<PAGE>   1
                       SECURITIES AND EXCHANGE COMMISSION

                             WASHINGTON, D.C. 20549

                                    FORM 10-K
(Mark one)
[X] Annual Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act
of 1934 For the fiscal year ended December 31, 1997

                                            or

[ ] Transition Report Pursuant to Section 13 or 15(d) of the Securities Exchange
Act of 1934 For the transition period from to

Commission File Number:  0-22314

                              PENEDERM INCORPORATED
             (Exact name of registrant as specified in its charter)

        Delaware                                   77-0146116
 (State or other jurisdiction of        (I.R.S. Employer Identification No.)
 incorporation or organization)

            320 Lakeside Drive, Foster City, California     94404
            (Address of principal executive offices)      (Zip Code)

Registrant's telephone number, including area code:          (650) 358-0100
Securities registered pursuant to Section 12(b) of the Act:   None
Securities registered pursuant to Section 12(g) of the Act:   Common Stock, 
                                                              $0.01 par value
                                                              Rights to purchase
                                                              Common Stock
                                                              (Title of class)

Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days.

                                 Yes [X] No [ ]

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405
of Regulation S-K is not contained herein, and will not be contained, to the
best of registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K. [ ]

The aggregate market value of the voting stock held by non-affiliates of the
registrant on January 30, 1998, based upon the closing price of the Common Stock
on the Nasdaq National Market for such date, was approximately $85,322,000.

The number of outstanding shares of the registrant's Common Stock on January 30,
1998 was 8,154,098.

DOCUMENTS INCORPORATED BY REFERENCE

(1)     Portions of the Proxy Statement to be filed with the Securities and
        Exchange Commission on or prior to April 30, 1998 and to be used in
        connection with the Annual Meeting of Stockholders expected to be held
        June 24, 1998 are incorporated by reference in Parts III and IV of this
        Form 10-K.



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                              PENEDERM INCORPORATED
                              1997 FORM 10-K REPORT


                                TABLE OF CONTENTS
<TABLE>
<CAPTION>

                                                                            PAGE
                                                                            ----
PART I
<S>     <C>                                                                <C>
   ITEM 1. BUSINESS.......................................................... 3
   ITEM 2. PROPERTIES........................................................33
   ITEM 3. LEGAL PROCEEDINGS.................................................33
   ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS...............33

PART II
   ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED 
            STOCKHOLDER MATTERS..............................................34
   ITEM 6. SELECTED FINANCIAL DATA...........................................35
   ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL 
             CONDITION AND RESULTS OF OPERATIONS.............................36
   ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA.......................40
   ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON 
             ACCOUNTING AND FINANCIAL DISCLOSURE.............................55

PART III
   ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT...............55
   ITEM 11. EXECUTIVE COMPENSATION...........................................55
   ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT...55
   ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS...................55

PART IV
   ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, 
              AND REPORTS ON FORM 8-K........................................55
</TABLE>

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    THE STATEMENTS IN THIS ANNUAL REPORT ON FORM 10-K AND OTHER STATEMENTS MADE
BY THE COMPANY FROM TIME TO TIME THAT RELATE TO FUTURE PLANS, EVENTS OR
PERFORMANCE ARE FORWARD-LOOKING STATEMENTS WHICH INVOLVE RISKS AND
UNCERTAINTIES. ACTUAL RESULTS, EVENTS OR PERFORMANCE MAY DIFFER MATERIALLY FROM
THOSE ANTICIPATED IN ANY FORWARD-LOOKING STATEMENTS AS A RESULT OF A VARIETY OF
FACTORS, INCLUDING THOSE SET FORTH UNDER "RISK FACTORS" AND ELSEWHERE IN THIS
ANNUAL REPORT ON FORM 10-K. READERS ARE CAUTIONED NOT TO PLACE UNDUE RELIANCE ON
THESE FORWARD-LOOKING STATEMENTS WHICH SPEAK ONLY AS OF THE DATE HEREOF. THE
COMPANY UNDERTAKES NO OBLIGATION TO PUBLICLY RELEASE THE RESULT OF ANY REVISIONS
TO THESE FORWARD-LOOKING STATEMENTS THAT MAY BE MADE TO REFLECT EVENTS OR
CIRCUMSTANCES AFTER THE DATE HEREOF OR TO REFLECT THE OCCURRENCE OF
UNANTICIPATED EVENTS.


                                     PART I

ITEM 1.  BUSINESS

COMPANY OVERVIEW

    Penederm is developing and commercializing topically administered
prescription dermatology products that use the Company's proprietary drug
delivery technology or drug compounds to achieve enhanced patient safety or
clinical efficacy. In the fourth quarter of 1996, Penederm received clearance
from the United States Food and Drug Administration ("FDA") to market Mentax, a
once-a-day prescription topical treatment for the treatment of three skin fungal
conditions: tinea pedis (athletes' foot), tinea corporis (ringworm) and tinea
cruris (groin fungus). In May 1997, the Mentax product was approved as an
over-the-counter product by the Health Protection Branch of Health Canada, where
it is being marketed by Schering-Plough HealthCare Products, Inc.
(Schering-Plough) under the Dr. Scholl's Once-A-Day brand name. In January 1997,
Penederm received FDA clearance to begin marketing its Avita cream prescription
product for the treatment of acne. Penederm subsequently received clearance, in
January 1998, to market the gel formulation of Avita upon the expiration of a
patent held by a third party. In January 1998, Penederm also announced it had
licensed permethrin cream 5% from Alpharma, Inc. (Alpharma) for the treatment of
sarcoptes scabiei (scabies infection). Penederm will market this product under
its Acticin brand name. Penederm initiated phase III human clinical trials of a
combination product (project name: 501 cream) for the treatment of skin fungal
conditions in 1997. Products for nail fungus and psoriasis are in earlier stages
of clinical development along with Mentax skin treatment line extensions. The
Company also sells its patented TopiCare Delivery Compounds as specialty
ingredients to major cosmetic companies for incorporation into their commercial
products. The Company's goal is to become a leader in the United States
prescription dermatology market and compete in other skin care markets by
creating safer and more efficacious topical formulations using its versatile
drug delivery technology with selected novel and off-patent drug compounds
addressing niche markets and by successfully commercializing these formulations.

----------
        The following trademarks of Penederm are used in this Annual Report on
Form 10-K: TopiCare Delivery Compounds(R), Avita(TM), Mentax(R), Penederm(R),
Vitinoin(R), Acticin(TM) and DuraScreen(R) (licensed to Pierre Fabre Inc. in the
United States).

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<PAGE>   4


MARKET OVERVIEW

    Prescription Products

    The market for prescription treatments for dermatologic disorders, or
diseases of the skin, is estimated to be in excess of $2 billion annually in the
United States at the manufacturer level. In the United States, dermatological
diseases are treated primarily by 7,000 high-prescribing dermatologists and
general practitioners. It is estimated that dermatologists prescribe drug
therapies in approximately 65 percent of patient visits. In many instances, the
dermatological disease being treated is chronic, requiring continued use of one
or more prescribed products.

        Dermatological treatments may be delivered topically, in the form of
creams, ointments, gels, liquids or patches, or orally, primarily in the form of
tablets and gelatin capsules. Dermatologists often prefer topical administration
of drugs to oral drug delivery for the treatment of many dermatological
conditions, since topical drug delivery may reduce the amount of drug required
and because targeted topical pharmaceutical application is often safer and less
expensive. In addition, topical administration may avoid side effects associated
with systemic ingestion of drug agents. The primary clinical approaches to
topical drug delivery include:

        Traditional Penetrating Agents. Typically, formulating agents, including
    ethanol, propylene glycol, surfactants and other agents are used to aid in
    the penetration into the skin of active pharmaceutical compounds. Although
    these formulating agents often initially provide enhanced penetration of
    active ingredients, they may not provide long-term penetration enhancement,
    and often cause irritation when used in doses concentrated enough to provide
    clinical efficacy.

        Specialized Delivery Technologies. A variety of topical drug delivery
    technologies, including liposomes, microspheres, injectable matrices,
    transdermal patches, electroporation and iontophoresis, have been developed
    to enhance or enable the topical delivery of pharmaceuticals. Although many
    of these technologies have demonstrated clinical efficacy for certain drugs
    and disease indications, these technologies have generally not been
    successfully developed for dermatological indications due to product
    instability, side effects, toxicity, cost or difficulty of administration.

    Although topical delivery is preferred by many dermatologists, the
development of new products and the market acceptance of topically delivered
dermatological therapies in many instances has been limited by side effects or
by the limited efficacy of existing topical formulations. Many effective active
ingredients may be irritating to the skin in traditional topical delivery
formulations. In addition, effective topical drug delivery is often difficult
because the skin provides a natural barrier to foreign substances, and because
topical therapies may be diluted or washed off by natural secretions or contact
with other liquids or may be rubbed off by contact with clothing.

    Although the aggregate market for prescription dermatological products is
large, the markets for pharmaceuticals to treat specific dermatological diseases
are smaller and fragmented. Large pharmaceutical companies have historically
focused on the drug discovery process, including preclinical and clinical
development, regulatory approvals, and marketing of therapeutics to treat
diseases affecting large patient populations. The clinical focus on enhancing
the delivery of existing pharmaceuticals is a relatively new field, and may
provide opportunities for companies developing novel drug delivery technologies
or new formulations of existing therapeutics targeted to niche markets.


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    Nonprescription Products

    Technologies used for the delivery of drugs to treat dermatologic
indications may be applied to the nonprescription skin care market. Cosmetics
and skin and hair care products are primarily sold through mass merchandisers,
food and drug chains, department stores, independent specialty and convenience
stores, pharmacies, mail order, door-to-door sales, and direct to doctors. New
product introductions are frequent, with market acceptance based on such factors
as breadth of distribution, cost, product efficacy, safety and appealing use
characteristics. Important attributes of delivery agents used for such products
include safety, emolliency, duration of action, stability and ease of
formulation.

PENEDERM DRUG DELIVERY TECHNOLOGY

    The Company's TopiCare Delivery Compounds represent a patented skin-loading
technology designed to target delivery to layers in the skin or other epithelial
tissue. TopiCare Delivery Compounds consist of a broad portfolio of liquid
polymers that can be designed to deposit an active ingredient and optimize
penetration at targeted levels of skin tissue where particular disease
conditions can be effectively treated. For example, formulations currently in
development containing TopiCare Delivery Compounds deliver an antifungal agent
to the upper epidermis, a skin layer where fungus predominates. Penederm has
developed another formula containing TopiCare Delivery Compounds which moderates
the delivery of retinoic acid into the follicular area for effective treatment
of acne. Laboratory, clinical or marketplace studies conducted by the Company
have indicated that products containing TopiCare Delivery Compounds possess one
or more of the following benefits:

        Longer duration of action. Due to their unique chemistry, TopiCare
    Delivery Compounds are resistant to accidental removal, causing them to
    remain on and in the upper layers of the skin for an extended period,
    thereby improving the duration of drug effects or delivery. Laboratory
    studies conducted by the Company have indicated that TopiCare Delivery
    Compounds upon application remain at or near the surface of the skin and
    penetrate only in very low levels beyond the stratum corneum.

        Reduced dosage requirements; improved safety profile. The Company
    believes that its technology provides for more effective topical deposition
    of certain drugs, thereby enabling the Company to develop topical treatments
    that contain smaller doses of active drug agent than existing topical
    treatments or that contain agents which previously have only been
    administered orally. Under typical usage conditions, the reduction in
    topical dosage and the administration topically of agents previously
    administered orally result in a reduction in the systemic exposure to the
    agent and, accordingly, a reduction in the potential for systemic toxicity
    and adverse reactions with other drugs taken by the patient.

        Fewer local adverse side effects. Clinical trials have shown the
    TopiCare Delivery Compounds to be non-irritating and non-sensitizing to the
    skin. In addition, the compounds have been shown to reduce the irritation
    caused by certain drug and skin care agents currently delivered topically.

    By tailoring the compound to the active agent and the skin condition, the
Company believes that its drug delivery system may more effectively target the
drug to the site of the disease and provide the benefits described above. These
benefits may thereby contribute to improved patient compliance and clinical
outcomes.

    The Company also believes that its TopiCare Delivery Compounds provide the
Company with the following strategic advantages in developing and
commercializing a broad spectrum of dermatological treatments and skin care
products:


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<PAGE>   6

        Broad application. The Company believes the properties of the TopiCare
    Delivery Compounds make them excellent candidates for inclusion in drugs,
    skin and hair care products and cosmetics. Clinical trials and laboratory
    studies have indicated that the TopiCare polymers hold to the skin, are
    moisturizing, are non-occlusive and do not clog pores. The Company has
    synthesized and evaluated numerous polymeric compounds, both water- and
    oil-compatible, as a basis for further development. The Company believes
    that the demonstrated flexibility and compatibility of the TopiCare Delivery
    Compounds will allow them to meet the varying delivery needs of many
    different drug compounds, skin care agents and cosmetics.

        Ease of formulation. The TopiCare Delivery Compounds, along with other
    product ingredients, are blended into the drug formulation during
    manufacture. This procedure may be less costly and time-consuming than
    delivery systems relying upon drug entrapment, such as liposome and
    microsphere technologies.

        Streamlined development. The ability of TopiCare Delivery Compounds to
    be combined with existing drug compounds or agents may involve less cost,
    time and risk than do the discovery, development and commercialization of
    new drug compounds or skin care agents. The Company has compiled
    considerable pre-clinical, clinical and market data which it believes may be
    helpful in shortening the development time of products incorporating
    TopiCare Delivery Compounds. To date, the Company has completed two
    in-licensing arrangements for compounds with existing preclinical data
    packages, enabling the Company to initiate clinical development.

        New topical treatments. TopiCare Delivery Compounds may make possible
    topical treatments with drugs that previously have not been effectively used
    topically, such as antifungal agents for treatment of nail fungal
    infections, chemotherapeutic agents for psoriasis and new Vitamin D
    treatments for psoriasis.

        New and expanded product markets. The attributes of TopiCare Delivery
    Compounds may create new product markets or may expand existing prescription
    and consumer markets by increasing the number of indications for which an
    existing drug or skin care agent can be used, by providing potential
    additional patent protection for off-patent drugs, by extending patent
    protection for patented drugs or by increasing patient use of treatments.

PRODUCTS

    The Company's marketed products and products under development include
prescription and nonprescription dermatology and skin care products. The
following charts summarize certain information regarding the products that the
Company currently is actively marketing or developing and should be read
together with the more detailed discussion of these products that follows.


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<TABLE>
<CAPTION>




                                         PRESCRIPTION PRODUCTS
      PRODUCT            INDICATION             STATUS                   MARKETING RIGHTS
-------------------      ----------      ----------------------          ------------------
<S>                      <C>             <C>                             <C>
Avita (retinoic          Acne            U.S.: Cream and gel             U.S.: Penederm
acid) cream and gel                      approved for marketing          Canada: Pharmascience Inc.
                                         Canada:  Approved for           ("Pharmascience")
                                         marketing                       Europe:  Penederm
                                         Europe:  Approved for           Latin America: Allergan Inc.
                                         marketing in the U.K.; filed    ("Allergan")
                                         as European Marketing
                                         Authorization Application
                                         ("MAA")

Mentax                  Skin fungus      U.S.: Approved for tinea        U.S.: Schering-Plough
(butenafine) cream                       pedis; tinea corporis and       HealthCare Products, Inc.
                                         tinea cruris                    ("Schering-Plough")
                                         Canada: Approved as             (podiatrists), Mylan
                                         over-the-counter (OTC)          Laboratories Inc. (primary
                                                                         care) and Penederm
                                                                         Canada: Schering-Plough and
                                                                         Penederm

501 Cream, a            Inflammatory     U.S.: Phase III human           U.S.: Penederm
combination of          fungal           clinical testing in
butenafine and          conditions       progress.
betamethasone
dipropionate

Butenafine nail         Nail fungus     U.S.: Phase II human             U.S.: Schering-Plough and
fungus formulation                      clinical testing completed.      Penederm
                                                                         Canada:  Schering-Plough and
                                                                         Penederm
                                                                         Europe, Africa and the Middle
                                                                         East:  UCB Group of Belgium
                                                                         ("UCB")

Vitamin D analogs       Psoriasis       U.S.: preclinical testing;       U.S.: Penederm
cream and ointment                      Investigtional New Drug          Canada: Penederm
                                        ("IND") opened; Phase II          
                                        human clinical testing in
                                        progress

                            NONPRESCRIPTION PRODUCTS

      PRODUCT            INDICATION              STATUS                      MARKETING RIGHTS
----------------------  ------------    ---------------------------      -----------------------------
DuraScreen SPF15 and    Prevention      Marketed in U.S. and Canada      U.S.:  Pierre Fabre, Inc.
SPF30 sunscreen         of                                               ("Pierre Fabre")
                        photo-damage
                                                                         Canada:  Pharmascience
Penederm Cream and      Severe dry      Marketed in U.S. and Canada      U.S.:  Penederm
Penederm Lotion         skin
                                                                         Canada: Pharmascience
Warner's Lubriderm      Severe dry      Marketed in Canada               Canada:  Warner
Alpha Hydroxy           skin
Moisture Recovery
Creme and Lotion

OTC Product (Europe)    Severe dry      Marketed in Europe               Europe: SmithKline Beecham
                        skin                                             ("SmithKline")
Undisclosed OTC         Undisclosed     Development completed            SmithKline
Product

TopiCare Delivery       Sunscreens,     Marketed worldwide               U.S.:  Barnet Products
Compounds (used with    color                                            Corporation
various agents)         cosmetics                                        Asia:  Nikko Chemicals Co. Ltd.
                        and skin                                         Europe and South Africa:
                        treatment                                          Sederma, S.A.
                        products                                         Australia and New Zealand:
                                                                           Bronson & Jacobs, Pty. Ltd.
</TABLE>

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<PAGE>   8


    There can be no assurance that the Company can successfully develop any
potential products or technologies or, if successfully developed, that they will
obtain regulatory approval or be successfully commercialized. See "Risk
Factors."


    PRESCRIPTION PRODUCTS

    Avita. The Company has developed Avita gel and cream as prescription
retinoic acid acne treatments that incorporate TopiCare Delivery Compounds.
According to industry sources, approximately 35 million people in the United
States are affected by acne each year. The Company estimates the United States
prescription acne market to be approximately $500 million and the topical
retinoic market to be approximately $200 million, or 40% of the prescription
acne market. Retinoic acid formulations are the leading prescription products
for the topical treatment of acne, and until late 1996 only Ortho McNeil
Pharmaceuticals, a subsidiary of Johnson & Johnson, marketed topical retinoic
acid products for the treatment of acne in the United States under the
Retin-A(R) brand. Studies indicate that a significant number of users experience
skin irritation (dryness, peeling and redness) from the Retin-A(R) products,
which is still the market leading product. The Company has completed human
clinical studies which the Company believes indicate that Avita retinoic acid
gel and cream treatments, which are formulated with TopiCare Delivery Compounds,
provide comparable effectiveness and less irritation than Retin-A(R). The
Company is aware of other companies that have developed prescription acne
treatments formulated with retinoids that are recently introduced and that may
also present substantial competition for Avita, including Differin(R) Gel
developed by Galderma Laboratories Inc. ("Galderma") that was launched in the
United States in November 1996 and a second Johnson & Johnson tretinoin gel
product, Retin-A(R) Micro, launched in the United States in February 1997. Both
of the recently introduced products are promoted as less irritating. The Company
does not have data from human clinical studies comparing the efficacy and
irritation of Avita with that of the more recently approved acne treatments with
retinoids and there can be no assurance that Avita will be as efficacious and
less irritating than those products or will achieve market acceptance.

