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UNITED STATES SECURITIES AND EXCHANGE COMMISSION

FORM 10-Q

for the quarterly period ended September 30, 2003

OR

for the Transition Period from __________ to __________

0-18962
(Commission File Number)

CYGNUS, INC.

(650) 369-4300
(Registrant’s telephone number, including area code)

     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  o

     Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Act). Yes  o   No  x

As of November 11, 2003, there were 38,480,253 shares of the Registrant’s common stock outstanding.

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CYGNUS, INC.

INDEX

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PART I. FINANCIAL INFORMATION

Item 1. Financial Statements.

Cygnus, Inc.

(See accompanying notes.)

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Cygnus, Inc.
CONDENSED CONSOLIDATED BALANCE SHEETS
( In thousands, except per share data )

Note: The condensed consolidated balance sheet at December 31, 2002 has been derived from the audited consolidated financial statements at that date but does not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements.

(See accompanying notes.)

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Cygnus, Inc.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(In thousands)
(unaudited)

(See accompanying notes.)

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Cygnus, Inc.

Notes to the Condensed Consolidated Financial Statements (unaudited)

1.

Basis of Presentation

     The interim condensed consolidated financial statements of Cygnus, Inc. and its subsidiaries (the “Company,” “Cygnus,” “us,” “we,” “our,” etc.) included herein have been prepared by the Company, without audit, pursuant to the rules and regulations of the Securities and Exchange Commission (“SEC”). Certain information and footnote disclosures normally included in annual financial statements prepared in accordance with accounting principles generally accepted in the United States (“GAAP”) have been condensed or omitted. The interim condensed consolidated financial statements reflect, in the opinion of Cygnus management, all normal and recurring adjustments that management believes necessary for a fair presentation of the financial position as of the reported dates and the results of operations for the respective periods presented. Interim financial results are not necessarily indicative of results for a full year. Certain prior period amounts in the condensed consolidated financial statements have been reclassified to conform with the current period presentation. The condensed consolidated financial statements should be read in conjunction with the audited consolidated financial statements and related notes for the year ended December 31, 2002 included in our 2002 Annual Report on Form 10-K, as amended by Form 10-K/A.

2.

Litigation with Sankyo Pharma Inc. and Sankyo Co., Ltd.

     On October 2, 2003, Sankyo Pharma Inc. (“Sankyo Pharma”) stated that they were stopping performance of their contractual obligations under our Sales, Marketing and Distribution Agreement and related contracts. In addition, Sankyo Pharma acknowledged that they had not paid invoices owed to us and informed us that they had no intention of remitting payment for such amounts. As of October 10, 2003, these invoices total over $6.0 million. Sankyo Pharma stated that they were relying on California Commercial Code, Section 2609(1) as a purported legal basis for ceasing performance of their contractual obligations. Section 2609(1) generally gives parties the right to demand adequate assurance of due performance by the counterparty of their contractual obligations if reasonable grounds of insecurity arise with respect to performance by the counterparty. Sankyo Pharma has stated that they had grounds for insecurity regarding our financial position and our ability to perform under the Sales, Marketing and Distribution Agreement and related contracts we have with Sankyo Pharma.

     On October 6, 2003, we filed a complaint in the Superior Court of the State of California for the County of San Mateo against Sankyo Pharma and its Japanese parent company Sankyo Co., Ltd. (“Sankyo Japan”) for breach of contract and intentional interference with contract relating to the sales, marketing and distribution of our GlucoWatch® Biographer products. During the initial 12-year term of our Sales, Marketing and Distribution Agreement with Sankyo Pharma, there are no termination rights except in very specific circumstances, none of which, we believe, has occurred. We are seeking substantial compensatory damages and other relief. The litigation in which we are currently involved may affect, among other things, our ability to sell, market and distribute our products in the United States, our financing activities, the retention of personnel and our ability to continue as a going concern. We cannot predict with certainty the eventual outcome of pending litigation, which may result in a significant adverse jury verdict or punitive damages award, or a judgment that certain of our allegations are invalid or unenforceable. Furthermore, this kind of litigation could be very costly and divert our management’s attention and resources, and any adverse determination in this litigation, or delay in resolving this litigation, may cause us to cease operations and/or seek protection under the bankruptcy laws.

