of total revenues in the three months ended March 31, 2004.  These revenues include royalties totaling$554,000 (compared to $50,000 in the first quarter of the prior year) from thecommercialization and continuing sales of Testim, the first product incorporating our drug delivery technology, which waslaunched by our licensee, Auxilium, in February 2003. Testim is currentlyreported to capture approximately 10-11% of all new testosterone gelreplacement prescriptions in the market. We have also recognizedrevenues totaling $142,000 during the three months ended March 31, 2004,related to product licensing activities in Europe.  Licensing and collaborationrevenues in the first quarter of the prior year included non-recurring one-timemilestone payments of $500,000.

 

*Gross Profit.*    Grossprofit increased by approximately 3% in the three months ended March 31, 2004compared to the three months ended March 31, 2003 to $9,106,000. As discussedpreviously, our gross margins on netproduct sales decreased to 51% for the three months ended March 31, 2004 from57% during the three months ended March 31, 2003.  Thedecrease in gross margins is the result of unexpected sales returns, which hadthe effect of decreasing our margins on net product sales by four percentagepoints.  We expect our gross margins on product sales to be approximately 54% to56% in the second quarter of 2004.  The government-mandated price reductions and our current product mix,partially offset by an increase in the weighted average value of theEuro, inrelation to the U.S. Dollar, of approximately $1,118,000 during thethree months ended March 31, 2004, explain the balance of the gross marginreduction in the first quarter of 2004.

 

It is possiblethat our gross margins could decrease in the future as sales of higher pricedproducts are continually replaced with sales of lower priced generic products,as a result of a change in our product mix or by additional governmentalaction. However, we have implemented severalinitiatives to mitigate the decline in margins. We expect to continue toincrease our future sales volume through our pipeline of approximately100 products, consisting of approximately 20 chemical entities that are notaffected by the new pricing regulations. In addition, we have modified our pricing structure in efforts toincrease our sales volume and market share throughout Spain. We will continueto focus on acquiring, developing and launching new products that will improve ourproduct mix. We will also continue our efforts to increase our sales outside ofSpain through additional registration, marketing, and supply agreements. Overthe past several years we have made significant investments in renovating andincreasing capacity in our manufacturing facility, as well as investments innew high speed, high volume equipment. Those investments are enabling us tomanufacture and package larger quantities of products more efficiently and costeffectively. We anticipate that our grossmargins will begin to gradually increase in the next few quarters as wecontinue to implement our strategy and benefit from economies of scale.

 

*Selling andMarketing Expenses*

 
|                    |   | **For the  Three Months Ended March 31,** |    | **Change** |   |
|-------------------------|--------|-------------------------------------------|---------|------------|--------|
| **(in  thousands)**     |   | **2004**                                  |    | **2003**   |   | **$** |   | **%** |   |
|                    |   |                                      |    |       |   |   |   |   |   |
| *Selling and marketing* |   | *$*                                       | *3,870* | * *   | *$*    | *3,353* | * * | *$* | *517* | * * | *15* | *%* |
|                         |        |                                           |         |            |        |  |  |  |  |  |  |  |

 

Selling and marketing expenses for the three months ended March 31,2004 increased 15% from the same period in the prior year. The weighted average value of the Euro, inrelation to the U.S. Dollar, had the effect of increasing selling and marketingexpenses by approximately $490,000 in the three months ended March 31,2004, accounting for approximately 95% of the increase.  Selling and marketing expenses as apercentage of net product sales decreased slightly to 23.3% in the three monthsended March 31, 2004 compared to 23.6% of net product sales in the three monthsended March 31, 2003.

 

20

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*General andAdministrative Expenses*

 
|                         |   | **For the  Three Months Ended March 31,** |    | **Change** |   |
|------------------------------|--------|-------------------------------------------|---------|------------|--------|
| **(in  thousands)**          |   | **2004**                                  |    | **2003**   |   | **$** |   | **%** |   |
|                         |   |                                      |    |       |   |   |   |   |   |
| *General and administrative* |   | *$*                                       | *2,162* | * *   | *$*    | *1,559* | * * | *$* | *603* | * * | *39* | *%* |
|                              |        |                                           |         |            |        |  |  |  |  |  |  |  |

 