    In January 1997, the FDA notified the Company that Avita cream was approved
for marketing. In January 1998, Avita gel was also approved for marketing by the
FDA upon expiration of a third party patent. The Company has completed human
clinical studies to support marketing claims related to the products. The FDA
has granted an export license to ship these products out of the United States.
The Company has also submitted data to the FDA to expand its label claims to
Avita Gel. The Company has retained United States marketing rights to Avita and
launched the product in the United States in August 1997 using a pharmaceutical
specialty contract sales force. In early 1998, Penederm began recruiting its own
direct, employee-based sales force and is transitioning selling activities from
the contract sales force. Penederm pays a modest royalty on the sales of Avita,
subject to a specified maximum amount, pursuant to a 1995 termination agreement
with a company that originally had distribution rights to Avita. See "Risk
Factors -- Uncertainty of Commercial Launch and Market Acceptance of
Prescription Products," "-- Government Regulation; No Assurance of Product
Approvals" and "-- Uncertainty of Future Product Development."

    The Company has also received approval to market Avita in Canada under the
trade name Vitinoin. The Company has licensed its rights to market the products
in Canada to Pharmascience. Pharmascience launched Vitinoin in June 1995 and is
promoting it with a less irritating label claim. In February 1997, the Company
received approval in the United Kingdom for this product. The U.K. will be
Penederm's sponsor country to seek approval in other European nations through
the European Mutual Recognition Process. See "Collaborative Arrangements."

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<PAGE>   9

    Mentax. The Company has licensed Mentax, a formulation of butenafine, from
Kaken Pharmaceutical Company, Ltd. ("Kaken") for sale as a topical treatment for
fungus. The Company estimates that the annual United States market for skin
fungus products is $400 million, of which approximately $300 million consists of
treatments for tinea pedis (athlete's foot). In the United States, the Company
believes that 18 million people experience skin fungus infections each year, and
that approximately 12 million of these indications are tinea pedis. Most
commercially available skin fungus treatments arrest the growth of fungus,
rather than result in cell death directly, and do not result in the complete
treatment of the disease. Mentax is a patented butenafine that has been shown to
result in the death of skin fungus cells. Kaken and a second Japanese partner
are marketing two brands of butenafine in Japan, having received approval of the
Japanese Ministry of Health and Welfare in 1992. The Company licensed from Kaken
exclusive rights to its butenafine compound in the United States and Canada for
topical administration of butenafine. See "Collaborative Arrangements."

    In the fourth quarter of 1996, Penederm received clearance from the FDA to
market Mentax, a once-a-day prescription topical treatment for three skin fungal
conditions: tinea pedis (athletes' foot), tinea corporis (ringworm) and tinea
cruris (groin fungus). The Company also received approval from the Canadian
Health Protection Branch for the product as an over-the-counter treatment for
tinea pedis in Canada. In December 1997 Penederm received FDA approval of a
revised label claim for Mentax. The new label reflects revised dosage
instructions for the treatment of tinea pedis that allows topical application
either twice-a-day for seven days, or once-a-day for four weeks. Mentax is the
only topical antifungal product approved in the U.S. which has such a one-week
dosing regimen. In addition, the Company plans to pursue the development of
Mentax formulated with TopiCare Delivery Compounds as an extension of its skin
antifungal product line. See "Risk Factors -- Uncertainty of Commercial Launch
and Market Acceptance of Prescription Products," "-- Government Regulation; No
Assurance of Product Approvals" and "-- Uncertainty of Future Product
Development."

    The Company has commenced marketing Mentax in the United States through a
pharmaceutical specialty contract sales force and has entered into an agreement
with Schering-Plough for the marketing and sale in the United States and Canada
of certain skin antifungal products. In early 1998, Penederm began recruiting
its own direct, employee-based sales force and to transition selling activities
from the contract sales force. The Company also expects that Mylan Laboratories
will begin co-promoting this product to primary care physicians in early 1998.
See "Sales and Marketing" and "Collaborative Arrangements."

    501 Cream Project. The Company has under development a combination topical
formulation, incorporating the licensed butenafine compound, betamethasone
dipropionate (a synthetic adrenocorticosteroid widely used in dermatology to
reduce inflammation), and a TopiCare Delivery Compound for the treatment of
inflammatory skin fungal conditions. The Company believes that this product
could offer safety and compliance advantages over current 28-day therapies that
may expose patients to steroids for a very long dosing period. Prolonged use of
steroid can result in the pronounced appearance of capillaries and veins, skin
thinning, redness, bruising, and irreversible streaking of the skin, sometimes
referred to as "stretch marks." The Company announced in October 1997 favorable
Phase II clinical results and that it had initiated two pivotal phase III human
clinical studies. Penederm intends to file a New Drug Application (NDA) for this
product in the second half of 1998.

    Butenafine nail fungus formulation. The Company has under development a
topical formulation of the licensed butenafine compound that incorporates
TopiCare Delivery Compounds for the treatment of nail fungus. The Company
believes that approximately ten million patients experience nail fungal
infections, a condition in which the nails become unsightly, malformed and, in
some cases, require removal. There currently are no FDA-approved topical drug
products for the treatment of nail fungus. The condition is 


                                       9
<PAGE>   10

generally treated with oral medication prescribed over many months. The Company
believes that some people with fungus in the nail area do not receive treatment
because of the potential side effects and costs associated with available oral
dosage forms or the difficulty of an extended treatment program.

    The Company licensed from Kaken exclusive rights to its butenafine compound
for nail fungus treatments in the United States, Canada, Latin America, Western
Europe, Scandinavia, Australia and New Zealand. The Company is developing a
topical nail antifungal treatment that is designed to use the TopiCare Delivery
Compounds to hold the butenafine agent in the nail and surrounding skin for a
period of time sufficient to achieve significant clinical cure rates. The
Company has completed two Phase II human clinical trials of its butenafine nail
formulation. The Company entered into an agreement with Schering-Plough
involving the development and, upon regulatory approval, the manufacturing,
marketing and sale in the United States of certain nail antifungal products. The
Company has also entered into a licensing agreement with a subsidiary of UCB, a
multinational pharmaceutical and chemical company, to market certain topical
prescription butenafine nail antifungal formulations in Europe, Africa and the
Middle East. See "Collaborative Arrangements."

    Vitamin D analogs. The Company is developing psoriasis therapies using
proprietary Vitamin D analogs and TopiCare Delivery Compounds. Psoriasis is a
chronic skin condition characterized by inflammation and an abnormally rapid
growth of skin cells that leads to dry, flaky, red, itchy skin. Industry sources
indicate that approximately four million people in the United States suffer from
psoriasis. Present treatments such as emollients and steroids either are
ineffective or are not indicated for long-term use because of safety problems or
because the skin stops responding to the treatment. Topical steroids, which are
currently prescribed to two-thirds of patients with moderate to severe
psoriasis, can cause side effects such as skin thinning and "rebound effect"
(condition worsening after cessation of treatment as compared to before
treatment) that limit long-term use of these products. A new promising area of
psoriasis therapies are Vitamin D analogs, certain of which have demonstrated
efficacy without the adverse side effects of steroids. One Vitamin D derivative
treatment is currently on the market. However, this treatment does not cause
total clearing of the psoriasis in most cases and should not be used on certain
parts of the body because it can cause irritation. The Company is exploring the
development of a therapy from a family of Vitamin D compounds which, when
formulated with TopiCare Delivery Compounds, may provide increased potency,
enhanced activity or duration of action, and better local safety than the
currently available Vitamin D treatment. The Company is currently conducting
preclinical and clinical testing of certain of these compounds in cream and
ointment formulations for the treatment of psoriasis. The Company is also
conducting preclinical testing of Vitamin D compounds for acne and photoaging
with funding from a Small Business Innovation Research Grant from the National
Institutes of Health. The Company has licensed rights to the Vitamin D analogs
from Wisconsin Alumni Research Foundation ("WARF") and Renaissance Corporation
("Renaissance"). See "Collaborative Arrangements."

    NONPRESCRIPTION PRODUCTS

    DuraScreen. The Company has developed DuraScreen SPF15 and SPF30 sunscreens
formulated with TopiCare Delivery Compounds, ultraviolet ("UV") absorbers and an
infrared blocker. Sunscreens with an SPF of 15 or higher are frequently
recommended by dermatologists. Tanning, burning and skin damage, such as
precancerous lesions, skin cancers, and accelerated skin aging, are a result of
exposure to the sun's UV light rays. More than 600,000 new cases of skin cancer
are diagnosed each year, and more than 90 percent of skin cancers are caused by
sun exposure. Sun protection products that contain UV-absorbing chemical
sunscreens can be very effective if they stay on the skin. However, many tend to
wash off with perspiration, contact with water, or rubbing and therefore require
frequent reapplication.


                                       10


<PAGE>   11

    The Company's DuraScreen products provide all-day waterproof protection with
one application in a formula that is cosmetically appealing. DuraScreen is
marketed in the United States by Pierre Fabre under an exclusive license. The
Company has licensed the rights to market DuraScreen in Canada to Pharmascience.
See "Collaborative Arrangements."

    Dry skin treatment products. The Company has developed different treatments
for severe dry skin that incorporate TopiCare Delivery Compounds. Industry
sources estimate that skin lotions are used by approximately 80 percent of
households in the United States. Lactic acid (an alpha-hydroxy acid) is known to
be effective in the treatment of severe dry skin. The Company believes that the
tendency of lactic acid and its salts to be irritating to sensitive dry skin and
the lack of cosmetic appeal of certain existing formulations have generally
limited their use.

    The Company has developed Penederm Cream and Penederm Lotion, formulations
containing lactic acid and TopiCare Delivery Compounds. These products have
demonstrated clinically effective relief of severe dry skin. In addition, these
products indicated statistically superior protection against the irritation
caused by detergents as compared to two leading over-the-counter products, as
measured by erythema (redness) and dryness. Penederm Cream and Penederm Lotion
have also been shown to be effective in treating dry skin associated with
psoriasis and atopic dermatitis. The Company sells these products direct to
retail chains and wholesalers in the United States. Penederm Cream and Lotion
are sold by Pharmascience Inc. in Canada. The Company licenses to Warner
proprietary product formulations containing TopiCare Delivery Compounds, which
Warner markets in Canada under the trade names Lubriderm Moisture Recovery Alpha
Hydroxy Formula Creme and Lotion, and has entered into an agreement with
SmithKline whereby SmithKline will market in Europe other formulations
containing TopiCare Delivery Compounds. See "Risk Factors -- Marketing and Sales
Uncertainties; Dependence on Collaborative Partners," "Sales and Marketing" and
"Collaborative Arrangements."

    TopiCare Delivery Compounds. TopiCare Delivery Compounds can be designed in
formulations to provide effective moisturization of the skin, to bind to the
hair and skin, to be waterproof, non-occlusive and compatible with a broad range
of cosmetic formulations and not to clog pores. The Company believes these
advantages make the compounds candidates for use in cosmetics and skin care
products, such as sunscreens, makeups, mascara, moisturizers, lipsticks, nail
lacquers, soaps, shampoos and other hair care products. The Company has engaged
exclusive distributors in the Americas and in Europe for the sale of its
patented polymeric materials to the cosmetic and toiletry industries. Estee
Lauder, Inc., Mary Kay Cosmetics, Inc., Maybelline, Inc., and Clinique
Laboratories, Inc., among others, have purchased TopiCare Delivery Compounds for
commercial use in certain cosmetic products. The global distribution network is
comprised of Barnet Products Corporation, Nikko Chemicals Co., Ltd., Sederma
S.A., and Bronson and Jacobs, Pty. Ltd., acting as distributors of TopiCare
Delivery Compounds in the United States, Asia, Europe and South Africa, and
Australia/New Zealand, respectively. The Company is discussing additional
collaborative arrangements to commercialize TopiCare Delivery Compounds in
additional cosmetic and consumer skin care and hair care products worldwide.

PRECLINICAL RESEARCH AND EARLY CLINICAL RESEARCH AND DEVELOPMENT

    The Company continues to evaluate new compound and product opportunities
utilizing its TopiCare Delivery Compounds. The Company is conducting research to
develop new types of butenafine formulations as line extensions to Mentax for
treatment of skin fungus. Laboratory and Phase II human clinical studies
conducted by the Company with corticosteroids, which are used for the topical
treatment of psoriasis and other inflammatory disorders have demonstrated
effective delivery of corticosteroids from TopiCare-containing formulations,
with the potential for reduced systemic absorption. The Company is also
conducting preclinical research on formulating TopiCare Delivery Compounds with
Vitamin D analogs, 

                                       11
<PAGE>   12


other anti-oxidants and UV blockers to develop products which may prevent sun
damage or reduce wrinkles.

    Although the Company has focused its research efforts on dermatology and
skin care, the Company believes that there may be future opportunities for the
application of the TopiCare Delivery Compounds for treatment of disorders in
tissues other than skin. The Company has conducted preclinical research to
determine whether its TopiCare Delivery Compounds have utility in other
epithelial tissues, such as vaginal, oral or ophthalmic tissues. Laboratory
studies have indicated that TopiCare Delivery Compounds may be useful in holding
drugs in the eye for extended periods without being cleared by the natural
tearing of the eye. Additionally, laboratory work has indicated that TopiCare
Delivery Compounds may be used to deliver antifungal agents in a manner to
reduce the recurrence of yeast infections in vaginal tissue. Preclinical studies
are also ongoing to define the opportunities for TopiCare Delivery Compounds to
deliver and hold agents to hair and hair follicles to determine ways to enhance
the activity of those agents at targeted sites.

SALES AND MARKETING

    The Company's United States product commercialization strategy is to promote
to dermatologists through its own sales organization and to primary care
physicians and institutions through corporate co-promotion partners. Outside of
the United States the company seeks suitable licensees for its products. For
nonprescription skin and hair care markets, the Company plans to license out its
technology worldwide.



    PRESCRIPTION PRODUCTS

    In the United States, the Company's strategy is to market its prescription
products directly to the approximately 7,000 high prescribers of dermatologic
products through its own pharmaceutical specialty sales force of approximately
50 full time and flex-time sales representatives. A contracted specialty
pharmaceutical sales force commenced detailing Mentax and Avita to physicians in
February 1997 and August 1997, respectively. In December 1997, Penederm
initiated the conversion of the sales force from a contracted organization by
hiring six experienced sales managers, primarily from larger dermatology and
pharmaceutical companies, and converted 15 of its contract sales representatives
to employee status. The Company expects to complete the majority of the
recruitment of its own sales force in the first quarter of 1998. In addition to
promoting directly to high prescribing physicians of dermatologic products, the
Company engages in an active advertising campaign geared towards these
physicians through medical journals, medical publications, direct mail,
conventions, electronic media and sampling of its products. The Company believes
that its market penetration will be determined by its success in gaining high
awareness and successful usage among these targeted customers. Sales and
marketing expenditures are expected to increase significantly as a result of
retaining the contract sales force and engaging in promotional activities
related to product launch.

    In addition, the Company has entered into arrangements with collaborative
partners for the marketing of certain pharmaceutical products in the United
States. In June 1994, the Company entered into an agreement with Schering-Plough
for the development, prescription product co-promotion, OTC product marketing
and sale, and manufacture by Schering-Plough of certain Penederm nail antifungal
and skin antifungal products in the United States and Canada. Schering-Plough
has rights for promotion of the Mentax product to podiatrists in the U.S. In
December 1997, Penederm announced a co-promotion agreement with Mylan
Laboratories, Inc. (Mylan) under which Mylan will market Mentax to family care
physicians, general practitioners, internists and osteopaths through Bertek
Pharmaceuticals Inc., a subsidiary. See "Collaborative Arrangements."
  

                                       12

<PAGE>   13

    NONPRESCRIPTION PRODUCTS

    The Company intends to compete in nonprescription markets in the United
States through corporate partners and distributors. The Company currently has
arrangements with Warner, Pierre Fabre, Schering-Plough and Barnet Products
Limited for the sale of nonprescription products or TopiCare Delivery Compounds
in the United States and is actively pursuing other arrangements in the United
States. See "Collaborative Arrangements."

    MARKETS OUTSIDE OF THE UNITED STATES

    The Company intends to use distribution partners to market its products in
geographies outside of the United States. The Company has agreements with
Pharmascience for the distribution of Avita (trade named Vitinoin in Canada),
Penederm Cream, Penederm Lotion and DuraScreen in Canada, with UCB for the
distribution of nail antifungal products in Europe and the Middle East, with
SmithKline to market certain OTC skin care products containing the Company's
patented TopiCare Delivery Compounds in Europe, and with Allergan Incorporated
(Allergan) to register and market Avita and Mentax in Central and South America.
Kaken has the rights to market certain future Mentax line extensions in Japan.
In addition, Nikko Chemicals Co., Ltd., Sederma S.A., and Bronson and Jacobs,
Pty. Ltd. distribute TopiCare Delivery Compounds in Asia, Europe and South
Africa, and Australia/New Zealand, respectively. See "Products -- Prescription
Products, -- Avita" and "-- Mentax," and "Products -- Nonprescription Products."

COLLABORATIVE ARRANGEMENTS

    The Company's strategy for the research, development and commercialization
of certain of its products requires entering into various arrangements with
corporate collaborators, licensors, licensees and others. Set forth below is a
description of the Company's significant collaborative arrangements. The Company
is discussing additional collaborative arrangements to develop and commercialize
certain products and as part of its strategy expects to continue to pursue such
arrangements in the future. The Company believes that the establishment and
success of such arrangements is an important element in the long term success of
the Company. There can be no assurance that the Company will be able to maintain
its current collaborative relationships or establish new relationships on
acceptable terms, that the Company's current or future collaborative partners
will perform their obligations under such relationships, or that such
relationships will be commercially successful. Certain of the Company's
collaborative arrangements are terminable upon as few as 90 days notice, in
which event the product rights revert to Penederm without further consdideration
and become available for outlicense to another development or marketing partner.
See "Risk Factors -- Marketing and Sales Uncertainties; Dependence Upon
Collaborative Partners," "-- Uncertainty of Future Product Development."



    IN-LICENSING AND CO-PROMOTION ARRANGEMENTS

    University of California. The Company has licensed from the University of
California on a worldwide exclusive basis three United States and six foreign
patents providing coverage in 17 counties outside of the U.S. for the technology
underlying the TopiCare Delivery Compounds for the life of the patents. These
patents will expire during 2007 and 2008. Under the license arrangement, the
University of California is required to file, prosecute and maintain foreign
patent applications as requested by the Company at the Company's expense. The
University of California is entitled to royalties based on the revenues received
by the Company from the TopiCare Delivery Compounds and products that
incorporate the compounds. In 


                                       13
<PAGE>   14

general, these royalties range from 1.5 to 2.5 percent of net sales of the
delivery technology component, as defined in the license agreement.

    Kaken. The Company has licensed from Kaken exclusive rights to develop skin,
nail, and other topical antifungal products incorporating Kaken's proprietary
butenafine compound in the United States, Canada, Mexico, and Central and South
America. In addition, the Company has the exclusive right to develop and market
nail antifungal products in additional territories, including Western Europe,
Scandinavia, Latin America, Australia, and New Zealand. The Company made a
payment of approximately $500,000 to Kaken in 1995 and an additional payment of
approximately $500,000 in 1996. Additional future payments of approximately
$1,200,000 would become due upon the achievement of certain other regulatory
milestones related to the nail products. The Company believes that the
achievement of these additional milestones would occur, if at all, over several
years. In addition, the Company has agreed to purchase butenafine raw material
from Kaken.