     On October 9, 2003, we announced a reduction in force of approximately 60% of our work force as a result of Sankyo Pharma’s decision to stop performing under its contracts with us. We have suspended our manufacturing activities and research and development efforts for future products. We are not likely to continue to manufacture current products or develop new products in the near future. According to Sankyo Pharma, however, they are currently warehousing inventory approximating two years’ sales of our products, and these products remain available for sale in the United States.

     On October 16, 2003, we responded to Sankyo Pharma’s request for assurances under California Commercial Code, Section 2609(1). Sankyo Pharma had notified us, as well as certain health care professionals, that they will continue to provide marketing, sales, and distribution support for our GlucoWatch G2 Biographer; however, given their decision to stop performance under their contracts with us and our litigation, the commercial status of our products in the United States is unclear. We have begun looking at alternative sales, marketing and distribution approaches for our products.

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     On November 6, 2003, Sankyo Pharma filed an answer and cross-claims against us for declaratory relief, breach of contract, and defamation. We have not yet filed a response to these claims. We believe that we have meritorious defenses to the causes of action asserted against us by Sankyo Pharma, and we intend to vigorously defend ourselves against these claims. This litigation is in its early stages, however, and is therefore inherently difficult to assess.

     We have incurred substantial operating losses and negative cash flows from operations since our inception, and we have used cash from equity and debt to supplement our operating cash flow requirements. As of September 30, 2003, we had cash, cash equivalents, and investments of $9.1 million. We expect to incur additional losses from operations in the foreseeable future.

     With Sankyo Pharma’s decision to stop performing under our Sales, Marketing and Distribution Agreement and related contracts, and their refusal both to pay receivables in excess of $6.0 million and to honor the balance of their binding purchase commitment to pay us $28.4 million in cash between October 1, 2003 and March 31, 2004, we will need to conserve cash and find ways to generate additional cash to finance our operations. Our ability to continue as a going concern is dependent on our ability to generate sufficient cash flow to fund our operations and meet our debt and other obligations on a timely basis. Our plans both to conserve and generate cash include further reduction of our expenses and raising additional capital. There is no certainty, however, that we will be able to undertake such measures or that additional funds will be available to us. In addition, we do not believe we will be able to generate additional cash from product sales in any significant amounts in the near term since Sankyo has been, as a practical matter, our only distribution channel. We are currently pursuing various strategic options, including but not limited to pursuing a new partnership and/or selling some or all of our assets and intellectual property. If substantial additional resources are not available, we may need to cease our operations and/or seek protection under the bankruptcy laws. These conditions raise substantial doubt about our ability to continue as a going concern after March 31, 2004.

     The financial statements, as discussed in these footnotes, do not include all adjustments necessary to reflect the possible future effects on the recoverability and classification of assets or the amounts and classifications of liabilities that might result from the resolution of the matter described above.

3.

Significant Accounting Policies

Accounting for Stock-Based Compensation

     We issue stock options to our employees and outside directors and provide them the right to purchase our stock pursuant to stockholder-approved stock option programs. We account for our stock-based compensation plans under the intrinsic-value method of accounting as defined by Accounting Principles Board Opinion No. 25 (APB 25), “Accounting for Stock Issued to Employees,” and related interpretations. For purposes of disclosures pursuant to Financial Accounting Standards Board (FASB) Statement No. 123 (FAS 123), “Accounting for Stock Based Compensation,” as amended by FASB Statement No. 148 (FAS 148), “Accounting for Stock-Based Compensation—Transition and Disclosure,” the estimated fair value of employee and director stock options is amortized to expense over the options’ vesting period.

     The following table illustrates the effect on net loss and net loss per share if we had applied the fair-value recognition provisions of FAS 123 to stock-based employee and director compensation (in thousands, except per share amounts):

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     No stock-based employee compensation was included in net loss, as reported for the three and nine months ended September, 2003 and 2002.