General and administrative expenses for the three months ended March31, 2004 increased 39% from the same period in the prior year.  The $603,000 increase was the result ofincreased general and administrative activities required to support ourcontinued growth and prepare for our anticipated future growth. These expendituresinclude increased costs in the current year for additional employees, outsideservices, occupancy costs, corporate communications, insurance, etc. Generaland administrative expenses as a percent of total revenues increased toapproximately 12.5% in the three months ended March 31, 2004, compared toapproximately 10.4% of total revenues in the three months ended March 31,2003.  General and administrativeexpenses would have been approximately $174,000 lower, absent the increase inthe weighted average value of the Euro, in relation to the U.S. Dollar, in thethree months ended March 31, 2004. This foreign currency impact accounted foralmost 30% of the increase in general and administrative expenses when comparedto the prior year’s first quarter. We expect that our future expenditures forgeneral and administrative expenses will continue to increase as we grow.Although we cannot reasonably estimate the costs associated with implementationof the internal control provisions of the Sarbanes-Oxley Act of 2002, we doexpect to incur costs not previously experienced.

 

*Research andDevelopment Expenses*

 
|                       |   | **For the  Three Months Ended March 31,** |   | **Change** |   |
|----------------------------|--------|-------------------------------------------|--------|------------|--------|
| **(in  thousands)**        |   | **2004**                                  |   | **2003**   |   | **$** |   | **%** |   |
|                       |   |                                      |   |       |   |   |   |   |   |
| *Research and development* |   | *$*                                       | *995*  | * *   | *$*    | *1,018* | * * | *$* | *(23* | *)* | *-2* | *%* |
|                            |        |                                           |        |            |        |  |  |  |  |  |  |  |

 

Researchand development expenses for the three months ended March 31, 2004 decreased 2% from the sameperiod in the prior year. We completed and reported the results of a Phase Iintranasal insulin trial during the first quarter of 2004.  We are scheduled to commence a study indiabetic patients as part of our clinical program for the intranasal deliveryof insulin in the near future.  In addition, we are currentlyin the planning stages of clinical programs, including bio-equivalence studiesto support the eventual distribution of certain of our Spanish genericpharmaceutical products in other countries, including the U.S. 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 facility inZaragoza, Spain. 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. Althoughcosts incurred in the first quarter of 2004 are consistent with those of thesame quarter in the prior year and some of our cost estimates for our researchand development programs are preliminary, and the specific timing is not known,our research and development expenses for the year ended December 31, 2004could be $1,500,000 to $2,000,000 higher than in the year ended December 31,2003.

 

21

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*Provision forIncome Taxes*

 
|                                   |   | **For the  Three Months Ended March 31, 2004** |     |
|----------------------------------------|--------|------------------------------------------------|----------|
| **(in thousands)**                     |   | **Spain**                                      |     | **U.S.** |   | **Consolidated** |   |
| *Income (loss) before income taxes*    |   | *$*                                            | *2,482*  | * * | *$* | *(752* | *)* | *$* | *1,730* | * * |
| *Provision (benefit) for income taxes* |   | *921*                                          | * * | *(256* | *)* | *665* | * * |
| *Valuation allowance*                  |   | *—*                                       | * * | *256* | * * | *256* | * * |
| *Net provision for income taxes*       |   | *921*                                          | * * | *—* | * * | *921* | * * |
| *Net income (loss)*                    |   | *$*                                            | *1,561*  | * * | *$* | *(752* | *)* | *$* | *809* | * * |
| *Effective tax rate*                   |   | *37%*                                          |     | *0%* |   | *53%* |   |
|                                        |        |                                                |          |  |  |  |  |  |  |  |  |

 

We recorded a provision for foreign income taxes totaling $921,000(approximately 37% of the Spanish pretax income of $2,482,000) for the threemonths ended March 31, 2004 compared to a provision for foreign income taxes of$1,151,000 (approximately 36% of the Spanish pretax income of $3,172,000) inthe three months ended March 31, 2003. The provision for foreign income taxeswould have been approximately $128,000 lower than reported, absent the increasein the weighted average value of the Euro, in relation to the U.S. Dollar,during the three months ended March 31, 2004.

 

We generated additional U.S. federal net operating loss carry-forwardsin the three months ended March 31, 2004 and 2003 as a result of U.S. pretaxlosses of ($752,000) and ($489,000), respectively. However, since we are notassured of future profitable domestic operations, we have recorded a valuationallowance for any future tax benefit of such losses in the U.S. Therefore, notax benefit has been recognized with respect to U.S. losses reported in thethree months ended March 31, 2004 or 2003.