    WARF and Renaissance. The Company has entered into an exclusive license with
WARF for the North American rights to develop topical and oral therapies for a
variety of skin diseases using Vitamin D metabolites and synthetic compounds and
to use a database of information regarding these metabolites and compounds. The
Company has licensed from WARF and Renaissance certain patents awarded to two
leading Vitamin D scientists. The Company's first disease target for these
Vitamin D analogs is psoriasis. The Company paid initial licensing fees to WARF
and certain patent licensing fees to Renaissance and will make payments
contingent upon achievement of product development and regulatory milestones and
will pay royalties upon any future product sales.

    Alpharma. The Company entered into an agreement with Alpharma to market in
the United States permethrin cream 5% for the treatment of scabies. Under the
terms of the agreement, Alpharma will manufacture and supply the product to
Penederm, which will pay Alpharma upfront milestones and royalties based upon
product sales and profits.

    The Merck KGaA Group/Center Laboratories. In January 1997, Penederm entered
into an arrangement with The Merck KGaA Group/Center Laboratories (Merck) to
co-promote in the United States Akne-Mycin, a topical cream ointment containing
erythromycin, and Cloderm, a mid-potency topical steroid. In September 1997, in
order to facilitate the sale of the products by Merck to a third party and to
allow the Company to focus on the promotion of its own brands, Penederm
terminated its co-promotion agreement with Merck at no cost to the Company.

                                       14

<PAGE>   15


    DEVELOPMENT AND DISTRIBUTION

    Schering-Plough. The Company has entered into an agreement with
Schering-Plough for the development, prescription product co-promotion, OTC
product marketing and sale, and manufacture by Schering-Plough of certain
Penederm nail antifungal and, at Schering-Plough's option, skin antifungal
products in the United States and Canada. Pursuant to the agreement,
Schering-Plough and the Company will collaborate in the development of, and the
regulatory filing related to, the antifungal products, and Schering-Plough will
have co-promotion and marketing rights with respect to podiatrists and the
Company will maintain exclusive rights to promote and market the products to all
other prescription audiences. The Company and Schering-Plough are co-promoting
the products as one brand. The agreement provides for Schering-Plough to pay the
Company upfront fees, development support and milestone payments if certain
conditions are met, including, but not limited to, clinical development and
regulatory approval of, and option payments for, the antifungal products. In
addition, the Company would receive royalties upon product sales and the
exclusive right to supply certain raw materials. The agreement may be terminated
by Schering-Plough at any time. In that event, the marketing rights would revert
to the Company, including the right to sublicense to another development
partner.

    UCB. The Company has entered into a licensing agreement with a subsidiary of
UCB to market certain topical prescription butenafine antifungal formulations in
Europe, Africa and the Middle East. UCB will complete clinical development and
seek regulatory approval in the countries under the agreement. The agreement
provides the Company with upfront and milestone payments, a royalty on sales and
a supply agreement for its TopiCare Delivery Compounds.

    Pharmascience. The Company has entered into an agreement with Pharmascience
to market retinoic acid prescription products, DuraScreen and Penederm Lotion
and Penederm Cream in Canada. Pharmascience launched these products in 1995.
Terms of the license include supply arrangements and royalties payable to the
Company based on net product sales.

    Mylan Laboratories Inc. In December 1997, Penederm entered into an
arrangement with the Bertek Pharmaceuticals Inc. subsidiary of Mylan
Laboratories Inc. (Mylan) to co-promote Mentax in the United States to family
care physicians, general practitioners, internists and osteopaths.

    Allergan. The Company has entered into a November 1997 agreement with a
Brazilian subsidiary of Allergan Incorporated (Allergan) to pursue regulatory
approval and market retinoic acid and butenafine prescription products in
Central and South America. Terms of the license include milestones, supply
arrangements and royalties payable to the Company based on net product sales.

    Warner. The Company has licensed to Warner proprietary formulations
containing TopiCare Delivery Compounds to create Lubriderm Moisture Recovery
Alpha Hydroxy Acid Creme and Lotion products. Warner markets these products in
Canada. Terms of the license include supply arrangements, fees and royalties
payable to the Company based on net product sales.

    SmithKline. The Company has entered into an agreement with SmithKline
whereby SmithKline will market in Europe certain OTC products containing
TopiCare Delivery Compounds. The Company will receive certain milestone payments
and royalties on sales of these SmithKline products, in addition to sales from
the supply of TopiCare Delivery Compounds. The companies have completed the
initial development phase of a second collaboration and are discussing
commercialization alternatives for these products.

                                       15
<PAGE>   16

    Pierre Fabre. Pierre Fabre holds the U.S. marketing rights to the DuraScreen
product line in 1996, and will continue to pay the Company royalties based on
annual net sales of DuraScreen and purchase TopiCare Delivery Compounds from the
Company on the same terms as the original distributor.

    TopiCare Delivery Compound Distributors. The Company has established a
global distribution network for the sale of its TopiCare Delivery Compounds for
use in cosmetics and skin care products. Barnet Products Corporation Limited,
Nikko Chemicals Co., Ltd., Sederma S.A., and Bronson and Jacobs, Pty. Ltd. act
as distributors of TopiCare Delivery Compounds in the United States, Asia,
Europe and South Africa, and Australia/New Zealand, respectively. TopiCare is
sold through these distributors on a purchase order basis.

RESEARCH AND DEVELOPMENT EXPENDITURES

    Penederm charges research and development expenses to operations as
incurred. Such expenses for 1997, 1996 and 1995 were $6,950,000, $5,292,000, and
$5,713,000, respectively.

MANUFACTURING AND RAW MATERIALS

    The Company contracts with third parties to manufacture its finished
products and the TopiCare Delivery Compounds, subject to strict industry and
governmental standards. By using contract manufacturers, the Company has avoided
the need to invest in substantial production equipment or hire a manufacturing
labor force to make its products. The Company currently has no plans to
establish internal manufacturing facilities, but does intend to continue
qualifying multiple contract manufacturers. The Company currently has two
qualified manufacturing sites for TopiCare Delivery Compounds, one qualified
manufacturing site for Avita and Mentax and two qualified manufacturing sites
for Penederm Cream, Penederm Lotion, DuraScreen and Lubriderm. The Company is in
the process of qualifying a second manufacturing site for Avita products.
Penederm intends to maintain rights to the manufacture of certain finished
products and TopiCare Delivery Compounds.

    The Company is dependent upon third parties for the supply of raw materials
used to produce TopiCare Delivery Compounds and finished products. One of the
materials used in the compounds is currently available from only one supplier,
Bayer Corporation ("Bayer"). Bayer is a major worldwide chemical company, and it
supplies this ingredient as a commodity to the Company on a purchase order basis
and to many other users in much larger quantities than it supplies to the
Company. The Company currently obtains certain other raw materials, including
butenafine and retinoic acid, from other sole sources. The Company currently
secures many of these supplies pursuant to contracts that are terminable on
short notice or purchase orders. In the event of termination or breach by a
supplier or other failure to continue to supply materials, the Company would be
required to secure and qualify an alternate supplier. Although the Company has
not experienced difficulty acquiring the necessary raw materials, it maintains
significant inventories of the affected raw materials and believes it could
qualify alternate suppliers for these materials. The Company continues to
attempt to identify an alternate supplier for the material now available only
from Bayer. There can be no assurance that the Company would not experience a
disruption in manufacturing if it experienced a disruption in supply from any
sole source. Any significant interruption of supply or significant increase in
the cost of raw materials could have a material adverse effect on the Company's
ability to produce its compounds and finished products.

PATENTS AND PROPRIETARY TECHNOLOGY

    The basic technology underlying the TopiCare Delivery Compounds was
originally discovered by researchers at the University of California, Irvine and
has been patented by the University of California. In 

                                       16
<PAGE>   17

1987, the University of California granted the Company an exclusive worldwide
license for the life of the applicable patents to use and develop this
technology. Under this license, the University of California is required to
maintain, at the Company's expense, all United States patent rights with respect
to the licensed technology and to file and prosecute patent applications in
foreign countries when requested by the Company. The University of California is
entitled to royalties based on the revenues received by the Company from the
TopiCare Delivery Compounds and products that incorporate the compounds. In
general, these royalties range from 1.5 to 2.5 percent of net sales of the
delivery technology component, as defined in the license agreement.

    To date, the Company has exclusive rights to three United States patents and
six foreign patents covering 17 countries outside of the U.S. obtained by the
University of California and relating to the uses of the TopiCare Delivery
Compounds. These patents will expire in 2007 and 2008. In 1997, two U.S. patents
were issued covering retinoic acid-containing polyether-polyurethane
formulations which can be used in the treatment of acne vulgaris and certain
other disorders of the skin. In addition, the Company has applied for four
patents in Japan for cosmetic applications, and one foreign patent covering 19
countries outside of the U.S. covering retinoic acid-containing
polyether-polyurethane formulations used for the treatment of acne vulgaris and
certain other disorders of the skin. Also, in 1997, the Company filed one U.S.
patent application covering an antifungal/steroid combination drug product.

    The Company's policy is to protect its technology by, among other things,
filing, or requiring the University of California to file, patent applications
for technology that it considers important to the development of its business.
The Company intends to file additional patent applications, when appropriate,
relating to its technology, improvements to its technology and to specific
products that it develops. There can be no assurance that any additional patents
will be issued, or, if issued, that they will be of commercial benefit to the
Company. In addition, it is impossible to anticipate the breadth or degree of
protection that any such patents will afford. Furthermore, there can be no
assurance that litigation seeking to challenge such patent protection will not
be brought against the Company or the University of California or that the
Company's or the University of California's patents will not be successfully
challenged. The expenses involved in any patent litigation can be significant
and cannot be estimated by the Company. In addition, there can be no assurance
that the Company will be successful in the current proceeding or that the scope
and validity of the Company's or the University of California's existing or
future patents, if any, will prevent third parties from developing similar or
competing products.

    The Company has also licensed certain composition of matter, process and use
patents from WARF and Renaissance related to various Vitamin D compounds.

    A substantial number of patents have been issued to other pharmaceutical and
drug delivery companies. Pharmaceutical companies, drug delivery system
companies and others, including competitors, may have filed applications for, or
may have been issued patents or may obtain additional patents and proprietary
rights relating to, products or processes competitive with those of the Company.
Accordingly, there can be no assurance that the Company's or the University of
California's future patent applications will result in issued patents or that
any patents will afford significant protection against competitors with similar
technology. There can be no assurance that any patents issued to the Company,
the University of California or other licensors of drug compounds or skin care
agents to the Company, such as Kaken, WARF and Renaissance, will not be
infringed or circumvented by others, or that others will not obtain patents that
the Company would need to license or circumvent. There can be no assurance that
licenses that might be required for the Company's processes or products would be
available on reasonable terms, or at all. In addition, there can be no assurance
that the Company's, the University of California's or other licensors' existing
or future patents, if any, would be held valid by a court of competent
jurisdiction.

                                       17
<PAGE>   18

    Third parties may hold or be issued patents which the Company's technology
may infringe. The Company could incur substantial costs in defending itself and
its collaborative partners against any resulting claims. Furthermore, parties
making such claims may be able to obtain injunctive or other equitable relief
which could effectively block the Company's ability to further develop or
commercialize its products in the United States and abroad, and could result in
the award of substantial damages. In the event of a claim of infringement, the
Company may be required to obtain one or more licenses from third parties. There
can be no assurance that the Company will be able to obtain such licenses at a
reasonable cost, if at all. Defense of any lawsuit or failure to obtain any such
license could have a material adverse effect on the Company.

    The Company also relies upon unpatented trade secrets and know-how, and
there can be no assurance that others will not independently develop
substantially equivalent proprietary information and techniques, or otherwise
gain access to the Company's trade secrets or disclose such technology, or that
the Company can meaningfully protect its rights to its unpatented trade secrets.

    The United States Patent and Trademark Office ("PTO") has recently adopted
changes to United States patent law which changed the term of issued patents,
subject to certain transition periods, to 20 years from the date of filing
rather than 17 years from date of issuance. For applications filed after June 7,
1995, the patent term will be 20 years from the earliest effective filing date
of the priority patent application. Such change may reduce the effective term of
protection for patents that are pending for more than three years in the PTO.
While the Company cannot predict the effect that such changes may have on its
business, the adoption of such changes could have a material adverse effect on
the Company's ability to protect its proprietary information and sustain the
commercial viability of its products. Furthermore, the possibility of shorter
terms of patent protection, combined with the lengthy FDA review process and
possibility of extensive delays in such process, could effectively further
reduce the term during which a marketed product could be protected by patents.
These changes in the patent law do not, however, affect the existing patents for
the technology underlying the TopiCare Delivery Compounds, for Mentax licensed
from Kaken, or for the Vitamin D analogs licensed from WARF and Renaissance.

    It is the Company's policy to require its employees and consultants to
execute a confidentiality agreement upon the commencement of employment by or
consultancy to the Company. Each agreement provides that all confidential
information developed or made known to the employee or consultant during the
course of employment or consultancy will be kept confidential and not disclosed
to third parties except in specified circumstances and that all inventions
conceived by the employee or consultant shall be the exclusive property of the
Company. In addition, the Company enters into confidentiality agreements with
all collaborators and potential collaborators. There can be no assurance,
however, that these agreements will provide meaningful protection for the
Company's trade secrets in the event of unauthorized use or disclosure of such
information.

GOVERNMENT REGULATION

    FDA Requirements for Drug Compounds. The research, testing, manufacture and
marketing of drug products are extensively regulated by numerous governmental
authorities in the United States and other countries. In the United States,
drugs are subject to rigorous regulation by the FDA. The federal Food, Drug and
Cosmetic Act, as amended (the "FDC Act"), and the regulations promulgated
thereunder, and other federal and state statutes and regulations, govern, among
other things, the research, development, testing, manufacture, storage,
recordkeeping, labeling, promotion and marketing and distribution of
pharmaceutical products. Failure to comply with applicable regulatory
requirements may subject a company to administrative or judicially imposed
sanctions such as civil penalties, criminal prosecution, injunctions, product
seizure or detention, product recalls, total or partial suspension of
production, and FDA refusal to approve pending premarket approval applications
or supplements to approved applications.

                                       18
<PAGE>   19


    Investigational New Drug (IND) Applications. The steps ordinarily required
before a new pharmaceutical product may be marketed in the United States
include: (i) preclinical laboratory tests, in vivo preclinical studies and
formulation studies; (ii) the submission to the FDA of an IND, which must become
effective before clinical testing may commence; (iii) adequate and
well-controlled clinical trials to establish the safety and effectiveness of the
drug; (iv) the submission of a New Drug Application ("NDA") to the FDA and (v)
FDA review and approval of the NDA prior to any commercial sale or shipment of
the drug. Preclinical tests include laboratory evaluation of product chemistry
and formulation, as well as animal studies to assess the potential safety and
efficacy of the product. Compounds must be formulated according to current Good
Manufacturing Practice ("cGMP") requirements, and preclinical tests must be
conducted in compliance with Good Laboratory Practice regulations. The results
of preclinical testing are submitted to the FDA as part of an IND. A 30-day
waiting period after the filing of each IND is required prior to the
commencement of clinical testing in humans. If the FDA has not commented on or
questioned the IND within this 30-day period, clinical studies may begin. If the
FDA has comments or questions, the questions must be answered to the
satisfaction of the FDA before initial clinical testing can begin. In addition,
the FDA may, at any time, impose a clinical hold on ongoing clinical trials. If
the FDA imposes a clinical hold, clinical trials cannot commence or recommence
without FDA authorization and then only under terms authorized by the FDA. In
some instances, the IND application process can result in substantial delay and
expense. The Company has filed INDs for retinoic acid and Mentax skin and nail
antifungal formulations and a Vitamin D analog formulation and has conducted
clinical testing of those formulations and other formulations incorporating
other drugs under IND submissions filed by others.

    New and Abbreviated New Drug Applications. Clinical trials involve the
administration of the investigational new drug to healthy volunteers or patients
under the supervision of a qualified principal investigator. Clinical trials are
conducted in accordance with good clinical practices under protocols detailing
the objectives of the study, the parameters to be used in monitoring safety and
the effectiveness criteria to be evaluated. Each protocol must be submitted to
the FDA as part of the IND. Further, each clinical study must be conducted under
the auspices of an independent Institutional Review Board ("IRB") at the
institution at which the study will be conducted. The IRB will consider, among
other things, ethical factors, the safety of human subjects and the possible
liability of the institution. Clinical trials to support NDAs are typically
conducted in three sequential phases, but the phases may overlap. In Phase I,
the initial introduction of the drug into healthy human subjects or patients,
the drug is tested to assess metabolism, pharmacokinetics and pharmacological
actions and safety, including side effects associated with increasing doses.
Phase II usually involves studies in a limited patient population to (i)
determine the efficacy of the drug for specific, targeted indications, (ii)
determine dosage tolerance and optimal dosage and (iii) identify possible
adverse effects and safety risks. If a compound is found to be effective and to
have an acceptable safety profile in Phase II evaluations, Phase III trials are
undertaken to further evaluate clinical efficacy and to further test for safety
within an expanded patient population at geographically dispersed clinical study
sites. There can be no assurance that Phase I, Phase II or Phase III testing
will be completed successfully within any specified time period, if at all, with
respect to any of the Company's products subject to such testing.

    After completion of the required clinical testing, an NDA is generally
submitted. FDA approval of the NDA (or, in the alternative an Abbreviated New
Drug Applications ("ANDA"), as described below) is required before marketing may
begin in the United States. The NDA must include the results of extensive
clinical and other testing and the compilation of data relating to the product's
chemistry, pharmacology and manufacture, the cost of all of which is
substantial. The FDA reviews all NDAs submitted before it accepts them for
filing and may request additional information rather than accepting an NDA for
filing. In such an event, the NDA must be resubmitted with the additional
information and, again, is subject to review before filing. Once the submission
is accepted for filing, the FDA begins an in-depth review of the NDA. Under 

                                       19
<PAGE>   20

the FDC Act, the FDA has 12 months in which to review the NDA and respond to the
applicant. The review process is often significantly extended by FDA requests
for additional information or clarification regarding information already
provided in the submission. The FDA may refer the application to the appropriate
advisory committee (typically a panel of clinicians) for review, evaluation, and
a recommendation as to whether the application should be approved. The FDA is
not bound by the recommendation of an advisory committee. During the review
process, the FDA generally will conduct an inspection of the relevant drug
manufacturing facilities to ensure that the facilities are in compliance with
applicable cGMP requirements. If FDA evaluations of the NDA application and the
manufacturing facilities are favorable, the FDA may issue either an approval
letter or an approvable letter, which usually contains a number of conditions
that must be met in order to secure final approval of the NDA. When and if those
conditions have been met to the FDA's satisfaction, the FDA will issue an
approval letter, authorizing commercial marketing of the drug for certain
indications. As a condition of NDA approval, the FDA may require postmarketing
testing and surveillance to monitor the drug's safety or efficacy. If the FDA's
evaluation of the NDA submission or manufacturing facilities is not favorable,
the FDA may refuse to approve the NDA or issue a not approvable letter,
outlining the deficiencies in the submission and often requiring additional
testing or information. Notwithstanding the submission of any requested
additional data or information in response to an approvable or not approvable
letter, the FDA ultimately may decide that the application does not satisfy the
regulatory criteria for approval. Once granted, product approvals may be
withdrawn if compliance with regulatory standards is not maintained or problems
occur following initial marketing.