     Pro forma information regarding net loss and net loss per share is required by FAS 123, which also requires that the information be determined as if we had accounted for our employee stock options granted under the fair-value method of FAS 123. For the three months ended September 30, 2003 and 2002, the estimated grant date fair value for stock options granted was $1,000 and $0, respectively. For the nine months ended September 30, 2003 and 2002, the estimated grant date fair value for stock options granted was $649,000 and $3.2 million, respectively. The fair value for the options was estimated at the date of grant using a Black-Scholes option valuation model with the following weighted-average assumptions:

     Effective January 8, 2003, the Board of Directors suspended the Amended 1991 Employee Stock Purchase Plan, as last amended and restated February 12, 2002, because our stock had been delisted from trading on the Nasdaq National Market. Thus, no shares were purchased pursuant to the Employee Stock Purchase Plan during the three and nine months ended September 30, 2003. The valuation related to the shares granted pursuant to the Employee Stock Purchase Plan in 2002 was calculated using the following variables:

     The Black-Scholes option valuation model was developed for use in estimating the fair value of traded options that have no vesting restrictions and are fully transferable. In addition, option valuation models require the input of highly subjective assumptions, including the expected stock-price volatility. Because our employee stock options have characteristics significantly different from those of traded options, and because changes in the subjective input assumptions can materially affect the fair-value estimate, in management’s opinion the existing models do not necessarily provide a reliable single measure of the fair value of our employee stock options.

     Any stock options and warrants granted to consultants and other non-employees are accounted for at fair value, determined by using the Black-Scholes valuation model, in accordance with the Emerging Issues Task Force (EITF) Consensus No. 96-18, “Accounting for Equity Investments that are issued to other than Employees for Acquiring, or in Conjunction with Selling Goods, or Services.” These options are subject to periodic revaluation over their vesting terms. The assumptions used to value stock-based awards to consultants are similar to those used

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for employees, except for the expected life for which the contractual life of the awards is used instead of the estimated useful life.

Use of Estimates

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

     Due to the early stage of our product commercialization activities, the estimates required in inventory valuation, including production yields and normal capacity, labor costs incurred in the production of each unit and overhead costs applicable to manufacturing operations, are inherently uncertain, thus actual results may differ from those estimates. Write-offs for potential obsolescence or for inventories in excess of demand and estimates for replacement costs of any stale-dated AutoSensor inventory held by Sankyo Pharma are also determined based on significant estimates, which may be significantly impacted by our litigation with Sankyo Pharma and Sankyo Japan.

Revenue Recognition

     Product revenues are generated upon the sale of our GlucoWatch Biographer and GlucoWatch® G2™ Biographers and related accessories in the United States and the United Kingdom. The GlucoWatch Biographer systems consist of two integrated parts: the durable Biographer and the disposable, single-use AutoSensor. After the initial sales of the Biographers, revenues will continue to be recorded upon the sale of additional AutoSensors and accessories to support the installed base of Biographers.

     Product sales are recorded when all of the following conditions have been met: product has been shipped, transfer of title has taken place, there is persuasive evidence of an arrangement, the price is fixed or determinable, and collection is reasonably assured. Revenues generated from our shipments of sample and practice Biographers are recognized when all the above conditions are met, typically upon delivery of these products to Sankyo Pharma, as the sales of such products are not subject to future pricing adjustments. With regard to product sales that were made directly by us to third parties, from time to time we allowed customers to return product for credit. In such instances, we deferred revenue until the return period expired. We accrue for estimated warranty costs and other allowances when the revenues from product sales are recognized. The warranty expenses recorded to date have not been significant and are within historical estimates. Revenues in the United States generated from our shipments of product to Sankyo Pharma for resale under our Sales, Marketing and Distribution Agreement were deferred until the product was sold by Sankyo Pharma to its third-party customers, because the net price of our product sales to Sankyo Pharma was subject to certain pricing adjustments, such as rebates, discounts and certain fees offered or paid by Sankyo Pharma to its third-party customers.

     For the three and nine months ended September 30, 2003, $2.2 million and $6.5 million of revenues were deferred, respectively. The costs of product revenues associated with these shipments are also deferred until the revenues are recognized. For the three and nine months ended September 30, 2003, $1.2 million and $4.2 million of such costs were deferred, respectively. In addition, for the three and nine months ended September 30, 2003, deferred costs of $0 and $821,000, respectively, were recorded for AutoSensors we estimated we would have had to replace due to stale-dating throughout the next twelve months. As of September 30, 2003, total revenues of $17.1 million were deferred, along with associated costs of $8.1 million. The net amount of $9.0 million is included on our condensed consolidated balance sheet as of September 30, 2003, under the caption “Deferred revenues from Sankyo Pharma net of deferred costs of product shipments.” This balance was $8.2 million as of December 31, 2002.