 

*Net Income*

 
|                                          |   | **For the  Three Months Ended March 31,** |     | **Change** |     |
|-----------------------------------------------|--------|-------------------------------------------|----------|------------|----------|
| **(in  thousands, except per share data)**    |   | **2004**                                  |     | **2003**   |     | **$** |   | **%** |   |
|                                          |   |                                      |     |       |     |   |   |   |   |
| *Net income*                                  |   | *$*                                       | *809*    | * *   | *$*      | *1,532* | * * | *$* | *(723* | *)* | *-47%* |   |
|                                          |   |                                      | * * |       | * * |   | * * |   | * * |
| *Net income per common share:*                |   |                                      | * * |       | * * |   | * * |   | * * |
| *Basic*                                       |   | *$*                                       | *0.04*   | * *   | *$*      | *0.09* | * * | *$* | *(0.05* | *)* | *-56%* |   |
| *Diluted*                                     |   | *$*                                       | *0.04*   | * *   | *$*      | *0.08* | * * | *$* | *(0.04* | *)* | *-50%* |   |
|                                          |   |                                      | * * |       | * * |   | * * |   |   |
| *Weighted average common shares outstanding:* |   |                                      | * * |       | * * |   | * * |   |   |
| *Basic*                                       |   | *20,597*                                  | * * | *17,455*   | * * | *3,142* | * * | *18%* |   |
| *Diluted*                                     |   | *22,784*                                  | * * | *20,350*   | * * | *2,434* | * * | *12%* |   |

 

We reportedincome from operations of $1,673,000 in the three months ended March 31, 2004compared to $2,654,000 (which included a non-recurring one-time milestonepayment of $500,000) in the three months ended March 31, 2003. The combinationof income from operations of $1,673,000 and the non-operating items, primarilythe provision for income taxes of $921,000, resulted in net income of $809,000,or $0.04 per basic common share ($0.04 per diluted common share) on 20,597,000weighted average basic common shares outstanding (22,784,000 weighted averagediluted common shares outstanding) in the current year first quarter, comparedto net income

 

22

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of $1,532,000, or $0.09 perbasic common share ($0.08 per diluted common share) on 17,455,000 weightedaverage basic common shares outstanding (20,350,000 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.

 

**LIQUIDITY AND CAPITAL RESOURCES:**

 

Total assets increased from $100,463,000 atDecember 31, 2003 to $101,503,000 at March 31, 2004, whilestockholders’ equity decreased from $76,165,000 at December 31, 2003 to$75,967,000 at March 31, 2004. The decrease in stockholders’ equityprimarily reflects the negative impact of the fluctuation of the Euro/U.S.dollar exchange rate, which totaled $1,229,000 in the current period, partiallyoffset by net income of $809,000, and net proceeds from the exercise of stockoptions of approximately $122,000.

 

Cash, cash equivalents and marketablesecurities decreased by 4% or $1,615,000 from $40,645,000 at December 31,2003 to $39,030,000 at March 31, 2004, primarily as a result of additionsto fixed assets totaling $2,096,000, net repayment of borrowings of $510,000,and expenditures for drug licenses and related costs totaling $268,000,partially offset by $1,442,000 in cash provided by operating activities.  Cash and cash equivalents at March 31,2004 include approximately $34,344,000 of short-term liquid investmentsconsidered to be cash equivalents.

 

Receivables increased by 5% from $18,036,000at December 31, 2003 to $18,885,000 at March 31, 2004. Receivablesincreased by approximately $1,438,000 in local currency, but fluctuations inforeign currency exchange rates decreased receivables reported in U.S. dollarsby approximately $535,000. We have not experienced any material delinquencieson our receivables that have had a material effect on our financial position,results of operations or cash flows.

 

Inventories increased by approximately$333,000 from $7,106,000 at December 31, 2003 to $7,439,000 atMarch 31, 2004, primarily as a result of increased production during thequarter required to meet anticipated sales demand. Inventory increased byapproximately $565,000 in local currency, and fluctuations in foreign currencyexchange rates decreased inventories reported in U.S. dollars by approximately$232,000.

 

The combined total of accounts payable andaccrued expenses increased from $17,257,000 at December 31, 2003 to$18,997,000 at March 31, 2004, primarily due to an increase in inventory(approximately $775,000) and income taxes payable (approximately $1,146,000),while fluctuations in foreign currency exchange rates decreased accountspayable and accrued expenses reported in U.S. dollars by approximately$593,000.