    In circumstances where a company submits an NDA for a novel formulation of
an active drug ingredient already approved by the FDA, clinical and preclinical
testing requirements may not be as extensive. Limited additional data about the
safety and/or effectiveness of the proposed new drug formulation, along with
chemistry and manufacturing information and public information about the active
ingredient, may be satisfactory for product approval. Consequently, the new
product formulation may receive marketing approval more rapidly than a
traditional full NDA, although there can be no assurance that a product will be
granted such treatment by the FDA or, if granted, will result in an approval.

    Once patent and other statutory protections covering a drug approved under
an NDA have expired or have been demonstrated not to apply, a generic equivalent
to that drug may be approved under an ANDA. An ANDA usually is based upon
bioequivalence data that demonstrate that the rate and extent of absorption of
the active drug ingredient of the generic drug, usually measured in the blood
stream, is equivalent to that of the drug approved under an NDA. The
demonstration of bioequivalence and, therefore, ANDA approval generally requires
less time than safety and efficacy studies and NDA approval.

    Although ANDAs are not available for the Company's retinoic acid products
because these products contain excipients not included in the marketed retinoic
acid products, the Company believes ANDAs may be available for the Company's
future topical formulations of drugs that have already been approved by the FDA.
Nevertheless, because there can be no assurance that other drugs utilizing the
TopiCare Delivery Compounds will be eligible for ANDAs, and because standard
bioequivalence studies may be of questionable utility in dermatologics, which
are generally non-systemically absorbed, the Company intends to perform clinical
studies to establish the safety, effectiveness, and therapeutic equivalence of
its new drugs to listed drugs in order to support the ANDAs it expects to file
for future products.

    Premarket approval under section 505(b)(2) of the FDC Act may be appropriate
for certain future drugs developed by the Company. Section 505(b)(2) allows the
FDA to approve an NDA using shortened procedures, usually for drugs that have
proven safety profiles because of the market place performance among a large
population. In a 505(b)(2) application, a company may rely on clinical
investigations conducted by others to which it does not hold a right of
reference. In general, a 505(b)(2) application is 


                                       20
<PAGE>   21


supported by two or three clinical studies among the target population group
designed to verify the safety and efficacy of the drug product in that
population using that target dose and dose sequence. The cost of this approach
is typically much less than a standard NDA.

    Until an NDA, ANDA or Section 505(b)(2) application is actually approved,
there can be no assurance that the information requested and submitted will be
considered adequate by the FDA to justify approval. It is impossible to
anticipate the amount of time that will be required to obtain approval from the
FDA to market any product.

    OTC Drug Products. Most OTC drug products marketed in the United States are
exempt from the FDA's premarketing approval requirements. In 1972, the FDA
instituted the ongoing OTC Drug Review to evaluate the safety and effectiveness
of OTC drugs then on the market. Through this process, the FDA issues monographs
that set forth the specific active ingredients, dosages, indications and
labeling statements for OTC drugs that the FDA will consider generally
recognized as safe and effective and therefore not subject to premarket
approval. For certain categories of OTC drug products not yet subject to a final
monograph, the FDA usually will not take regulatory action against such a
product unless failure to do so poses a potential health hazard to consumers.
The active ingredients in DuraScreen are covered by the FDA tentative final
monograph for OTC sunscreen drug products issued May 12, 1993, and the Company
believes that it has formulated and labeled DuraScreen in accordance with that
proposed regulation. Changes in that monograph may require changes to the
product and its labeling. OTC drug products and manufacturing facilities are
subject to FDA inspection, and failure to comply with applicable regulatory
requirements may lead to administrative or judicially imposed penalties.

    Manufacturing. Each domestic drug manufacturing facility must be registered
with FDA. Domestic drug manufacturing establishments are subject to inspection
by the FDA and must comply with cGMP. To supply products for use in the United
States, foreign manufacturing establishments must comply with cGMP and are
subject to periodic inspection by the FDA or corresponding regulatory agencies
in countries under reciprocal agreements with the FDA. Drug product
manufacturing establishments located in California must be licensed by the State
of California in compliance with local regulatory requirements. The Company uses
and will continue to use contract manufacturers to produce its products in
commercial quantities. The Company will audit its contract manufacturers
periodically to monitor their compliance with cGMP, although there can be no
guarantee that future FDA inspections will proceed without any compliance issues
requiring the expenditure of money or other resources.

    Foreign Regulation of Drug Compounds. Whether or not FDA approval has been
obtained, approval of a product by comparable regulatory authorities may be
necessary in foreign countries prior to the commencement of marketing of the
product in such countries. The approval procedure varies among countries, can
involve additional testing, and the time required may differ from that required
for FDA approval. Although there are some procedures for unified filings for
certain European countries with the sponsorship of the country which first
granted marketing approval, in general each country has its own procedures and
requirements, many of which are time consuming and expensive. Thus, there can be
substantial delays in obtaining required approvals from foreign regulatory
authorities after the relevant applications are filed. The Company expects to
rely on corporate partners and licensees, external consultants, and Company
expertise to obtain governmental approval in foreign countries of drug
formulations utilizing its compounds.

    Cosmetics. Cosmetics do not require approval by the FDA for marketing in the
United States. Cosmetic products must be safe under normal conditions of use and
must comply with FDA labeling regulations.

                                       21
<PAGE>   22

COMPETITION

    In the development and marketing of dermatologic drugs, skin care products
and drug delivery systems, the Company faces significant competition from, among
others, large pharmaceutical companies with established dermatology divisions,
such as Ortho Pharmaceutical Company, a subsidiary of Johnson & Johnson,
Schering-Plough, Pharmacia & Upjohn, Inc. and Westwood Pharmaceuticals Inc., a
subsidiary of Bristol-Myers. The Company believes that its principal competition
with respect to Avita is the retinoic acid products marketed by Johnson &
Johnson under the Retin-A(R) brand name and to a lesser extent the newer
generation topical retinoic acid products introduced by Johnson & Johnson and
Galderma Laboratories Inc. The Johnson & Johnson Retin-A(R) products have been
on the market for many years and continue to have a significant portion of the
market share for prescription acne treatments. The Company expects that its
principal competition with respect to Mentax will be products marketed by Glaxo
Wellcome plc (Glaxo), Johnson & Johnson, and Novartis. Most of the Company's
competitors have substantially greater financial, technical, production,
marketing and regulatory experience and resources, larger sales and marketing
forces and more experience than the Company in developing, commercializing and
marketing drug and skin care products. The Company also competes with several
smaller companies which have been formed to develop unique delivery systems or
to produce competing drug or skin care products. In recent years, several other
companies have been formed and, in certain instances, are collaborating with
large pharmaceutical companies, to develop specific drug delivery systems or
drug or skin care products that might compete directly with the Company's
technologies and products. Drug delivery systems and products developed by the
Company's competitors may be superior to, or gain greater or faster market
acceptance than, the Company's drug delivery systems and products. The Company
also faces competition from universities and related entities seeking to develop
drug delivery technologies and to earn revenues from technology and patent
licensing. In addition, these companies and academic and research institutions
compete with the Company in recruiting and retaining highly qualified scientific
and management personnel.

    Competition in the dermatology market is generally based on performance
characteristics and, to a somewhat lesser extent, price. Acceptance by doctors
and patients, of which there can be no assurance, is crucial to the success of a
product. There can be no assurance that the Company's current products and
products under development will be able to compete successfully with existing
products or that other companies, universities and other institutions will not
be able to develop products that compete effectively with the Company's current
products and products under development.

    In licensing its compounds for use in cosmetics and consumer skin care
products, the Company faces strong competition both from specialty chemical
companies and from cosmetic companies with substantially greater resources that
develop their own formulating agents. The Company expects technological
developments to occur at a rapid rate and believes that competition may
intensify as technological advances in the field are made and become more widely
known.

SCIENTIFIC ADVISORY BOARD

        The Company has established a Scientific Advisory Board composed of
individuals with expertise in the fields of dermatology, topical drug delivery
and non-prescription skin care. The Scientific Advisory Board was formed to
assist in establishing strategic research and development policy. The members of
the Scientific Advisory Board meet as a group periodically. In addition, members
of the Scientific Advisory Board also meet from time to time on an individual
basis with scientists and management of the Company to review projects and
programs. Individual members of the Scientific Advisory Board help guide the
Company's clinical and scientific evaluation programs. If appropriate, certain
members of the Scientific Advisory Board conduct clinical studies of the
Company's formulations as investigators and conduct 

                                       22

<PAGE>   23

experiments on behalf of the Company. The Company intends to expand the
Scientific Advisory Board and continue to use other external research
consultants as the number of its products increases.

        As of December 31, 1997, the members of Penederm's Scientific Advisory
Board were as follows:
<TABLE>
<CAPTION>

              NAME                AFFILIATION
              ----                -----------
<S>                               <C>    
Albert M.  Kligman, M.D., Ph.D    Professor of Dermatology, University of Pennsylvania
                                  School of Medicine

Gerald G. Krueger, M.D            Professor of Medicine, University of Utah School of
                                  Medicine

James Leyden, M.D                 Professor of Dermatology, University of Pennsylvania
                                  School of Medicine

Nicholas J. Lowe, M.D             Clinical Professor of Dermatology, University of California,
                                  Los Angeles, School of Medicine

Gerald D. Weinstein, M.D          Professor and Chairman, Department of Dermatology, University
                                  of California, Irvine, College of Medicine
</TABLE>

                                       23
<PAGE>   24


HUMAN RESOURCES

  As of December 31, 1997, the Company had 52 employees, 29 of whom were engaged
in research and development, 12 in marketing and sales activities, and 11 in
finance, administration and operations. The Company believes that its future
success will depend upon its ability to continue to attract and retain a team of
highly motivated and skilled individuals. None of the Company's employees is
represented by a labor organization. The Company believes that its employee
relations are good.



SUPPLEMENTAL ITEM.  EXECUTIVE OFFICERS OF THE REGISTRANT

        The executive officers of the Company and their ages as of January 31,
1998 are as follows:
<TABLE>
<CAPTION>

             Name                  Age       Position with the Company
             ----                  ---       -------------------------

<S>                                <C>   <C>                                  
Lloyd H. Malchow..............     44    Director, President and Chief Executive
                                         Officer

John W. Quigley, Jr., Ph.D....     57    Senior Vice President, Research and
                                         Development

William T. Gutshall...........     54    Vice President, Operations

Edward Ebbers.................     40    Vice President, Sales and Marketing

Michael A. Bates..............     39    Vice President, Finance and
                                         Administration and Chief Financial
                                         Officer

</TABLE>

    There is no family relationship between any of the directors or executive
officers of the Company.

    MR. MALCHOW has served as President, Chief Executive Officer and a director
of the Company since January 1995. Prior to that, he served as the Company's
President and Chief Operating Officer from May 1993 through January 1995. He was
the Vice President and General Manager of the Herbert Skin Care Division of
Allergan, Inc. from 1992 to May 1993. From 1983 to 1991 Mr. Malchow held various
positions, including Vice President, Sales of Allergan Medical Optics (formerly
American Medical Optics prior to acquisition by Allergan in 1985) and, most
recently, Vice President for Global Development, Skin Care. He holds a B.A. from
Carroll College, a M.A. from the University of Maryland and a M.B.A. from
Pepperdine University.

    DR. QUIGLEY has served as Senior Vice President, Research and Development
since July 1996. From November 1987 to July 1996 he served as the Company's Vice
President, Research and Development. After 16 years in research and management
at Procter & Gamble Co., a consumer products company, he joined Bristol Myers
Co., a pharmaceuticals and toiletries company, in 1984 as Director of
Preclinical Research, Dermatology, a position he held until joining Penederm.
From 1984 through 1987 he also served as an adjunct professor in the Department
of Dermatology at the State University of New York, Buffalo. Dr. Quigley holds a
B.S. degree in Chemistry, an M.S. in Plant Biochemistry and Physiology and a
Ph.D. in Biochemistry from Rutgers University and was a post-doctoral fellow at
the University of Pennsylvania School of Medicine.

    MR. GUTSHALL has served as Vice President of Operations since April 1993.
Prior to managing his own consulting business from 1990 to 1993, he served as
Vice President of Global Operations from 1986 to 1989 for the Optometric
Division of CooperVision, Inc., a former opthalmologic products subsidiary of
the Cooper Companies, Inc. From 1970 to 1985, he held various operations
management positions with Johnson & Johnson, a health care company, the last
being Director of Purchasing and Contract Manufacturing. Mr. Gutshall holds a
B.S. degree from East Central State University.

                                       24
<PAGE>   25


    MR. EBBERS has served as Vice President of Sales and Marketing since April
1996. From November 1994 to April 1996 he served as Director of Marketing for
the Company. From 1987 to 1994, Mr. Ebbers held various management positions
with Syntex Laboratories, the last being Group Product Director. From 1979 to
1987, he served in several capacities for a subsidiary of Minnesota Mining and
Manufacturing Company, Riker Laboratories, Inc. (now known as 3M Pharmaceuticals
Division). Mr. Ebbers holds a B.B.A. from the University of Wisconsin and an
M.B.A. in Information Systems from the University of Minnesota, Minneapolis.

    MR. BATES has served as Vice President, Finance and Administration and Chief
Financial Officer since October 1997. From December 1996 to October 1997 he
served as Director of Finance and Administration and from February 1995 to
December 1996 as Controller for the Company. In 1994 Mr. Bates served as Vice
President, Finance and Administration for De Novo, Inc. and in 1993, Mr. Bates
served as Director of Finance and Controller for Pharmetrix Corporation. From
1988 to 1994 Mr. Bates served in various financial management positions with
Tandem Computers. From 1981 to 1988 Mr. Bates held various positions with
Deloitte & Touche. Mr. Bates holds a B.S. from the University of California,
Hayward and an M.B.A in Finance from the University of California, Berkeley. Mr.
Bates is a Certified Public Accountant.

                                       25

<PAGE>   26


RISK FACTORS

        The statements in this Annual Report on Form 10-K and other statements
made by the company from time to time that relate to future plans, events or
performance are forward-looking statements which involve risks and
uncertainties. Actual results, events or performance may differ materially from
those anticipated in any forward-looking statements as a result of a variety of
factors, including those set forth below and elsewhere in this Annual Report on
Form 10-K. The following risk factors should be considered carefully in
evaluating the Company and its business by the Company's stockholders and by
prospective investors in the Company.

        Uncertainty of Early Commercialization Efforts and Market Acceptance of
Prescription Products. Although the Company has invested significant
expenditures in the launch of both Avita and Mentax in 1996 and 1997, the
products have achieved only modest market shares and will continue to face
manufacturing, sales and marketing, market acceptance and other risks associated
with the continued commercialization of prescription pharmaceutical products.
The Company will face certain risks related to the initial launch of its Avita
gel product and Acticin product in 1998. The Company relies on third-party
contract manufacturers for commercial production of all of its products. There
can be no assurance that the Company will be able to obtain contract
manufacturing of adequate quantities on a timely basis or on commercially
acceptable terms, if at all, for its products. The Company has commenced
marketing in the United States prescription products through a pharmaceutical
specialty contract sales force which will be replaced by its own direct,
employee-based sales force in early 1998. The Company has no experience
developing or managing a sales force and limited experience promoting
prescription products, and there can be no assurance that the Company will be
able to manage the sales force transition without customer disruption, or
establish and maintain a successful marketing and sales effort. A number of
factors may limit the market acceptance of the Company's products, including the
timing of market entry, the availability of alternative products, the price of
the Company's products relative to alternative products, the availability of
third-party reimbursement, acceptance by prescribing physicians, managed care
providers and patients, the nature of publicity regarding the products (if any),
and the extent of marketing efforts by the Company's collaborators or partners
(if any). The Company's products will be subject to continued post-market review
which may result in restrictions on marketing or withdrawal of any such products
from the market. There can be no assurance that prescribing physicians, managed
care providers or patients will demand the products in quantities consistent
with expectations of public market analysts and investors. The failure of such
products to receive market acceptance could have a material adverse effect on
the Company's operating results or the market price of the Company's Common
Stock.

        Competition and Technological Change. The Company faces significant
competition from, among others, large pharmaceutical companies with established
dermatology divisions. The Company believes that its principal competition with
respect to Mentax are products marketed by Allergan Inc., Johnson & Johnson, and
Novartis (formerly Sandoz Pharmaceuticals). The Company believes that its
principal


                                       26

<PAGE>   27

competition with respect to Avita initially are the retinoic acid products
marketed by Johnson & Johnson and Galderma. Such Johnson & Johnson products have
been on the market for many years and have substantially all of the market share
for prescription acne treatments. The Company is aware of other newly-approved
novel acne treatments that may present substantial competition for Avita,
including another Johnson & Johnson tretinoin gel product and a new topical
retinoid product from Galderma that are both being promoted as less irritating.
Most of the Company's competitors have substantially greater financial,
technical, production, marketing and regulatory experience and resources, larger
sales and marketing forces and more experience than the Company in developing,
commercializing and marketing drug and skin care products. There can be no
assurance that the Company's existing and proposed products, including Avita and
Mentax, will compete successfully with the existing and proposed products of the
Company's competitors, and the failure of the Company's products to do so would
have a material adverse effect on the Company's operating results.

        The Company's current products and those under development are based on
relatively new technologies. The Company expects technological developments in
its business to occur at a rapid rate and believes that competition may
intensify as technological advances in the field are made and become more widely
known. In recent years, several other companies have been formed and, in certain
instances, are collaborating with large pharmaceutical companies, to develop
specific drug delivery systems or drug or skin care products that might compete
directly with the Company's technologies and products. Delivery systems and
products developed by the Company's competitors may be superior to, or gain
greater or faster market acceptance than, the Company's drug delivery systems
and products. There can be no assurance that the Company's competitors will not
succeed in developing technologies and products that are more effective than any
which have been or are being developed by the Company or that would render the
Company's products and technologies obsolete or noncompetitive. See "Business
--Competition."

        Dependence on Sole Suppliers and Third Party Manufacturers. The Company
is dependent on third parties for both the supply of raw materials used to
produce TopiCare Delivery Compounds and finished products and the manufacturing
of these compounds and products. One of the materials used in TopiCare Delivery
Compounds is currently available from only one supplier, Bayer. The Company
currently obtains certain other raw materials, including butenafine and retinoic
acid, from other sole sources. The Company currently secures many of these
supplies pursuant to purchase orders or contracts that are terminable on short
notice. In the event of termination or breach by a supplier or other failure to
continue to supply materials, the Company would be required to secure and
qualify an alternate supplier. Although the Company has not experienced
difficulty acquiring raw materials, maintains significant inventories of these
materials and believes it could qualify alternate suppliers for these materials,
there can be no assurance that interruptions in supplies will not occur in the
future or that the Company would be able to timely secure the materials
necessary to produce its products so as to not experience a disruption in
manufacturing if a supplier breached or terminated its contract and the Company
experienced a disruption in supply. Any significant interruption in the supply
of raw materials could have a material adverse effect on the Company's ability
to produce its compounds and finished products and its operating results.

        The Company neither has nor plans to acquire the equipment and
facilities necessary to manufacture its current and future products and is and
will be dependent upon third-party contract manufacturers for commercial
production of all of its existing and proposed products. The Company currently
secures the manufacture of its products pursuant to contracts or purchase
orders. In the event of breach by a manufacturer or other failure to provide
manufacturing services, the Company would be required to secure and qualify an
alternate manufacturer, which could delay production and sale of the Company's
products. In addition, because the Company must contract for the manufacture of
its products, the Company has little control over the production of finished
products and the associated raw materials 

                                       27
<PAGE>   28

costs. There can be no assurance that the Company will continue to be able to
obtain contract manufacturing on commercially acceptable terms, if at all, for
its products in the quantities required. Quality control and manufacturing
problems have arisen from time to time, and there can be no assurance that
future manufacturing or quality control problems will not arise at the plants of
the Company's contract manufacturers or that such manufacturers will be able to
maintain the necessary licenses from governmental authorities to continue or to
commence manufacturing the Company's products. For example, in 1994 one of the
Company's contract manufacturers had certain regulatory deficiencies which led
to the Company removing the manufacturer from its drug application and
qualifying a new manufacturing site. There can be no assurance that the Company
will be able to secure the timely and cost-efficient manufacture of its products
in accordance with FDA requirements from these independent parties, and the
inability of the Company to do so could have a material adverse effect on the
Company's operating results. See "Business -- Manufacturing and Raw Materials."