     If Sankyo Pharma had continued to perform under our Sales, Marketing and Distribution Agreement and related contracts, we would have been responsible for replacing any AutoSensors in Sankyo Pharma’s inventory that became stale-dated (had less than six months of shelf life remaining). Revenue recognition is not impacted by the replacement of stale-dated AutoSensors because revenues related to these AutoSensors will not yet have been recognized. The costs of product revenues, however, would ultimately have increased by the cost of the replacement AutoSensors. Based on Sankyo Pharma’s inventory and our estimates of Sankyo Pharma’s sales to its third-party customers, we accrued the estimated costs of replacing stale-dated AutoSensors during the second quarter of 2003. Such additional cost accruals amounted to $1.4 million, of which approximately $821,000 is included as a component of “Deferred revenues from Sankyo Pharma net of deferred costs of product shipments” and the remaining $554,000, the amount by which the original cost and replacement cost of the AutoSensors would have exceeded revenues, has been recorded as additional costs of product revenues because the total cost of the original

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AutoSensors and the estimated cost of the replacement AutoSensors were expected to exceed our sales price of these products to Sankyo Pharma. Due to the uncertainty of our litigation with Sankyo Pharma and Sankyo Japan, we have not accrued any additional costs associated with stale-dated AutoSensors for the three months ended September 30, 2003. Whether we will eventually need to replace any stale-dated AutoSensors depends upon the resolution of our dispute with Sankyo Pharma and Sankyo Japan.

     Our contract revenues may include up-front and/or interim milestone payments from co-promotion; sales, marketing and distribution; and development agreements. Milestone payments are recorded as revenue based on the provisions of the underlying agreement and the estimated period of continuing obligations, generally the contract term. No revenues are recognized for such milestones if there is any potential that these milestones may have to be repaid. All milestone payments received ($25.0 million) pursuant to our contractual arrangements with Sankyo have been deferred, since the milestone payments may need to be repaid if the agreement is terminated prior to April 2005 because (1) we cannot supply product for a specified period of time, or (2) our product is recalled or withdrawn from the market for a specified period of time, or (3) there is a change of control and our successor in interest terminated our agreement with Sankyo Pharma. Because these conditions could occur and the payments might need to be repaid at any time, we are required to report the deferred amounts as current deferred revenue until the potential for repayment expires in 2005. Consequently, if the contractual relationship had run its full term, the milestone amounts would have been recognized as revenue beginning in 2005 and continuing over the remaining term of the initial 12-year agreement with Sankyo Pharma; thus, in 2005, we would have expected to record the accumulated revenue of $7.8 million and thereafter would have recorded proportional amounts of the deferred revenue of approximately $521,000 per quarter over the remaining 9 years. In light of the litigation with Sankyo Pharma and Sankyo Japan, however, the timing of revenue recognition for the milestones may be subject to adjustment.

     Our contract revenues also include payments received pursuant to research grants. Revenues are recognized based on the performance requirements of the grant contract and as reimbursable expenses are incurred.

     We evaluate the collectability of our trade receivables based on our customers’ abilities to meet their financial obligations and generally do not require collateral. We determine amounts to be past due based on the terms and conditions set forth in the purchase agreements. At September 30, 2003, we have receivables from Sankyo Pharma of $5.2 million, which are past due and which Sankyo Pharma has refused to pay. For financial statement presentation purposes, at September 30, 2003, we have offset the receivables for prepayments due at the time of order ($5.1 million at September 30, 2003) against “Advances from Sankyo Pharma” in the current liability section of our condensed consolidated balance sheet.

Accounting for Impairment or Disposal of Long-Lived Assets

     We review equipment and improvements and other long-lived assets for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Recoverability is measured by comparison of carrying amount of the assets to future net cash flows that the assets are expected to generate. If such assets are considered to be impaired, the impairment is recognized and is measured as the amount by which the carrying amount of the assets exceeds the fair value of the assets, evaluated by considering the present value of future net cash flows. In light of the litigation with Sankyo Pharma and Sankyo Japan, the carrying amounts of these assets may be subject to future adjustments.

Net Loss Per Share

     Basic and diluted net loss per share are computed using the weighted average number of shares of common stock outstanding. Shares issuable from stock options, warrants and convertible debentures are excluded from the diluted loss per share computation, as their effect is anti-dilutive.