 

Short-term borrowings and current portion oflong-term debt decreased from $1,985,000 at December 31, 2003 to$1,355,000 at March 31, 2004, primarily as a result of net repayment ofshort-term borrowings, payment of the current portion of long-term debt and theeffect of fluctuations in foreign currency exchange rates. The weighted averageinterest rate on our short-term borrowings at March 31, 2004 was 3.7%.

 

23

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Operating activities for the three months ended March 31, 2004 providednet cash of $1,442,000. Our future operating cash flows could be negativelyimpacted as a result of therecently enacted government regulations in Spain and anticipated increases inresearch and development programs that are expected to benefit future periods. However, as previously discussed, our broad-basedgrowth strategy should mitigate the impact of these developments.

 

Investing activities, primarily capitalexpenditures to: (1) increase the capacity of our manufacturing facility inSpain, and (2) increase our manufacturing and packaging capabilities with newhigh speed equipment, along with additions to drug licenses and related costs,used net cash of $2,309,000 during the three months ended March 31, 2004.

 

Financing activities during the three months ended March 31, 2004required cash totaling $388,000, and included net repayments of borrowings ofapproximately $510,000.

 

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 paymentto us 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 earningroyalty revenues on a percentage of Testim sales as defined in the licensingagreement with Auxilium.  Royalty revenueson Testim 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 three months endedMarch 31, 2004 and 2003, we recognized royalty revenues of $554,000 and$50,000, respectively, based on an estimate of prescriptions filled.  The difference between the total amountearned from Auxilium under the royalty arrangement and the amount recognized aslicensing and collaboration revenues is recorded as a component of *deferredincome* in the Consolidated Balance Sheets.  As of March 31, 2004 and December 31, 2003, deferred income fromTestim royalties totaled $681,000 and $634,000, respectively.  We will continue to use available marketinformation to determine the amount and timing of royalty revenuerecognition.  Auxilium has recentlyfiled an initial public offering with the SEC and has indicated in that filing,that approximately 30% of the proceeds from its offering of stock will bededicated to furthering the commericialization of Testim.

 

*Seasonality.*  In thepast, we have experienced lower sales in the third calendar quarter and highersales in the fourth calendar quarter due to seasonality.  As we market more pharmaceutical productswhose sales are seasonal, seasonality of sales may become more significant.

 

*Effect ofInflation and Changing Prices.*  Neither inflation nor changingprices has materially impacted our net product sales or income from operationsfor the periods presented.

 

*Liquidity*.  We planto continue making improvements to our manufacturing facilities during thebalance of 2004 to accommodate our continuing growth.  As previously discussed, in April of 2004, we purchased an FDA approved manufacturing facility located in Spain, whichspecializes in the manufacture of several active pharmaceutical ingredients,for approximately $3,300,000. We estimate that capital investments ofapproximately $2,000,000 for the purchase of new manufacturing equipment willbe required in the balance of 2004 to expand that facility.  We also plan to continue improving andexpanding our other manufacturing facility in Spain and plan to purchase newequipment to support our research anddevelopment activities in the U.S. Weexpect to invest an additional $3,000,000 in capital improvements and additionsfor these items during the balance of 2004. As mentioned above, we have cash,cash equivalents and short-term liquid investments totaling approximately$39,030,000 as of March 31, 2004, which is sufficient to fund our operationsfor the foreseeable future. Even though the Company is generating positive cashflow

 

24

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fromoperations, (approximately $1,442,000 in the three months ended March 31, 2004),there can be no assurance that changes in our research and development plans,capital expenditures and/or acquisitions, or other events affecting our netproduct sales or operating expenses will not result in the earlier depletion ofour funds.  However, we continue toexplore alternative sources for financing our business activities. Inappropriate situations, which will be strategically determined, we may seekfinancial assistance from other sources, including contribution by others tojoint ventures and other collaborative or licensing arrangements for thedevelopment, testing, manufacturing and marketing of products underdevelopment.

 

**Critical AccountingPolicies and Estimates**

 

Our significant accounting policies are more fully described in Note 2to our consolidated financial statements in our Annual Report on Form 10-K forthe year ended December 31, 2003. However, certain of our accounting policiesare particularly important to the portrayal of our financial position, resultsof operations and cash flows and require the application of significantjudgment by our management; as a result they are subject to an inherent degreeof uncertainty. In applying those policies, our management uses its judgment todetermine the appropriate assumptions to be used in the determination of certainestimates. Those estimates are based on our historical experience, terms ofexisting contracts, our observance of trends in the industry, informationprovided by our customers and information available from other outside sources,as appropriate.