        Marketing and Sales Uncertainties; Dependence on Collaborative Partners
for Product Distribution. In 1997, the Company commenced marketing in the United
States prescription products through a pharmaceutical specialty contract sales
force specializing in pharmaceuticals and solely dedicated to Penederm products.
In early 1998, Penederm began the transition to a direct, employee-based sales
force. Although the sales force is partially comprised of representatives that
previously worked for the contract sales force, and that the reorganized sales
force consists of personnel with experience promoting principally dermatological
products, none of the sales representatives has experience working under the
direction of the Company or the experience promoting its products for a
substantial period of time and certain of its representatives may not have
experience promoting dermatological products. Accordingly, the ongoing training
and management of the sales force will require significant management attention
and cost. The Company has no experience establishing, training or managing a
sales force and has limited experience promoting prescription products. There
can be no assurance that the Company will be able to successfully train and
maintain a sales force or that such sales force will be able to commercialize
Avita, Mentax, Acticin or any of the Company's other products successfully. The
inability to establish a successful sales effort would have a material adverse
effect on the Company's operating results.

        The Company's strategy for the distribution of certain of its products,
including prescription products in certain geographic territories, requires
entering into various arrangements with corporate collaborators such as
Schering-Plough, Warner, UCB, Pharmascience Inc., SmithKline, and Mylan.
Revenues from these agreements constituted substantially all of the Company's
revenues in 1996. These agreements often are of short duration, terminable with
little or no notice and subject to periodic amendment. Although the Company
believes parties to any such arrangements would have an economic motivation to
succeed in performing their contractual responsibilities, the amount and timing
of resources to be devoted to these activities are not within the control of the
Company. There can be no assurance that such parties will perform their
obligations, that the agreements will not be terminated or renegotiated or that
the Company will derive any revenue from such arrangements. Any such event could
have a material adverse effect on the Company's operating results. The Company
intends to seek additional collaborative arrangements to commercialize certain
of its products. There can be no assurance that the Company will be able to
negotiate acceptable collaborative arrangements in the future, or that current
or future collaborative arrangements will be successful.

        In 1997, no customer accounted for more than 10% of the Company's
revenues. See "Business -- Sales and Marketing" and "-- Collaborative
Arrangements."

        Fluctuations in Quarterly Results; History of Operating Losses. The
Company's future operating results may be subject to significant quarterly
variations based on a wide variety of factors, including, but 

                                       28
<PAGE>   29


not limited to, the timing of regulatory notifications and approvals, the
commercial success of the Company's products in the United States, the timing of
the commercial introduction of other products both in the United States and
abroad, the timing and extent of marketing efforts by the Company and its
partners, the timing of contract payments to and from the Company, the
introduction of competing products by other companies, the pricing of existing
and future products by the Company's competitors, the publication of clinical
results from the Company's products under development, interruptions in the
supply of raw materials necessary to produce the Company's products, and
interruptions or delays in the manufacturing of such products. In addition,
sales of a product upon initial market introduction generally include a
significant amount of initial orders for inventory by wholesalers and
distributors and are not necessarily indicative of actual demand for the product
by patients and physicians. There can be no assurance that distributors or
wholesalers will be able to forecast demand for product accurately. Fluctuations
in operating results will occur to the extent that resales do not meet
distributors' or wholesalers' expectations. The Company's expense levels are
based, in part, on its expectations of future sales levels and have increased
significantly in 1997 with the launch of Avita and Mentax. The Company's selling
expense will increase significantly in 1998 as the Company makes the transition
from a contract sales force in 1997 to a direct sales force that is employee
based. The Company may be unable to estimate accurately when revenues will be
realized from the sales of these and other products. If sales are below
expectations or the release of products is delayed, the Company's quarterly and
annual operating results will be adversely affected, which would have a material
adverse effect on the market price of the Company's Common Stock. In any event,
it is likely that in future quarters the Company's operating results may from
time to time be below the expectations of public market analysts and investors,
which also could have a material adverse effect on the price of the Company's
Common Stock.

        The Company is in the early stages of commercializing its products and
developing collaborative relationships. To date, the Company has generated only
limited revenues from the sale of its products and from licensing arrangements.
As of December 31, 1997 the Company had accumulated net losses of approximately
$51.1 million. To achieve profitable operations, the Company must, among other
things, successfully market its existing products, develop and market new
products and may need to establish significant long-term collaborative
relationships with other pharmaceutical companies. The Company's products under
development will require significant additional development, laboratory and
clinical testing, regulatory approvals and investment prior to
commercialization. The Company may continue to incur significant additional
operating losses depending principally on the market acceptance of the Company's
products, the success of product development efforts, the timing of potential
FDA approvals and subsequent launch of the drug products, the timing of
expenditures and other related factors. There can be no assurance that the
Company will achieve profitability. See Item 5 "Market for the Registrant's
Common Equity and Related Stockholder Matters," Item 6 "Selected Financial Data"
and Item 7 "Management's Discussion and Analysis of Financial Condition and
Results of Operations."

        Government Regulation; No Assurance of Product Approvals. The research,
testing, manufacture and marketing of drug products is subject to extensive
regulation by numerous regulatory authorities in the United States and other
countries. Failure to comply with FDA or other applicable regulatory
requirements may subject a company to administrative or judicially-imposed
sanctions such as civil penalties, criminal prosecution, injunctions, product
seizure or detention, product recalls, total or partial suspension of production
and FDA refusal to approve pending premarket approval applications or
supplements to approved applications. The process of obtaining FDA and other
required regulatory approvals, including foreign approvals, often takes many
years and can vary substantially based upon the type, complexity and novelty of
the products involved. Furthermore, such approval process is extremely expensive
and uncertain. There can be no assurance that the Company will be able to obtain
the labeling claims necessary or desirable for the promotion of those products.
FDA requirements prohibit the marketing or promotion of a 



                                       29
<PAGE>   30


drug for unapproved indications. Furthermore, regulatory marketing approval may
entail ongoing requirements for postmarketing studies. Even after regulatory
approval is obtained, whether for Avita or Mentax or potential future products
of the Company, a marketed product, its manufacture and its manufacturing
facilities are subject to continued regulatory review and periodic inspection by
the FDA. Later discovery of previously unknown problems or failure to comply
with applicable regulatory requirements may result in penalties such as
restrictions on a product's marketing or withdrawal of the product from the
market.

        Prior to the submission of premarket approval applications, drugs
developed by the Company must undergo rigorous preclinical and clinical testing,
which may take several years and the expenditure of substantial resources.
Before commencing clinical trials in humans, the Company must submit to the FDA
and receive clearance of an IND. There can be no assurance that submission of an
IND for future clinical testing of any products under development or other
future products of the Company would result in FDA authorization to commence
clinical trials or that the Company will be able to obtain the necessary
approvals for future clinical testing in any foreign jurisdiction. Further,
there can be no assurance that if such testing of products under development is
completed, any such drug compounds will be accepted for formal review by the FDA
or any foreign regulatory body or approved by the FDA for marketing in the
United States or by any such foreign regulatory bodies for marketing in
particular foreign jurisdictions.

        The Company's research and development involves the controlled use of
hazardous materials, including but not limited to chemicals, fungi and various
radioactive compounds. Although the Company believes that its safety procedures
for handling and disposing of such materials comply with the standards
prescribed by state and federal regulations, the risk of accidental
contamination or injury from these materials cannot be completely eliminated. In
the event of such an accident, the Company could be held liable for any damages
that result and any such liability could exceed the coverage limits of or not be
covered by the Company's insurance and could have a material adverse effect on
the Company's operating results. See "Business -- Government Regulation."

        Uncertainty of Future Product Development. The future success of the
Company will be dependent upon development of new products that obtain
regulatory approval and market acceptance. Such development will require that
the Company successfully identify appropriate products, compounds or
technologies and that the Company obtain any necessary rights thereto. The
Company's strategy for the development of future products requires entering into
various arrangements with third party development partners, licensors and
licensees, such as Kaken, Schering-Plough WARF and Renaissance. The development
of new pharmaceutical products is subject to a number of significant risks and
uncertainties. Potential products, compounds or technologies that appear to be
promising at various stages of development may not receive regulatory approval,
reach the market or achieve widespread use for a number of reasons. In any
event, development of new products will subject the Company to significant
product development costs for which the Company may never receive revenue or for
which revenue may be significantly delayed. In addition, the Company may be
required to pay royalties or other license development or commercialization
fees, which could have a material adverse effect on the profitability of such
products to the Company. There can be no assurance that the Company will be able
to in-license products, compounds or technologies on terms financially
acceptable to the Company, successfully develop potential products, obtain
regulatory approval for any such products, obtain necessary support from third
party collaborators, or successfully commercialize such products, and the
inability of the Company to do so could have a material adverse affect on the
Company's operating results.

        Proprietary Technology; Patent Protection. The Company's success,
competitive position, revenue and profits, if any, will depend in part upon its
ability to obtain patent protection in various jurisdictions 


                                       30
<PAGE>   31

related to the technologies and processes it possesses and the technologies and
products it develops. The University of California has obtained three United
States and six foreign patents covering 17 countries outside of the U.S. for the
technology underlying the TopiCare Delivery Compounds and has licensed these
patents to the Company on a worldwide exclusive basis for the life of the
patents. These patents will expire in 2007 and 2008. Under the license
arrangement, the University of California is required to file, prosecute and
maintain foreign patent applications as requested by the Company at the
Company's expense. The Company has licensed rights to certain patented compounds
from Kaken, WARF, and Renaissance and in the future may license patented
compounds from other parties. Any failure by these parties properly to file,
prosecute or maintain any such patents licensed by the Company could materially
adversely affect the Company's operating results.

        The Company has filed and intends to file additional patent
applications, when appropriate, relating to its technologies, improvements to
its technologies and specific products that it develops and to direct the
University of California to file any additional patent applications where
appropriate. The Company has filed two United States patent applications, one of
which has a corresponding Patent Cooperation Treaty application, and also has
four foreign patent applications pending. The scope and breadth of patent
protection with respect to pharmaceutical products is uncertain and involves
complex legal, scientific and factual questions. Accordingly, it is impossible
to anticipate the breadth or degree of protection that any such patents will
afford. Furthermore, there can be no assurance that litigation seeking to
challenge such patent protection will not be brought against the Company or the
University of California or that the Company's or the University of California's
patents will not be successfully challenged. The expenses involved in any patent
litigation can be significant and cannot be estimated by the Company. In
addition, there can be no assurance that the scope and validity of the Company's
or the University of California's existing or future patents, if any, will
prevent third parties from developing similar or competing products.

        Third parties may hold or be issued patents which the Company's
technology may infringe. The Company could incur substantial costs in defending
itself and its collaborative partners against any resulting claims. Furthermore,
parties making such claims may be able to obtain injunctive or other equitable
relief which could effectively block the Company's ability to further develop or
commercialize its products in the United States and abroad, and could result in
the award of substantial damages. In the event of a claim of infringement, the
Company may be required to obtain one or more licenses from third parties. There
can be no assurance that the Company will be able to obtain such licenses at a
reasonable cost, if at all. Defense of any lawsuit or failure to obtain any such
license could have a material adverse effect on the Company's operating results.

        In July 1996, Johnson & Johnson filed a complaint in federal district
court alleging that the Company's Avita gel formulation infringes a Johnson &
Johnson patent. The parties entered into a settlement agreement in December 1996
pursuant to which the Company agreed not to market the Avita gel formulation
before the expiration of the Johnson & Johnson patent in January 1998.

        The Company also relies upon unpatented trade secrets and know-how.
There can be no assurance that others will not independently develop
substantially equivalent proprietary information and techniques or otherwise
gain access to the Company's trade secrets or disclose such technology or that
the Company can meaningfully protect its rights to its unpatented trade secrets.

        The PTO has recently adopted changes to United States patent law which
changed the term of issued patents, subject to certain transition periods, to 20
years from the date of filing rather than 17 years from date of issuance. For
applications filed after June 7, 1995, the patent term will be 20 years from the
earliest effective filing date of the priority patent application. Such change
may reduce the effective term of protection for patents that are pending for
more than three years in the PTO. While the Company cannot 

                                       31

<PAGE>   32

predict the effect that such changes will have on its business, the adoption of
such changes could have a material adverse effect on the Company's ability to
protect its proprietary information and sustain the commercial viability of its
products. Furthermore, the possibility of shorter terms of patent protection,
combined with the lengthy FDA review process and possibility of extensive delays
in such process, could effectively further reduce the term during which a
marketed product could be protected by patents. See "Business -- Products --
Prescription Products" and "-- Patents and Proprietary Technology."

        Uncertainty of Pharmaceutical Pricing and Reimbursement. The Company's
business may be materially adversely affected by the continuing efforts of
governmental and third-party payers to contain or reduce the costs of health
care in general and drugs in particular. For example, in most international
markets, pricing of prescription pharmaceuticals is subject to government price
controls. In these markets, once marketing approval is received, pricing
negotiation could take another six to 12 months or longer. In the United States
there have been, and there may continue to be, federal and state proposals to
implement similar government price controls. In addition, an increasing emphasis
on managed care and consolidation of hospital purchasing in the United States
has and will continue to put pressure on pharmaceutical pricing. Such proposals,
if adopted, and such initiatives could decrease the price that the Company
receives for any current or future products and thereby have a material adverse
effect on the Company's business, financial condition and results of operations.
Further, to the extent that such proposals or initiatives have a material
adverse effect on pharmaceutical companies that are collaborators or prospective
collaborators for certain of the Company's products, the Company's ability to
commercialize its products may be materially adversely affected. In addition,
price competition may result from competing product sales, attempts to gain
market share or introductory pricing programs, which would have a material
adverse effect on the Company's business, financial condition and results of
operations.

        The Company's ability to commercialize its products may depend in part
on the extent to which reimbursement for such products and related treatments
will be available from government health administration authorities, private
health insurers and other third-party payers. Significant uncertainty exists as
to the reimbursement status of newly approved health care products, and
third-party payers are increasingly challenging the prices charged for medical
products and services. There can be no assurance that any third-party insurance
coverage will be available to patients for any of the Company's products.
Government and other third-party payers are increasingly attempting to contain
health care costs by limiting the level of reimbursement for new therapeutic
products, and be refusing, in some cases, to provide coverage or reimbursement
for indications for which the FDA has not granted marketing clearance. Moreover,
reimbursement may be denied even for FDA-approved indications. If adequate
coverage and reimbursement levels are not provided by the government and
third-party payers for the Company's products, the Company's business, financial
condition and results of operations would be materially adversely affected.

        Dependence on Key Personnel. The success of the Company is dependent
upon its ability to retain and attract highly qualified scientific, management
and marketing personnel. The Company faces intense competition for personnel
from other companies, academic institutions, government entities and other
organizations. There can be no assurance that the Company will be successful in
attracting and retaining key personnel. The loss of key personnel, or the
inability to attract and retain the additional, highly-skilled employees
required for the expansion of the Company's activities, could adversely affect
its business. See Item 10 "Directors and Executive Officers of the Registrant."

        Risk of Product Liability Claims; No Assurance of Adequate Insurance.
Testing, manufacturing and marketing of the Company's products entail a risk of
product liability. In addition, third-party manufacturers of certain drugs and
skin care agents used by the Company in its products have limited 

                                       32
<PAGE>   33

contractual responsibility for product liability. Although the Company has
obtained aggregate product liability insurance coverage in the amount of
$3,000,000, there can be no assurance that the existing coverage is adequate for
current operations. Furthermore, this existing coverage may not be adequate as
the Company further develops products, and there can be no assurance that
additional insurance coverage will be available in the future at an acceptable
cost, if at all. Failure of the Company to prevail on a product liability claim
could have a material adverse effect on the Company's operating results. In
addition, the Company could incur substantial costs in defending a claim, even
where that claim was ultimately unsuccessful, and defense of any such claim
could divert management's efforts and attention from the Company's business and
have a material adverse effect on the Company's operating results.

        Volatility of Stock Price. The Nasdaq National Market has from time to
time experienced significant price and volume fluctuations that may be unrelated
to the operating performance of particular companies. In addition, the market
price of the Common Stock, like the stock prices of many publicly traded
pharmaceutical and biotechnology companies, has been, and may continue to be,
highly volatile. Announcements of technological innovations or new commercial
products by the Company or its competitors, developments or disputes concerning
patent or proprietary rights, publicity regarding actual or potential medical
results relating to products under development by the Company or its
competitors, regulatory developments in both the United States and foreign
countries, public concern as to the safety of biotechnology and pharmaceutical
products and economic and other external factors, as well as period-to-period
fluctuations in financial results, among other factors, may have a material
adverse effect on the market price of the Common Stock.

ITEM 2.  PROPERTIES

  The Company currently leases approximately 19,000 square feet of laboratory
and office space in Foster City, California. Penederm's research and development
group occupies approximately 10,000 square feet. The remaining 9,000 square feet
is divided between administrative office space, sales and marketing offices, and
clinical and regulatory space.

ITEM 3.  LEGAL PROCEEDINGS

  Not Applicable.

ITEM 4.  SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

  No matters were submitted to a vote of security holders during the fourth
quarter of the fiscal year ended December 31, 1997.

                                       33

<PAGE>   34


                                              PART II

ITEM 5.  MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS

  The Company's Common Stock is traded on the Nasdaq National Market tier of the
Nasdaq Stock Market under the symbol "DERM". The following table sets forth, for
the periods indicated, the high and low closing prices for the Company's Common
Stock as reported by the Nadaq Stock Market:
<TABLE>
<CAPTION>


1996                       High          Low
-------------            -------       -------
<S>                      <C>           <C> 
First Quarter            $17-1/4       $10-3/4
Second Quarter           $17-1/2         $13
Third Quarter            $13-1/4        $5-1/2
Fourth Quarter           $12-1/2        $6-3/4

1997                       High          Low
-------------            -------       -------
First Quarter            $17-1/4         $11
Second Quarter           $13-1/2       $10-1/4
Third Quarter            $14-3/4         $10
Fourth Quarter           $13-3/4        $9-5/8
</TABLE>


As of January 31, 1998, the number of stockholders of record of the Common Stock
was 164. The Company has never paid a cash dividend on its Common Stock and does
not anticipate paying any cash dividends for the foreseeable future.


                                       34
<PAGE>   35


ITEM 6.  SELECTED FINANCIAL DATA

<TABLE>
<CAPTION>

                                                                 Year Ended December 31,
(In thousands except per share data)           1997           1996            1995            1994            1993
                                            --------        --------        --------        --------        --------

<S>                                         <C>             <C>             <C>            <C>             <C>    
STATEMENT OF OPERATIONS DATA:
Total revenues                              $  9,005        $  2,905        $  5,401        $  5,123        $  1,378
Costs and expenses:
   Cost of product sales                       2,661           1,472           2,034           2,887             502
   Research and development                    6,950           5,292           5,713           4,509           3,691
   Selling, general and                       12,535           4,317           3,623           3,625           2,954
   administrative
                                            --------        --------        --------        --------        --------
        Total costs and expenses              22,146          11,081          11,370          11,021           7,147
                                            --------        --------        --------        --------        --------
Loss from operations                         (13,141)         (8,176)         (5,969)         (5,898)         (5,769)
Interest income, net                             424             533             933             905             230
                                            --------        --------        --------        --------        --------
Net loss                                    $(12,717)       $ (7,643)       $ (5,036)       $ (4,993)       $ (5,539)
                                            ========        ========        ========        ========        ========
Net loss per basic and diluted
   share (1)                                $  (1.59)       $  (1.05)       $   (.70)       $   (.71)       $  (4.61)
                                            ========        ========        ========        ========        ========
Shares used in computing net
   loss (basic and diluted) per share          7,995           7,275           7,171           6,990           1,202
                                            ========        ========        ========        ========        ========

                                                                            December 31,
                                               1997           1996            1995            1994            1993
                                            --------        --------        --------        --------        --------
BALANCE SHEET DATA:
Cash, cash equivalents and investments       $ 5,621         $ 6,420         $15,011         $20,801         $26,416
Total assets                                  10,231          10,694          17,968          23,538          27,498
Stockholders' equity                           5,194           8,591          15,934          20,659          26,160
</TABLE>



(1) Net loss per share for the year ended December 31, 1993 has been
retrospectively restated to apply Staff Accounting Bulletin (SAB) 98. SAB 98 had
no impact on any other year presented.

                                       35
<PAGE>   36


ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND 
        RESULTS OF OPERATIONS

  The statements in "Management's Discussion and Analysis of Financial condition
and Results of Operations" that relate to future plans, events or performance
are forward-looking statements which involve risks and uncertainties. Actual
results, events or performance may differ materially from those anticipated in
these forward-looking statements as a result of a variety of factors, including
those set forth under "Item 1 - Risk Factors" and elsewhere in this Annual
Report on Form 10-K. Readers are cautioned not to place undue reliance on these
forward-looking statements, which speak only as of the date hereof. The Company
undertakes no obligation to publicly release the result of any revisions to
these forward-looking statements that may be needed to reflect events or
circumstances after the date hereof or to reflect the occurrence of
unanticipated events.

OVERVIEW

Penederm is a pharmaceutical company that specializes in developing and
marketing dermatology products. In 1997, Penederm launched Mentax(R), a
once-a-day prescription topical treatment for three skin fungal conditions:
tinea pedis (athlete's foot), tinea corporis (ringworm) and tinea cruris (groin
fungus) and its Avita(TM) prescription cream product, a topical form of retinoic
acid for the treatment of acne. Penederm also received FDA contingent approval
to begin marketing its Avita gel product upon expiration of a third party patent
in January 1998. Penederm has several other pharmaceutical products for fungal
inflammatory conditions, psoriasis, nail fungus and Mentax skin treatment line
extensions in human clinical trials. The Company also sells its patented
TopiCare Delivery Compounds(R) for use in cosmetics and personal care products,
and markets its own over-the-counter (OTC) skin care products. Penederm has
established collaborative relationships with other pharmaceutical companies as
follows: 

<TABLE>
<CAPTION>

          COMPANY                      PRODUCT AREA                   TERRITORY
          -------                      ------------                   ---------
<S>                           <C>                                    <C> 
In-License and
Co-Development
Agreements:

Kaken Pharmaceutical          Penederm in-licensed                   U.S., Canada, Mexico and Latin
Company Ltd. (Kaken)          butenafine, the active                 America for skin antifungal;
                              ingredient incorporated in             U.S., Canada, Europe, Mexico,
                              Mentax                                 Latin America, Australia and New
                                                                     Zealand for nail antifungal 

SmithKline Beecham            Undisclosed OTC product                SmithKline option to market
(SmithKline)                                                         worldwide

Alpharma, Inc. (Alpharma)     Acticin for scabies                    U.S.

Out-License Agreements:

Schering-Plough HealthCare    Prescription and OTC Nail              U.S. and Canada
Products, Inc.                antifungal and co-promote
(Schering-Plough)             prescription skin cream
                              antifungal

UCB Group of Belgium (UCB)    Prescription antifungal                Europe, Africa and Middle East
                              products
</TABLE>

                                       36

<PAGE>   37
<TABLE>
<CAPTION>


<S>                           <C>                                 <C>    
Warner Wellcome Consumer      OTC Dry Skin                        Canada
Health Products (Warner)

SmithKline Beecham            OTC Consumer Products               Europe and Eastern Europe
(SmithKline)

Pierre Fabre Inc. (Pierre     DuraScreen sunscreen                U.S.
Fabre)

Allergan, Inc. (Allergan)     Butenafine topical antifungal       Central and South America
                              and retinoic acid cream and gel

Mylan Laboratories, Inc.      Co-promote Mentax cream to          U.S.
(Mylan)                       primary care physicians
</TABLE>


        The Company has been unprofitable since inception and expects to incur
significant additional operating losses in the near future. For the period from
inception through December 31, 1997, the Company incurred a cumulative net loss
of $51,110,000. Penederm's sources of working capital have been equity
financings, product sales to corporate partners, sales of Mentax, Avita and
over-the-counter products, product license fees, sales of TopiCare Delivery
Compounds and interest earned on investments.


RESULTS OF OPERATIONS

        Total 1997 revenues of $9,005,000 increased 210% from total 1996
revenues of $2,905,000. 1996 revenues declined 46% from $5,401,000 in 1995. The
1997 revenue increase is due primarily to the initial product stocking shipments
of Mentax which was launched to trade in January and Avita which was launched to
trade in June and out-license milestone payments from corporate partners.

        License revenues in 1997 of $2,664,000 increased 312% from $647,000 in
1996. License revenues decreased 68% in 1996 from 1995 license revenues of
$2,050,000. License fees were received from Schering-Plough, SmithKline, the
Merck KGaA Group/Center Laboratories, Allergan and Mylan in 1997; Warner and
SmithKline in 1996, and Schering-Plough, UCB and SmithKline in 1995.

        Total product sales increased 181% to $6,341,000 in 1997 from $2,258,000
in 1996 due to the 1997 launch of Mentax and Avita. Total product sales declined
33% in 1996 from $3,351,000 in 1995 due primarily to lower quantities of
Lubriderm products shipped to Warner as compared to 1995. Slower sales to Warner
also negatively impacted sales of TopiCare Delivery Compounds in 1996.

        The Company expects its future revenues in the near term to be derived
principally from the sale of its pharmaceutical products, and for the revenues
derived from OTC dry skin products and cosmetic products to become less
significant relative to total revenues.

        The Company's cost of sales increased to $2,661,000 in 1997 from
$1,472,000 in 1996 as a result of the 1997 launch of Mentax and Avita. Cost of
sales declined in 1996 from $2,034,000 in 1995 due to the decrease in product
sales. Product gross margins improved in 1997 due to a product revenue mix
change toward higher-margin pharmaceutical products launched in 1997.

                                       37


<PAGE>   38

        The Company's research and development expenses increased 31% to
$6,950,000 in 1997 from $5,292,000 in 1996 The Company's research and
development expenses decreased 7% in 1996 from $5,713,000 in 1995. The 1997
increase is a result of the Company initiating two pivotal phase III human
clinical studies of its combination product for the treatment of skin fungal
conditions (project name 501 cream) at 32 clinical sites and involving
approximately 1,600 patients. The 1996 spending decrease is related to the
timing and size of later stage human clinical trials compared to the prior year.

        Sales and marketing expenses increased 614% in 1997 to $10,103,000 from
$1,414,000 in 1996. Sales and marketing expenses increased 4% in 1996 from
$1,354,000 in 1995. The increase in 1997 is primarily due to marketing and other
expenses related to the commercial launch of Mentax and Avita. The 1996 increase
is primarily due to costs of pre-launch preparations for Mentax offset by
continued reductions in OTC promotions and reduced personnel costs.

        General and administrative expenses decreased 16% in 1997 to $2,432,000
from $2,903,000 in 1996. General and administrative expenses increased 28% in
1996 from $2,269,000 in 1995. The 1997 decrease is primarily due to the
reimbursement of legal costs in a settlement of a case related to enforcement of
patent rights. The 1996 increase relates primarily to increased legal costs
related to enforcement of patent rights.

        The Company had net interest income of $424,000, $533,000 and $933,000
in 1997, 1996 and 1995, respectively. Net interest income declined 20% in 1997
and 43% in 1996 primarily as a result of lower cash balances available for
investment from the prior year.

        As of December 31, 1997, the Company had available net operating loss
carryforwards of approximately $49,000,000 for Federal income tax purposes.
Utilization of the net operating loss carryforwards may be subject to
substantial limitation due to the change in ownership provisions of the Internal
Revenue Code of 1986.

        The Company expects that annual revenues, and costs and expenses will
continue to increase in the future, due principally to further commercialization
of its recently approved pharmaceutical products. Sales and marketing expenses
are expected to increase significantly from the prior year due to the
establishment of an employee-based sales force in 1998 and increased promotion
of these products in the marketplace. The Company expects a modest reduction in
research and development expenses in 1998 coinciding with the completion of its
two phase III clinical trials in the first quarter of 1998. The Company also
expects some expansion of research and development programs, increased patent
and regulatory costs, expansion of regulatory, clinical, and quality assurance
capabilities, and increased administrative support costs. Therefore, additional
operating losses are expected in the near future.

        In addition, sales of a product upon initial market introduction
generally include a significant amount of initial orders for inventory by
wholesalers and distributors and are not necessarily indicative of actual demand
for that product by patients and physicians. There can be no assurance that
distributors and wholesalers will be able to forecast demand for product
accurately. Fluctuations in operating results will occur to the extent that sell
through of products does not meet distributors' or wholesalers' expectations.
The Company also expects that future operating results may be subject to
quarterly variations that may impact cash flow from operations. Operating
results for the year ended December 31, 1997 are not necessarily indicative of
future operating results.

                                       38
<PAGE>   39


LIQUIDITY AND CAPITAL RESOURCES

        The Company's principal sources of capital to date have been the
proceeds from public and private offerings of its equity securities, including a
1997 private placement for which the net proceeds were $8,975,000. At December
31, 1997, the Company had cash, cash equivalents and investments totaling
$5,621,000. In January 1998, the Company entered into an agreement with an
investment group for an equity line of credit which allows the Company to access
up to $10 million through sales of its common stock at a discount to market. The
equity line of credit will remain available for a period of two years, and the
decision to draw any funds and the timing for any such draw is solely at the
Company's discretion. Drawing under the equity line of credit is subject to the
satisfaction of certain conditions, including registration of the shares, a
minimum trading price per share, and certain limitations on the number of shares
of the Company's common stock being held by the investment group at any point in
time.

        Cash expenditures related to operating activities, the acquisition of
fixed assets and repayment of long-term debt totaled $10,119,000 in 1997,
$8,272,000 in 1996 and $5,003,000 in 1995. Operating activities were comprised
of research and development, clinical trials, product sales, promotion and
general administration activities. The Company also made milestone payments of
$619,000 related to the in-licensing of drug compounds in 1996. The Company
expects that amounts expended historically are not indicative of future
expenditures by the Company, which the Company believes will increase. The
Company expects to continue to incur substantial expenditures related to the
further research and development of its technologies, development of its
products, acquisition of additional products and rights to drug compounds and
sales and marketing.

        The Company does not expect to have significant computer software
malfunctioning issues in the year 2000 and thereafter. Based on preliminary
inquiries of Penederm's warehousing and logistics vendor, the Company does not
believe it is vulnerable to the vendor's failure to remediate its own year 2000
issues. The Company plans to upgrade its accounting system to year 2000
compliant software during 1998. The cost of these changes is not expected to be
significant.

        The Company believes that existing capital resources, after giving
effect to the availability of proceeds of the equity credit line, including the
interest income earned on its invested cash balances, together with anticipated
revenues (consisting of product sales, license fees and royalties), will satisfy
the Company's working capital and identified capital expenditure requirements at
least through 1998. The Company's future capital requirements will depend on
many factors, including the commercial success of the Company's products,
progress of the Company's collaborative and independent research and development
programs, payments received under collaborative agreements with other companies,
if any, the results and costs of preclinical and clinical testing for the
Company's products, the costs associated with and the timing of regulatory
approvals, technological advances, the status of competitive products, and the
commercial success of Penederm's strategic relationships. There can be no
assurance that additional funds will be available to the Company on favorable
terms, if at all, to permit the Company to continue with its current plan for
operations.


                                       39

<PAGE>   40


ITEM 8.  FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
<TABLE>
<CAPTION>

Index to Financial Statements                                  Page
-----------------------------                                  ----

<S>                                                             <C>
Report of Ernst & Young LLP, Independent Auditors               40
Consolidated Balance Sheets                                     41
Consolidated Statements of Operations                           42
Consolidated Statement of Stockholders' Equity                  43
Consolidated Statements of Cash Flows                           44
Notes to Consolidated Financial Statements                      45
</TABLE>



REPORT OF ERNST & YOUNG LLP, INDEPENDENT AUDITORS


The Board of Directors and Stockholders of Penederm Incorporated

We have audited the accompanying consolidated balance sheets of Penederm
Incorporated as of December 31, 1997 and 1996, and the related consolidated
statements of operations, stockholders' equity and cash flows for each of the
three years in the period ended December 31, 1997. Our responsibility is to
express an opinion on these financial statements based on our audits.

We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements are free of material
misstatement. An audit includes examining on a test basis, evidence supporting
the amounts and disclosures in the financial statements. An audit also includes
assessing the accounting principles used and significant estimates made by
management as well as evaluating the overall financial statement presentation.
We believe that our audits provide a reasonable basis for our opinion.

In our opinion, the financial statements referred to above present fairly, in
all material respects, the consolidated financial position of Penederm
Incorporated at December 31, 1997, and 1996 and the consolidated results of its
operations and its cash flows for the three years in the period ended December
31, 1997 in conformity with generally accepted accounting principles.



                                                     Ernst & Young LLP



Palo Alto, California
January 27, 1998

                                       40

<PAGE>   41



PENEDERM INCORPORATED
CONSOLIDATED BALANCE SHEETS

<TABLE>
<CAPTION>

                                                                       December 31,
                                                                  ------------------------
(In thousands except share data)                                       1997         1996
                                                                  -----------   ----------
                             ASSETS
<S>                                                               <C>           <C> 
Current assets:
     Cash and cash equivalents                                    $    1,519    $   3,062
     Short-term marketable securities                                  3,102        2,259
     Accounts receivable (less allowance for doubtful
         accounts of none in 1997 and 1996)                            1,013          276
     Inventory                                                         1,501        1,539
     Employee note receivable                                            125          125
     Prepaid expenses and other current assets                           341          524
                                                                  ----------    --------- 
           Total current assets                                        7,601        7,785
Marketable securities                                                  1,000        1,099
Property and equipment, at cost, less accumulated
     depreciation and amortization                                       267          277
Intangible assets (less accumulated amortization of
     $378 in 1997 and $206 in 1996)                                    1,339        1,511
Other assets                                                              24           22
                                                                  ==========    ========= 
           Total assets                                           $   10,231    $  10,694
                                                                  ==========    ========= 

                      LIABILITIES AND STOCKHOLDERS' EQUITY

Current liabilities:
     Accounts payable                                             $    1,264    $   1,196
     Accrued liabilities                                               3,745          863
     Current portion of long-term obligations                             18           16
                                                                  ----------    ---------
           Total current liabilities                                   5,027        2,075
Long-term obligations, less current portion                               10           28
                                                                  ----------    ---------
           Total liabilities                                           5,037        2,103
                                                                  ----------    ---------

Commitments

Preferred stock, $.01 par value in 1997 
     and no par value in 1996;
     10,000,000 shares authorized; 
     no shares issued and outstanding                                     -            -
     
Common stock, $.01 par value in 1997 
     and no par value in 1996; 30,000,000 shares
     authorized; shares issued and
     outstanding: 8,154,098 shares in 1997 
     and 7,315,697 shares in 1996                                         82        46,984
Additional paid-in capital                                            56,222             -
Accumulated deficit                                                  (51,110)      (38,393)
                                                                  ----------    ----------
           Total stockholders' equity                                  5,194         8,591
                                                                  ----------    ----------
           Total liabilities and stockholders' equity             $   10,231    $   10,694
                                                                  ==========    ==========
</TABLE>

See accompanying notes

                                       41
<PAGE>   42



PENEDERM INCORPORATED
CONSOLIDATED STATEMENTS OF OPERATIONS

<TABLE>
<CAPTION>

                                                                   Year Ending December 31,
                                                           ----------------------------------------
(In thousands except per share data)                          1997           1996            1995
                                                           --------        --------        --------
<S>                                                        <C>            <C>              <C>
Revenues:
     Product sales                                         $  6,341        $  2,258        $  3,351
     Licensing revenues                                       2,664             647           2,050
                                                           --------        --------        --------
         Total revenues                                       9,005           2,905           5,401
                                                           --------        --------        --------

Costs and expenses:
     Cost of product sales                                    2,661           1,472           2,034
     Sales and marketing                                     10,103           1,414           1,354
     Research and development                                 6,950           5,292           5,713
     General and administrative                               2,432           2,903           2,269
                                                           --------        --------        --------
         Total costs and expenses                            22,146          11,081          11,370
                                                           --------        --------        --------

Loss from operations                                        (13,141)         (8,176)         (5,969)

Interest income, net                                            424             533             933

                                                           --------        --------        --------
Net loss                                                   $(12,717)       $ (7,643)       $ (5,036)
                                                           ========        ========        ========

Basic and diluted net loss per share                       $  (1.59)       $  (1.05)       $   (.70)
                                                           ========        ========        ========

Number of shares used in computing basic and diluted
      net loss per share                                      7,995           7,275           7,171
                                                           ========        ========        ========
</TABLE>


See accompanying notes.



                                       42

<PAGE>   43





PENEDERM INCORPORATED
CONSOLIDATED STATEMENT OF STOCKHOLDERS' EQUITY

(In thousands)

<TABLE>
<CAPTION>

                                                                 
                                               Common Stock              Additional                        Total
                                           -----------------------         Paid-In     Accumulated     Shareholders'
                                            Shares         Amount          Capital        Deficit         Equity
                                           --------       --------        --------       --------        --------

<S>                                        <C>           <C>             <C>           <C>              <C>     
Balances, December 31, 1994                   6,999       $ 46,373        $     --       $(25,714)       $ 20,659

    Issuance of common stock under
        stock option and other employee
        stock plans                             229            311              --             --             311
    Net loss                                     --             --              --         (5,036)         (5,036)
                                           --------       --------        --------       --------        --------

Balances, December 31, 1995                   7,228         46,684              --        (30,750)         15,934
    Issuance of common stock under
        stock option and other employee
        stock plans                              88            300              --             --             300
    Net loss                                     --             --              --         (7,643)         (7,643)
                                           --------       --------        --------       --------        --------

Balances, December 31, 1996                   7,316         46,984              --        (38,393)          8,591
    Creation of par value common
    stock                                        --        (46,911)         46,911             --              --
    Issuance of common stock under
        stock option and other
        employee stock plans                     86              1             344             --             345
                   
    Issuance of stock in private
        placement, net of offering costs        752              8           8,967             --           8,975
    Net loss                                     --             --              --        (12,717)        (12,717)
                                           --------       --------        --------       --------        --------

Balances, December 31, 1997                   8,154       $     82        $ 56,222       $(51,110)       $  5,194
                                           ========       ========        ========       ========        ========
</TABLE>

See accompanying notes.