 

**Important FactorsThat May Affect Future Results**

 

This Quarterly Report on Form 10-Q contains forward-looking statements.These forward-looking statements appear principally in the section entitled“Management’s Discussion and Analysis of Financial Condition and Results ofOperations.” Forward-looking statements may appear in other sections of thisreport, as well. Generally, the forward-looking statements in this reportinclude such words as “expect,” “believe,” “continue,” “anticipate,”“estimate,” “may,” “will,” “could,” “opportunity,” “future,” “project,” andsimilar expressions.

 

The forward-looking statements include statements about our:

•                  Strategic plans;

•                  Anticipatedsources of future revenues;

•                  Anticipated 2004margins and operating performance;

•                  Expected launchof new products;

•                  Anticipatedexpenses and spending;

•                  Commencement ofclinical trials;

•                  The sufficiencyof capital to fund our operations.

 

These forward-looking statements are based on our current expectations,beliefs, assumptions, estimates, forecasts and projections for our business andthe industry and markets in which we compete. These statements are notguarantees of future performance and involve certain risks, uncertainties andassumptions that are difficult to predict. Therefore, actual outcomes andresults may differ materially from what is expressed in such forward-lookingstatements. We caution investors not to place undue reliance on theforward-looking statements contained in this report. These statements speakonly as of the date of this report, and we do not undertake any obligation toupdate or revise them, except as required by law.  The following factors, among others, create risks anduncertainties that could affect our future or other performance:  expanding generic and branded drugoperations,

 

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changes inthird-party reimbursement and government mandates which impact pharmaceuticalpricing, development and commercialization of our products, relationships withour strategic partners, uncertainty of clinical trial results, regulatoryapproval process, unpredictability of patent protection, technological changes,the effects of economic conditions, risks associated with internationaloperations, competition from other manufacturers of generic and proprietarypharmaceuticals, and difficulties in managing our growth and the other riskfactors contained in the section entitled “Risk Factors” in our Annual Reporton 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.*  Asubstantial amount of our business is conducted in Europe and is thereforeinfluenced to the extent to which there are fluctuations in the U.S. Dollar’svalue against other currencies, specifically the Euro. The exchange rate atMarch 31, 2004 and December 31, 2003 was .82 Euros and .80 Euros per U.S.Dollar, respectively. The weighted average exchange rate for the three monthsended March 31, 2004 and 2003 was .81 Euros and .93 Euros per U.S. Dollar,respectively. The effect of foreign currency fluctuations on long lived assetsfor the three months ended March 31, 2004 was a decrease of $1,229,000 andthe cumulative historical effect was an increase of $3,940,000, as reflected inour Consolidated Balance Sheets as *accumulatedother**comprehensive income*.Although exchange rates have fluctuated significantly in recent years, we donot believe that the effect of foreign currency fluctuation is material to ourresults of operations as the expenses related to much of our foreign currencyrevenues are in the same functional currency as those revenues, namely theEuro. However, the carrying value of assets and liabilities can be materiallyimpacted by foreign currency translation, as can the translated amounts ofrevenues and expenses. Nonetheless, we do not plan to modify our businesspractices at this time.

 

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

 

*Interest Rates.*  Theweighted average interest rate on our short-term borrowings is 3.7% and thebalance outstanding is $1,355,000 as of March 31, 2004. A portion of ourlong-term borrowings is non-interest bearing and the balance outstanding onthese borrowings at March 31, 2004 is $358,000 including imputed interest(ranging from 4.8% to 6.0%) of $80,000. 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 4.7% on short-termborrowings and to an average of 6.6% on long-term borrowings would have theeffect of increasing interest expense by approximately $17,000 annually.

# ** **

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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 March31, 2004, Bentley carried out an evaluation, under the supervision of, and withthe participation of Bentley’s management, including the Company’s ChiefExecutive Officer and Chief Financial Officer, of the effectiveness of thedesign and operation of Bentley’s disclosure controls and procedures (asdefined in Exchange Act Rules 13a - 15(e) and 15d - 15(e)).  Based on that evaluation, Bentley’s ChiefExecutive Officer and Chief Financial Officer concluded that Bentley’sdisclosure controls and procedures are effective in timely alerting them tomaterial information relating to Bentley (including its consolidatedsubsidiaries) which is required to be included in its publicly filed reports orsubmitted under the Exchange Act is recorded, processed, summarized andreported within the time periods specified in the Securities and ExchangeCommission’s rules and forms.  AlthoughBentley’s management continues to evaluate the internal control structure andstrengthen the Company’s control procedures, particularly in connection withthe requirements of Section 404 of the Sarbanes-Oxley Act of 2002, there havebeen no significant changes in Bentley’s internal controls, or in other factorswhich could significantly affect internal controls since that evaluation.