                                       43

<PAGE>   44



PENEDERM INCORPORATED
CONSOLIDATED STATEMENTS OF CASH FLOWS

<TABLE>
<CAPTION>


Increase (decrease) in cash and cash equivalents (in thousands)        1997            1996            1995
                                                                     --------        --------        --------

<S>                                                                 <C>             <C>              <C> 
Cash flows from operating activities:
     Net loss                                                        $(12,717)       $ (7,643)       $ (5,036)

     Adjustments to reconcile net loss to net cash
       used in operating activities:
        Loss on disposal of fixed assets                                   --              --             139
        Depreciation and amortization of property
             and equipment                                                154             132             173
        Amortization of intangible assets                                 172             129              77
        Decrease (increase) in accounts receivable                       (737)            586            (168)
        Decrease (increase) in inventory                                   38          (1,238)            279
        Decrease (increase) in prepaid expenses and other
             current assets                                               183            (182)             80
            
        Increase (decrease) in accounts payable, accrued
             liabilities and rent                                       2,950             102            (352)
        Decrease (increase) in other assets                                (2)              2              (1)
                                                                     --------        --------        --------
           Net cash used in operating activities                       (9,959)         (8,112)         (4,809)
                                                                     --------        --------        --------

Cash flows from investing activities:
     Purchases of available-for-sale securities                        (7,032)         (6,901)         (7,258)
     Maturities of held-to-maturity securities                             --              --           2,000
     Maturities of available-for-sale securities                        2,286           6,850          10,076
     Sales of available-for-sale securities                             4,002           3,009           2,939
     Acquisition of intangible assets                                      --            (619)         (1,098)
     Acquisition of fixed assets                                         (144)           (127)           (131)
                                                                     --------        --------        --------
           Net cash provided by (used in) investing activities           (888)          2,212           6,528
                                                                     --------        --------        --------

Cash flows from financing activities:
     Proceeds from issuance of common stock under stock plans             345             300             311
     Issuance of common stock in private placement                      8,975              --              --
     Repayment of long-term obligations                                   (16)            (33)            (63)
                                                                     --------        --------        --------
           Net cash provided by financing activities                    9,304             267             248
                                                                     --------        --------        --------

Net increase (decrease) in cash and cash equivalents                   (1,543)         (5,633)          1,967
Cash and cash equivalents at beginning of year                          3,062           8,695           6,728
                                                                     ========        ========        ========
Cash and cash equivalents at end of year                             $  1,519        $  3,062        $  8,695
                                                                     ========        ========        ========
</TABLE>


See accompanying notes.


                                       44
<PAGE>   45


PENEDERM INCORPORATED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

1. BUSINESS OF THE COMPANY

Penederm is a pharmaceutical company that specializes in development and
marketing of dermatology products. The Company launched Mentax(R), a once-a-day
prescription topical cream for the treatment of skin fungal conditions and
Avita(TM), a topical form of retinoic acid for the treatment of acne during
1997. The Company has initiated pivotal phase III human clinical trials of a
combination product (project name: 501 cream) for the treatment of skin fungal
conditions. Products for nail fungus and psoriasis are in earlier stages of
clinical development along with Mentax skin treatment line extensions. The
Company also markets its patented TopiCare Delivery Compounds(R) as specialty
ingredients to major cosmetic companies for incorporation into their commercial
products.


2.  SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

PRINCIPLES OF CONSOLIDATION: The consolidated financial statements include the
accounts of the Company and its wholly-owned subsidiary in the United Kingdom,
Penederm Limited. All significant intercompany balances and transactions have
been eliminated in consolidation.

USE OF ESTIMATES: The preparation of the financial statements in conformity with
generally accepted accounting principles requires management to make estimates
and assumptions that affect the amounts reported in the consolidated financial
statements and accompanying notes. Actual results could differ from those
estimates.

CASH AND CASH EQUIVALENTS: The Company considers all highly liquid investments
purchased with a remaining maturity of three months or less to be cash
equivalents.

MARKETABLE SECURITIES: All of the Company's marketable securities are classified
as available-for-sale with unrealized holding gains and losses, when material,
reported as a separate component of stockholders' equity. Unrealized gains and
losses on marketable securities were not material as of December 31, 1997 and
1996. Realized gains and losses on sales of investments are reported in interest
income and computed using the specific identification cost method. Short-term
marketable securities mature within one year of the balance sheet date.
Marketable securities typically have a maximum maturity of two years from the
purchase date.

CONCENTRATION OF CREDIT RISK: The Company's cash, cash equivalents, and
marketable securities are highly liquid and are diversified to ensure safety of
principal. The Company generally invests excess cash in deposits with major
banks, in various government or government agency obligations, and in
obligations of corporations with strong credit ratings and in a variety of
industries.

                                       45
<PAGE>   46


INVENTORY: Inventories are stated at the lower of cost (first-in, first-out) or
market and consist of the following at December 31:. 

<TABLE>
<CAPTION>

(In thousands)               1997        1996
-------------             -------     -------

<S>                      <C>         <C>      
Raw materials              $  572      $  907
Finished goods                929         632
                          -------     -------
                           $1,501      $1,539
                          =======     =======
</TABLE>

PROPERTY AND EQUIPMENT: Property and equipment are stated at cost and are
depreciated on a straight-line basis over their estimated useful lives of three
years for computing equipment and four years for all other property and
equipment. Property and equipment acquired under capital leases and leasehold
improvements are amortized on a straight-line basis over their estimated useful
lives or their lease terms, whichever is shorter.

<TABLE>
<CAPTION>
Property and equipment consists of the following at December 31:

<S>                                <C>        <C> 
(In thousands)                     1997       1996
-------------                  --------   --------

Computers and equipment         $ 1,191    $ 1,047
Furniture and fixtures              123        119
Leasehold improvements              284        288
                               --------    -------
                                  1,598      1,454
Less accumulated depreciation
    and amortization             (1,331)    (1,177)
                               --------    -------
Net property and equipment      $   267    $   277
                               ========    =======
</TABLE>

Property and equipment includes $574,000 of equipment under capital leases at
December 31, 1997 and 1996. Accumulated depreciation for such equipment was
$546,000 and $522,000 at December 31, 1997 and 1996, respectively.

INTANGIBLE ASSETS: Intangible assets consist principally of development and
marketing rights related to in-licensed pharmaceutical compounds and are
amortized on a straight-line basis over their estimated useful lives of ten
years.

ACCRUED LIABILITIES:  Accrued liabilities consist of the following at December 
31:
<TABLE>
<CAPTION>

(In thousands)                    1997       1996
--------------               ---------    -------

<S>                          <C>          <C>    
Clinical studies                $1,362       $219
Marketing programs                 734        219
Contract sales force related       365          -
Accrued payroll and
  related expenses                 295        198
Other accrued liabilities          989        227
                             ---------    -------
                                $3,745       $863
                             =========    =======
</TABLE>


                                       46

<PAGE>   47


REVENUE RECOGNITION: The Company recognizes product sales upon shipment of
product. License payments are generally recognized upon the execution of the
license agreement. Research and development milestones are recorded when the
underlying performance objective has been attained. License payments received
which are related to future performance are deferred and recorded as revenues as
they are earned over specified future performance periods. Payments received
under research and development agreements are recognized as revenue ratably with
the performance specified in the agreement, which approximates the incurrence of
related costs.

RESEARCH AND DEVELOPMENT: Research and development expenditures are charged to
operations as incurred.

ADVERTISING COSTS: Advertising costs are expensed as incurred and amounted to
approximately $689,000, $41,000 and $4,000 in 1997, 1996 and 1995 respectively.

NET LOSS PER SHARE: In February 1997, the Financial Accounting Standards Board
(FASB) issued Statement of Financial Accounting Standards (SFAS) No. 128,
"Earnings Per Share", which the Company has adopted. The Statement replaces the
presentation of Primary EPS with a presentation of basic EPS, which excludes
dilution and is computed by dividing net loss by the weighted average number of
common shares outstanding for the period. The Statement also requires the dual
presentation of basic and diluted EPS on the face of the income statement for
all entities with complex capital structures and requires a reconciliation of
the numerator and denominator of the basic EPS computation to the numerator and
denominator of the diluted EPS computation. SFAS No. 128 did not impact the
Company's current or previously reported loss per share.

STOCK-BASED COMPENSATION: In October 1995 the FASB issued Statement of Financial
Accounting Standards (SFAS) No. 123, "Accounting for Stock-Based Compensation,"
which encourages, but does not require, companies to record compensation expense
for stock-based employee compensation plans at fair value. The Company has
chosen to continue to apply Accounting Principles Board Opinion No. 25,
"Accounting for Stock Issued to Employees," and related Interpretations in
accounting for its stock based plans and, accordingly, does not recognize
compensation expense related to employees or directors under its stock option
plans or employee stock purchase plan. Note 7 contains a summary of the pro
forma effects to reported net loss and net loss per basic and diluted share for
1997 and 1996 if the Company had elected to recognize compensation expense based
on the fair value of the options granted as described by SFAS No. 123.

ACCOUNTING PRONOUNCEMENTS: In June 1997, the FASB issued SFAS No. 130,
"Reporting Comprehensive Income." The Statement is effective for fiscal years
beginning after December 15, 1997. The Statement establishes standards for
reporting and display of comprehensive income and its components in a company's
consolidated financial statements. The Company will adopt this Statement in 1998
and does not believe it will have a material impact on its consolidated
financial statements.

In June 1997, the FASB issued SFAS No. 131, "Disclosures About Segments of an
Enterprise and Related Information." This Statement is effective for fiscal
years beginning after December 15, 1997. This Statement establishes standards
for disclosure about operating segments, products and services, geographic areas
and major customers, as well as descriptive information on how the operating
segments were determined. The Company will adopt this Statement in 1998 and does
not believe it will have a material impact on its consolidated financial
statements.

RECLASSIFICATIONS: Certain prior year amounts have been reclassified to conform
to the current year presentation.

                                       47
<PAGE>   48


3.  MARKETABLE SECURITIES

At December 31, 1997 and 1996, marketable securities classified as
available-for-sale are summarized below (in thousands):

<TABLE>
<CAPTION>

                                 Amortized
                                   Cost     Unrealized   Unrealized       Fair
December 31, 1997                  Basis       Gains       Losses         Value
                                  -------     -------     -------        -------
<S>                            <C>          <C>          <C>             <C>   
Available for sale:
U.S. Treasury and U.S. 
  agency securities                $  750     $    --     $    (1)        $  749
Corporate commercial paper,
  notes and bonds                   3,352          --          (4)         3,348
                                  -------     -------     -------        -------
                                   $4,102     $    --     $    (5)        $4,097
                                  =======     =======     =======        =======

                                 Amortized
                                   Cost     Unrealized   Unrealized       Fair
December 31, 1996                  Basis       Gains       Losses         Value
                                  -------       ---       -------        -------
<S>                            <C>          <C>          <C>             <C>   
Available for sale:
U.S. Treasury and U.S. 
  agency securities                $1,248     $    --     $    (3)        $1,245
Corporate commercial paper,
  notes and bonds                   2,110           2          (5)         2,107
                                  -------     -------     -------        -------
                                   $3,358     $     2     $    (8)        $3,352
                                  =======     =======     =======        =======
</TABLE>

The amortized cost of marketable securities at December 31, 1997 totaling
$3,102,000 and $1,000,000 mature in 1998 and 1999, respectively. Realized gains
and losses on sales of available-for-sale securities during the year ended
December 31, 1997 and 1996 were immaterial.


4.  LONG-TERM DEBT

The Company leases certain of its laboratory equipment and its phone system
under capital leases. The capital leases expire at various dates through 1999
and bear interest rates from 12% to 19%.

Future minimum lease payments under the capital lease obligations are not
material. Interest expense under these obligations totaled approximately $6,000,
$8,000, and $14,000 for each of the years ended December 31, 1997, 1996 and
1995, respectively.

In May 1997, the Company entered into a $2.5 million revolving credit facility
with a bank under which it can borrow at prime plus 2%. Borrowings are limited
to 75% of certain accounts receivable and all borrowings are collateralized by
essentially all of the Company's assets. Availability of the line is subject to
the Company maintaining certain reporting and financial covenants. There were no
borrowings or repayments under the line from inception to December 31, 1997.


                                       48
<PAGE>   49



5.  COMMITMENTS

FACILITY LEASE: The Company rents office and laboratory facilities under a
noncancelable operating lease expiring in April 2003. Under the terms of the
lease, the Company is responsible for its share of common area costs. Future
minimum lease payments are as follows:
<TABLE>
<CAPTION>

Year             (In thousands)
-------------------------------
<S>              <C>          
1998                    $  557
1999                       391
2000                       400
2001                       409
2002                       417
Thereafter                 159
                 -------------
Total                   $2,333
                 =============
</TABLE>

Rent expense under operating leases amounted to approximately $312,000,
$300,000, and $342,000 in 1997, 1996, and 1995, respectively.

The Company may be obligated to make license and development milestone payments
in the future under certain license and collaborative research agreements, as
described further in Note 6.


6.  LICENSE AND COLLABORATIVE RESEARCH AGREEMENTS

IN-LICENSE AGREEMENTS: Penederm has in-license agreements with the University of
California, Kaken Pharmaceutical Company, Ltd. (Kaken), and a group of entities
including the Wisconsin Alumni Research Foundation and Renaissance Corporation,
for certain topical drug delivery technology, the rights to develop and market
an antifungal butenafine drug compound, and the right to develop and market
patented Vitamin D compounds, respectively. These agreements generally require
the payment by the Company of nonrefundable license fees, additional milestone
payments contingent on the achievement of regulatory objectives and royalties on
future product sales resulting from commercialization of the technologies or
compounds. These license agreements are generally for specified skin disorders
and limited to specified territories. Royalties paid under these agreements were
not significant in any of the three years in the period ended December 31, 1997.

OUT-LICENSE AGREEMENTS: Penederm has agreements granting licenses to the
Company's proprietary technologies to Warner Wellcome Consumer Health Products
and SmithKline Beecham for certain over-the-counter skin care products and with
Schering-Plough HealthCare Products, Inc., UCB Group of Belgium, Allergan
Incorporated and Mylan Laboratories Inc. to develop and commercialize certain
antifungal skin and nail prescription products based on the butenafine compound
in-licensed from Kaken. The agreements generally provide for the licensee to
sell certain products incorporating the Company's proprietary TopiCare Delivery
Compounds, and/or in-licensed drug compounds in certain specified territories or
to specified medical specialties. Terms of the license agreements also generally
include supply agreements, license fees, performance milestone payments and
royalties due to Penederm. Certain of the agreements are terminable upon as few
as 90 days notice, in which event the product rights revert to Penederm without
further consideration and become available for out-license to another
development or 


                                       49


<PAGE>   50

marketing partner. The Company's agreement with Warner U.S. terminated on
December 31, 1997. For the years ending December 31, 1997, 1996, and 1995, the
Company recorded license fee milestone revenues of $2,664,000, $647,000, and
$2,050,000, respectively, under these agreements.

7.  STOCKHOLDERS' EQUITY

SHAREHOLDER RIGHTS PLAN: On November 20, 1996, the Board of Directors adopted
the Shareholder Rights Plan ("Rights Plan") to assist its stockholders in
realizing fair value and equal treatment in the event of any attempted takeover
of the Company and to protect the Company and its stockholders against coercive
takeover tactics. In the event a third party or group were to acquire 20% or
more of the Company's outstanding Common Stock without the prior approval of the
Board of Directors, each Company stockholder, other than the acquirer, will have
the right to buy Common Stock of the Company with a market value of twice the
exercise price. In addition, if the Company were to be acquired in a merger,
stockholders with unexercised rights could purchase common stock of the acquirer
with a value of twice the exercise price of the rights.

STOCK OPTION PLANS: In September 1993, the Company adopted an Equity Incentive
Plan under which stock options, restricted stock, stock purchase rights or
performance shares may be awarded to employees and consultants. Shares
authorized under the Equity Incentive Plan include the shares previously
authorized under the 1987 Employee and Consultant Stock Option plans. Under the
plans, options may be granted at prices not less than 85% of the fair market
value at the date of grant in the case of nonqualified options and not less than
fair market value in the case of incentive options (110% of fair market value in
certain instances), as determined by the Board of Directors.

Options are generally exercisable upon grant, expire ten years from the date of
grant and vest over five years. Shares issued upon exercise of unvested options
are subject to the right of repurchase by the Company which lapses in accordance
with the option's vesting schedule.

In June 1994, the Company adopted the 1994 Nonemployee Directors Stock Option
Plan, under which nonqualified stock options may be granted to nonemployee
directors on a formula basis. At December 31, 1997, 200,000 shares of common
stock were reserved under this Plan. Options may be granted at an exercise price
equal to the fair market value of common stock on the date of the grant. Options
vest ratably over the period of one year from the date of grant, and have a term
of ten years.

Had compensation expense been recognized for the Company's employee stock
purchase plan and stock option plans based on the fair value at the grant date
for awards made in 1997, 1996 and 1995 consistent with the provisions of SFAS
No. 123, the Company's net loss and loss per share would have been increased to
the following pro forma amounts:
<TABLE>
<CAPTION>

(In thousands, except per share amounts)
                                                1997              1996        1995
                                            -----------       ----------    ----------

<S>                                         <C>               <C>           <C>       
Net loss, as reported                         $(12,717)           $(7,643)    $(5,036)
Net loss, pro forma                           $(13,717)           $(8,163)    $(5,141)
Net loss per basic and diluted share,
  as reported                                 $  (1.59)           $ (1.05)    $  (.70)
Net loss per basic and diluted share,
  pro forma                                   $  (1.72)           $ (1.12)    $  (.72)
</TABLE>

                                       50

<PAGE>   51

Because SFAS No. 123 is applicable only to options granted subsequent to
December 31, 1994, its pro forma effect will not be fully reflected until 1998.

The weighted average fair value for stock options granted in 1997, 1996 and 1995
was $6.54, $7.20 and $4.10, respectively. The weighted average fair value for
shares issued under the employee stock purchase plan in 1997, 1996 and 1995 was
$3.03, $1.93 and $1.48, respectively.

The fair value of each option granted during the years 1997, 1996 and 1995 is
estimated at the grant date using the Black-Scholes option-pricing model
utilizing the following assumptions:
<TABLE>
<CAPTION>

                                               Employee
                                                Stock
                                  Stock        Purchase
                               Option Plans      Plan
                               ------------    --------
<S>                           <C>              <C> 
Expected stock price
  volatiltiy                        60%           60%
Risk-free interest rate            6.0%          6.0%
Expected option life             3-6 years     .5-2 years
Expected dividend yield            None          None
</TABLE>

The activity under the stock option plans for the three years in the period
ended December 31, 1997 was as follows:
<TABLE>
<CAPTION>

                                        Outstanding Options
                              --------------------------------------------------
                                   Shares      Number    Price
                                  Available     of        Per
                                  for  Grant   Shares    Share             Total
                                  ----------   ------    -----             -----

(In thousands except for price per share)

<S>                                <C>         <C>       <C>               <C>    
Balance at December 31, 1994         158         635     $0.20-$14.25       $ 1,407
   Additional shares
     reserved                        200          --
   Options granted                  (201)        201     $4.75-$ 8.50         1,405
   Options exercised                  --        (201)    $0.20-$ 1.60          (133)
   Options canceled                   84         (84)    $0.80-$14.25          (145)
                                    ----     -------                        -------
Balance at December 31, 1995         241         551     $0.35-$14.25         2,534

   Additional shares
     reserved                        400          --
   Options granted                  (475)        475     $6.25-$16.875        5,924
   Options exercised                  --         (45)    $0.35-$ 8.375          (71)
   Options canceled                   74         (74)    $0.80-$16.875         (648)
                                    ----     -------                        -------
Balance at December 31, 1996         240         907     $0.35-$16.875        7,739

   Additional shares
     reserved                        400          --
   Options granted                  (166)        166     $10.375-$14.375       2006
   Options exercised                  --         (59)    $ 0.35 -$14.25        (180)
   Options canceled                   24         (24)    $ 1.60 -$16.875       (275)
                                    ----     -------                        -------
Balance at December 31, 1997         498         990     $ 0.35 -$16.875    $ 9,290
                                    ====     =======                        =======
</TABLE>

                                       51

<PAGE>   52

As of December 31, 1997, no shares exercised under the plans were subject to the
right of repurchase and 426,000 of the outstanding options were vested.

The following table summarizes information regarding outstanding stock options
all of which are exercisable, but subject to the right of repurchase by the
Company, at December 31, 1997: 

<TABLE>
<CAPTION>

                       Shares
                     outstanding    
                         at        Weighted     Weighted
  Range of            December      Average      Average
  Exercise            31, 1997     Remaining    Exercise
   Prices         (in thousands)   Life (Yrs)     Price                        
   ------         --------------   ----------    ------                        
<S>               <C>              <C>        <C>  
$ 0.35-$ 1.60           187            5.0       $ 1.46
$ 4.75-$ 7.875          156            7.9       $ 5.94
$ 8.00-$11.75           247            7.8       $10.24
$12.00-$13.375          252            9.1       $12.41
$13.75-$16.875          148            8.3       $16.46
--------------          ----           ---       ------
$ 0.35-$16.875          990            7.7       $ 9.39
==============          ====           ===       ======
</TABLE>


EMPLOYEE STOCK PURCHASE PLAN: In May 1995, the Company adopted an Employee Stock
Purchase Plan (ESPP). The ESPP provides employees an opportunity to purchase
Company stock through payroll deductions, subject to a maximum percentage of
compensation, currently 7%. The purchase price per share is the lower of 85% of
market value on the enrollment date or on the date purchased. Under the plan,
150,000 shares of common stock have been reserved for issuance. For the years
ended December 31, 1997, 1996 and six-month period ended December 31,1995,
27,361, 37,074 and 15,049 shares were issued under the ESPP, respectively.

SHARES RESERVED FOR FUTURE ISSUANCE: As of December 31, 1997, the Company has
reserved approximately 71,000 and 1,488,000 shares of Common Stock for future
issuance under the Employee Stock Purchase Plan and the Company's Stock Option
Plans, respectively.


8.  RELATED PARTY TRANSACTIONS

On June 15, 1990, the Company loaned an officer $125,000, bearing interest at
8.82% payable quarterly. The loan is repayable on demand or termination of
employment, whichever is earlier, and is collateralized by stock options with a
value equal to the loan.


9.  EMPLOYEE BENEFIT PLANS

During 1989, the Company adopted a qualified profit-sharing plan and trust under
Internal Revenue Service Codes 401(a) and 401(k). The plan provides for
tax-deferred salary deductions whereby employees can elect to contribute up to
20% of their salary (subject to current statutory limits) to the plan. Beginning
in July 1994, the Company matched employee contributions up to 2% of their gross
salary with Company common stock. Such matching contributions become fully
vested when the employee completes five years of service. The Company has the
option to contribute up to an additional 2% based 

                                       52
<PAGE>   53

on the achievement of specified corporate goals. The Company contributed 4,651
shares (valued at $46,510), 5,561 shares (valued at $68,817), and 6,436 shares
(valued at $73,210) for the years ended December 31, 1997, 1996 and 1995,
respectively.


10.  INCOME TAXES

As of December 31, 1997, the Company had federal net operating loss
carryforwards of approximately $49,000,000. The Company also had federal
research and development tax credit carryforwards of approximately $1,700,000 as
of December 31, 1997. The net operating loss and credit carryforwards will
expire at various dates beginning in 2002 through 2012 if not utilized.

Significant components of the Company's deferred tax assets and liabilities for
federal and state income taxes as of December 31, 1997 and 1996 are as follows:


<TABLE>
<CAPTION>

(In thousands)                           1997       1996
                                    ---------   ---------

<S>                                   <C>       <C>     
Net operating loss carryforwards     $ 17,300   $ 12,900
Research credit
  carryforwards (expire 2002-2012)      2,400      1,900
Capitalized research & development        700        700
Other - net                               200        200

                                    ---------- ----------
Net deferred tax assets                20,600     15,700
Valuation allowance                   (20,600)   (15,700)
                                    ---------- ----------
Total                                $      -   $      -
                                    ========== ==========
</TABLE>



Because of the Company's lack of an earnings history, the deferred tax asset has
been fully offset by a valuation allowance. The net valuation allowance
increased by $4,900,000, and $3,500,000 for the years ended December 31, 1997
and 1996, respectively.

Utilization of the net operating losses and credits may be subject to a
substantial annual limitation due to the "change in ownership" provisions of the
Internal Revenue Code of 1986 and similar state provisions. The annual
limitation may result in the expiration of net operating losses and credits
before utilization.


                                       53
<PAGE>   54


11.  MAJOR CUSTOMERS AND EXPORT SALES

In 1997, no customer accounted for more than 10% of the Company's revenues. In
1996, four unaffiliated customers accounted for approximately 28% ($816,000),
25% ($736,000), 18% ($519,000), and 15% ($430,000) of the Company's revenues. In
1995, four unaffiliated customers accounted for approximately 24% ($1,322,000),
18% ($955,000), 17% ($900,000), and 14% ($750,000) of the Company's revenues.

Export sales, principally to Canada and France, were $984,000, $1,115,000 and
$1,400,000 in 1997, 1996 and 1995, respectively.


12.  SUBSEQUENT EVENTS

On January 21, 1998, the Company entered into an agreement with an investment
group for an equity line of credit which allows the Company to access up to $10
million through sales of its common stock over a two year period. The decision
to draw any funds and the timing of any such draw is solely at the Company's
discretion. Should the Company draw upon the equity line of credit, any shares
sold would be at a discount to the average trading price of the Company's stock
over a specified period at the time of the draw. Drawing under the equity line
of credit is subject to the satisfaction of certain conditions, including
registration of the shares, a minimum trading price per share, and certain
limitations on the number of shares of the Company's common stock being held by
the investment group at any point in time. In conjunction with the equity line
of credit agreement, the Company issued the investment group a three-year
warrant for 25,000 shares of common stock at an exercise price of $12.66.

In January 1998, Penederm announced that it had licensed Permethrin Cream 5%
from Alpharma Inc. for marketing under the brand name Acticin in the United
States. Under the terms of the agreement, Alpharma will manufacture and supply
the product to Penederm, and the Company will pay Alpharma upfront milestones
and royalties based upon product sales and profits.


                                       54
<PAGE>   55


ITEM 9.  CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND 
         FINANCIAL DISCLOSURE

  Not applicable.


                                    PART III

ITEM 10.  DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT

        The information required by this Item with respect to executive officers
is set forth in Part I of this report and the information with respect to
directors is incorporated by reference to the information set forth under the
caption "Election of Directors" in the Proxy Statement.

ITEM 11.  EXECUTIVE COMPENSATION

        The information required by this Item is incorporated herein by
reference to the information set forth under the caption "Executive
Compensation" in the Proxy Statement.

ITEM 12.  SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT

        The information required by this Item is incorporated herein by
reference to the information set forth under the caption "Security Ownership of
Certain Beneficial Owners and Management" in the Proxy Statement.

ITEM 13.  CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS

        The information required by this Item is incorporated herein by
reference to the information set forth under the caption "Certain Relationships
and Related Transactions" in the Proxy Statement.


                                     PART IV

ITEM 14.  EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K

  (a)1.  FINANCIAL STATEMENTS.

         Included in Part II Item 8 of this report.

  (a)2.  FINANCIAL STATEMENT SCHEDULES.

         All schedules have been omitted because the required information is not
present or is not present in amounts sufficient to require submission of the
schedule, or because the information required is included in the consolidated
financial statements, including the notes thereto.

                                       55
<PAGE>   56

<TABLE>
<CAPTION>

(a)3.  EXHIBITS:
<S>                    <C>                                       
      3.1     (1)      Certificate of Incorporation
      3.2     (1)      Bylaws
      4.1     (2)      Specimen Common Stock Certificate
      10.1A   (3)      Employee Stock Option Plan, as amended
      10.1B   (3)      Consultant Stock Option Plan, as amended
      10.1C   (4)      Equity Incentive Plan
      10.1D   (3)      1994 Nonemployee Directors Stock Option Plan
      10.1E   (4)      Employee Stock Purchase Plan
      10.3    (2)      Employment Agreement dated May 10, 1993 between the
                       Company and Lloyd H. Malchow
      +10.4B  (2)      Incentive Stock Option Agreement dated September 12, 1991
                       between the Company and John W. Quigley, Jr., as amended
                       February 25, 1993
      +10.4J  (5)      1995 Performance Share Award Agreement - Lloyd H. Malchow
      +10.4K  (5)      1995 Performance Share Award Agreement - John W. Quigley
      +10.4N  (6)      1995 Performance Share Award Agreement - William Gutshall
      +10.4O  (7)      1996 Performance Share Award Agreement - Lloyd H. Malchow
      +10.4P  (7)      1996 Performance Share Award Agreement - John W. Quigley
      +10.4R  (7)      1996 Performance Share Award Agreement - William Gutshall
      10.4S   (8)      Form of 1997 Performance Share Award Agreement between
                       the Company and each of Lloyd H. Malchow, John W.
                       Quigley, William Gutshall and Edward Ebbers
      10.4T            Form of 1998 Performance Share Award Agreement between
                       the Company and each of Lloyd H. Malchow, John W.
                       Quigley, William Gutshall, Edward Ebbers, Michael Bates
                       and William Thomas.
      10.5A   (2)      Nonqualified Stock Option Agreement dated March 14, 1991
                       between the Company and William I. Bergman
      10.5B   (2)      Nonqualified Stock Option Agreement dated September 12,
                       1991 between the Company and William I. Bergman
      10.6    (2)      Information and Registration Rights Agreement dated June
                       1, 1988, as amended through September 4, 1991
      10.7    (2)      License Agreement, effective April 27, 1988, between the
                       Company and the Regents of the University of California
      10.8    (2)      Research and Development Lease dated December 14, 1988,
                       as amended through February 1, 1991 between the Company
                       and Vintage Park Associates
      10.8B   (5)      Amendment No. 4 to Vintage Park Research and Development
                       Lease dated September 30, 1994, between the Company and
                       Vintage Park Associates
      10.8C            Vintage Park Research and Development Lease dated May
</TABLE>



                                       56
<PAGE>   57

<TABLE>
<CAPTION>

<S>                    <C>                           
                       21, 1997, between the Company and
                       WCB Sixteen Limited Partnership.
      10.9             Common Stock Investment Agreement between the Company and
                       Promethean Investment Group L.L.C. dated January 21, 1998
      23.1             Consent of Ernst & Young LLP, Independent Auditors
      24.1             Power of Attorney (see pages 58-59)
      27.1             Financial Data Schedule
</TABLE>

---------------

 (1)       Incorporated by reference to appendices to the Proxy Statement filed
           on May 5, 1997 by Penederm Incorporated, a California corporation
           which was the predecessor to the Company ("Penederm California").

 (2)       Incorporated by reference to exhibits to Penederm California's
           Registration Statement on Form S-1 (No. 33-67950) effective November
           2, 1993.

 (3)       Incorporated by reference to Exhibits to Registration Statement on
           Form S-8 (No. 33-76100) filed on March 4, 1994.

 (4)       Incorporated by reference to Exhibits to Registration Statement on
           Form S-8 (333-32689) filed on August 1, 1997.

 (5)       Incorporated by reference to Exhibits to Penederm California's Annual
           Report on Form 10-K for the Fiscal Year Ended December 31, 1994.

 (6)       Incorporated by reference to Exhibits to Penederm California's
           Quarterly Report on Form 10-Q for the Quarter Ended June 30, 1995.

 (7)       Incorporated by reference to Exhibits to Penederm California's Annual
           Report on Form 10-K for the Fiscal Year Ended December 31, 1995.

 (8)       Incorporated by reference to Exhibits to Penederm California's Annual
           Report on Form 10-K for the Fiscal Year Ended December 31, 1996.

+ Confidential treatment requested.

  (b)    REPORTS ON FORM 8-K:

               None.

                                       57
<PAGE>   58



                                   SIGNATURES

  Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange
Act of 1934, the Registrant, Penederm Incorporated, a corporation organized and
existing under the laws of the State of California, has duly caused this report
to be signed on its behalf by the undersigned thereunto duly authorized, in the
City of Foster City, State of California, on the 26th day of February, 1998.

                                       PENEDERM INCORPORATED


                                       By  /s/ LLOYD H. MALCHOW
                                           -------------------------------------
                                           Lloyd H. Malchow
                                           President and Chief Executive Officer


                               POWERS OF ATTORNEY

  KNOW ALL PERSONS BY THESE PRESENTS, that each person whose signature appears
below constitutes and appoints Lloyd H. Malchow and Michael A. Bates, jointly
and severally, his attorneys-in-fact, each with the power of substitution, for
him in any and all capacities, to sign any amendments to this Annual Report on
Form 10-K and to file the same, with exhibits thereto and other documents in
connection therewith, with the Securities and Exchange Commission, hereby
ratifying and confirming all that each of said attorneys-in-fact, or his
substitute or substitutes, may do or cause to be done by virtue hereof.

  Pursuant to the requirements of the Securities Exchange Act of 1934, this
Annual Report on Form 10-K has been signed below by the following persons on
behalf of the Registrant and in the capacities and on the dates indicated.

<TABLE>
<CAPTION>

          SIGNATURE                    TITLE                           DATE
          ---------                    -----                           ----
<S>                         <C>                               <C>   

/s/ LLOYD H. MALCHOW        Director, President and Chief      February 26, 1998
-------------------------   Executive Officer (Principal 
    Lloyd H. Malchow        Executive Officer)
     
/s/ MICHAEL A. BATES        Vice President of Finance and      February 26, 1998
-------------------------   Administration and Chief 
    Michael A. Bates        Financial Officer (Principal 
                            Financial and Accounting 
                            Officer)
/s/ ROBERT F. ALLNUTT
-------------------------   Director                           February 26, 1998
  Robert F. Allnutt

/s/ WILLIAM I. BERGMAN
-------------------------   Director                           February 26, 1998
  William I. Bergman
</TABLE>


                                       58
<PAGE>   59
<TABLE>
<CAPTION>


<S>                             <C>                               <C>   
/s/ DAVID E. COLLINS            Chairman of the Board              February 26, 1998
-----------------------------   
   David E. Collins

/s/ MARK J. GABRIELSON
-----------------------------   Director                           February 26, 1998
   Mark J. Gabrielson

/s/ HARVEY S. SADOW, Ph.D. 
-----------------------------   Director                           February 26, 1998
 Harvey S. Sadow, Ph.D.

/s/ GERALD D. WEINSTEIN, M.D. 
-----------------------------   Director                           February 26, 1998
Gerald D. Weinstein, M.D.
</TABLE>



                                       59

<PAGE>   60

                                         
                                INDEX TO EXHIBITS
<TABLE>
<CAPTION>

                                                                    SEQUENTIALLY
    EXHIBIT                                                            NUMBERED
      NO.                                  DESCRIPTION                   PAGES
      ---                                  -----------                   -----
<S>              <C>                                
3.1       (1)    Certificate of Incorporation
3.2       (1)    Bylaws
4.1       (2)    Specimen Common Stock Certificate
10.1A     (3)    Employee Stock Option Plan, as amended
10.1B     (3)    Consultant Stock Option Plan, as amended
10.1C     (4)    Equity Incentive Plan
10.1D     (3)    1994 Nonemployee Directors Stock Option Plan
10.1E     (4)    Employee Stock Purchase Plan
10.3      (2)    Employment Agreement dated May 10, 1993 between the
                 Company and Lloyd H. Malchow
+10.4B    (2)    Incentive Stock Option Agreement dated September 12,
                 1991 between the Company and John W. Quigley, Jr., as
                 amended February 25, 1993
+10.4J    (5)    1995 Performance Share Award Agreement - Lloyd H. Malchow
+10.4K    (5)    1995 Performance Share Award Agreement - John W. Quigley
+10.4N    (6)    1995 Performance Share Award Agreement - William Gutshall
+10.4O    (7)    1996 Performance Share Award Agreement - Lloyd H. Malchow
+10.4P    (7)    1996 Performance Share Award Agreement - John W. Quigley
+10.4R    (7)    1996 Performance Share Award Agreement - William Gutshall
10.4S     (8)    Form of 1997 Performance Share Award Agreement between
                 the Company and each of Lloyd H. Malchow, John W.
                 Quigley, William Gutshall and Edward Ebbers
10.4T            Form of 1998 Performance Share Award Agreement between
                 the Company and each of Lloyd H. Malchow, John W.
                 Quigley, William Gutshall, Edward Ebbers, Michael Bates
                 and William Thomas.
10.5A     (2)    Nonqualified Stock Option Agreement dated March 14, 1991
                 between the Company and William I. Bergman
10.5B     (2)    Nonqualified Stock Option Agreement dated September 12,
                 1991 between the Company and William I. Bergman
10.6      (2)    Information and Registration Rights Agreement dated June
                 1, 1988, as amended through June 4, 1991
10.7      (2)    License Agreement, effective April 27, 1988, between the
                 Company and the Regents of the University of California
10.8      (2)    Research and Development Lease dated December 14, 1988,
                 as amended through February 1, 1991 between the Company
                 and Vintage Park Associates
10.8B     (5)    Amendment No. 4 to Vintage Park Research and Development
                 Lease dated September 30, 1994, between the 
</TABLE>


                                       60

<PAGE>   61
<TABLE>
<CAPTION>


<S>              <C>   
                 Company and Vintage Park Associates
10.8C            Vintage Park Research and Development Lease dated May
                 21, 1997, between the Company and WCB Sixteen Limited
                 Partnership.
10.9             Common Stock Investment Agreement between the Company
                 and Promethean Investment Group L.L.C. dated January 21,
                 1998
23.1             Consent of Ernst & Young LLP, Independent Auditors
24.1             Power of Attorney (see pages 58-59)
27.1             Financial Data Schedule
</TABLE>

---------------

  (1)  Incorporated by reference to appendices to the Proxy Statement filed
       on May 5, 1997 by Penederm Incorporated, a California corporation
       which was the predecessor to the Company ("Penederm California").

  (2)  Incorporated by reference to exhibits to Penederm California's
       Registration Statement on Form S-1 (No. 33-67950) effective November
       2, 1993.

  (3)  Incorporated by reference to Exhibits to Registration Statement on
       Form S-8 (No. 33-76100) filed on March 4, 1994.

  (4)  Incorporated by reference to Exhibits to Registration Statement on
       Form S-8 (333-32689) filed on August 1, 1997.

  (5)  Incorporated by reference to Exhibits to Penederm California's Annual
       Report on Form 10-K for the Fiscal Year Ended December 31, 1994.

  (6)  Incorporated by reference to Exhibits to Penederm California's
       Quarterly Report on Form 10-Q for the Quarter Ended June 30, 1995.

  (7)  Incorporated by reference to Exhibits to Penederm California's Annual
       Report on Form 10-K for the Fiscal Year Ended December 31, 1995.

  (8)  Incorporated by reference to Exhibits to Penederm California's Annual
       Report on Form 10-K for the Fiscal Year Ended December 31, 1996.

  +  Confidential treatment requested.


                                       61