 

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**PART II.                OTHER INFORMATION**

 

# **Item 1.     Legal Proceedings**

 

On February 4, 2002, we were notifiedthat a legal proceeding had been commenced against us by Merck & Co. Inc.and its Spanish subsidiary, Merck Sharp & Dohme de España, S.A.,alleging that we violated their patents in our production of simvastatinproducts and requested an injunction ordering us not to manufacture or marketthe products. The case was brought against our Spanish subsidiaries in the 39thFirst Instance Court of the City of Madrid. After a hearing on February 18,2002, the court refused to grant the requested injunction and dismissed thecase on February 25, 2002, awarding court costs and legal fees to us.  Merck has appealed the award of fees.  Merck re-instituted its claim against us inanother proceeding brought in the 19th First Instance Court of theCity of Madrid, of which we received notice on January 23, 2003.  This case also alleged violation of Merck’spatents in the production of simvastatin products, requested an order that wecease manufacturing the products and demanded damages during the period ofmanufacture.  After a trial with respectto this matter held on February 19and 20, 2004, the court, on April8, 2004, ruled in our favor, again awarding us court costs and legal fees.  Merck has subsequently appealed this ruling.

 

On January 10, 2004, we were notified that alegal proceeding had been commenced against us by Smith Kline Beecham PLC,Smith Kline Beecham, S.A. and GlaxoSmithKline S.A. alleging that we violatetheir patents in our production of paroxetine products and they requested anorder requiring us to not manufacture or market the products.  The case was brought against our Spanishsubsidiaries in the 50th First Instance Court of the City ofMadrid.  This proceeding followed apreliminary injunction that the same plaintiffs attempted to bring against usin 2003, which was dismissed.  We fileda response to this suit in February 2004 that included a counterclaimrequesting that the court declare the asserted patent invalid.  We intend to vigorously oppose this claim aswe believe the claim is without merit. Our paroxetine product line was launchedin 2003.

 

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 theCompany’s financial position, results of operations or cash flows.

 

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# **Item 6.     Exhibits and Reportson 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 March 31, 2004:

 

i)                 TheCompany furnished a Current Report on Form 8-K dated February 18, 2004,providing earnings guidance for the year ended December 31, 2003 and attachinga press release related thereto. (Items 7 and 12) *

 

ii)              TheCompany furnished a Current Report on Form 8-K dated February 27, 2004,announcing earnings for the three months and year ended December 31, 2003 andattaching a press release related thereto. (Items 7 and 12) *

 

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* Thisinformation shall not be deemed “filed” for purposes of Section 18 of theSecurities Exchange Act of 1934, as amended (the “Exchange Act”), or otherwisesubject to the liabilities of that section, nor shall it be deemed incorporatedby reference in any filing made by Bentley under the Securities Act of 1933 orthe Exchange Act, except as expressly set forth by specific reference in suchfiling.

 

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SIGNATURES

 

 

Pursuant to the requirements ofthe Securities Exchange Act of 1934, the Registrant has duly caused this reportto be signed on its behalf by the undersigned thereunto duly authorized.

 

 
|         |   | BENTLEY PHARMACEUTICALS, INC.                                                                                   |   |
|--------------|--------|-----------------------------------------------------------------------------------------------------------------|--------|
|         |   | Registrant                                                                                                      |
|         |   |                                                                                                            |
|         |   |                                                                                                            |
|         |   |                                                                                                            |
| May 10, 2004 | By:    | /s/ James R. Murphy                                                                                             |   |
|         |   | James R. Murphy                                                                                                 |
|         |   | Chairman of the Board of Directors,  President and Chief Executive Officer                                      |
|         |   | (Principal Executive Officer)                                                                                   |
|         |   |                                                                                                            |
| May 10, 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 No.** |   |                                                                                                                                                                          |
|-----------------|--------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|            |   |                                                                                                                                                                          |
|    3.1     |   | Amended and  Restated Bylaws.  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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