Recent Accounting Pronouncements

     In May 2003, the FASB issued Statement No. 150 (FAS 150), “Accounting for Certain Financial Instruments with Characteristics of Both Liabilities and Equity,” which will become effective for financial instruments entered into or modified after May 31, 2003. We do not expect the adoption of FAS 150 to have a material effect on our financial condition or results of operations.

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4.

Comprehensive Loss

     Unrealized gains or losses on investments for the three and nine months ended September 30, 2003 and 2002 were not material, and total comprehensive loss approximated net loss for each of these periods.

5.

Inventory

     Inventory is stated at standard cost adjusted to approximate the lower of actual cost (first-in, first out method) or market cost, after appropriate consideration has been given to obsolescence and inventory in excess of anticipated future demand.

     In light of our litigation with Sankyo Pharma and Sankyo Japan and our subsequent reduction in force, as well as Sankyo Pharma reporting to us that they are holding approximately a two-year supply of inventory of product and their instructions to stop shipments of any additional product to them, it is unlikely that we will continue to manufacture any product in the near future. We have determined that we will not be able to realize the value of our remaining raw materials and work-in-process inventories and have thereof written off approximately $4.9 million of this inventory that was not either subsequently shipped to Sankyo Pharma or converted to finished goods. The finished goods inventory amounts may be subject to future adjustments based on the results of our litigation. We will continue to evaluate the realizable value of our finished goods inventory.

     Inventory at September 30, 2003 consisted of the following (in thousands):

     Approximately $1.3 million of our finished goods inventory at September 30, 2003 was product in transit to Sankyo Pharma and an additional $236,000 of our September 30, 2003 raw materials inventory balance was converted to finished goods in early October 2003 and shipped to Sankyo Pharma.

     Additionally, in light of our litigation with Sankyo Pharma and their instructions to us to stop all product shipments and the likelihood that we will not continue to manufacture any product in the near future, we have written off $831,000 in prepaid component orders to one of our sole source component suppliers. This amount was included in “Other current assets” on our condensed consolidated balance sheet.

     Prior to the approval by the FDA of our products and our commercial processes, material was generally charged to research and development expenses upon receipt and was not carried as inventory in the financial statements. Accordingly, inventory values at September 30, 2003 and December 31, 2002 and the costs of product revenues for the three and nine months ended September 30, 2003 and 2002 do not include such previously expensed or written off obsolete material. Our costs of product revenues for the three months ended September 30, 2003 and 2002 would have been $130,000 and $834,000 higher, respectively, had we not utilized some of this previously expensed material in our production process. For the nine months ended September 30, 2003 and 2002, these costs would have been $379,000 and $1.2 million higher, respectively, for the same reason.

6.

Financing Instruments

Convertible Debentures

     Pursuant to the August 21, 2002 amendment to our Convertible Debentures, we paid $2.0 million in principal to the debenture holders on June 26, 2003, as the holders had not converted any shares of stock. As of September 30, 2003, the principal due to the debenture holders was $20.3 million. Under our amended Convertible Debentures, we are required to make a second $2.0 million payment on December 31, 2003. These payments result in the maturity dates of equal amounts of the remaining principal being extended for one year. Thus, the $2.0 million paid in June 2003 both reduced the amount of principal owed and extended the maturity date for $2.0 million from June 29, 2004 to June 29, 2005.

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     Additionally, we may, at our discretion, make additional prepayments with no penalty, and such prepayments will also extend the maturity dates of equal amounts of remaining principal. As of September 30, 2003, without prepayments, $14.4 million in principal is due June 29, 2004, $3.9 million in principal is due September 29, 2004, and $2.0 million in principal is due June 29, 2005 (resulting from the mandatory $2.0 million payment made in June 2003).

7.

Contractual Arrangements with Sankyo Pharma

     We are currently in litigation with Sankyo Pharma and Sankyo Japan relating to our contractual arrangements. On July 8, 2002, we had entered into a Sales, Marketing and Distribution Agreement with Sankyo Pharma that superseded and replaced our prior November 28, 2001 Co-Promotion Agreement with them. Under the new agreement, Sankyo Pharma was responsible for sales, marketing, managed care and government contracting, and distribution of our GlucoWatch G2 Biographer and our other similar glucose monitoring products for a period of 12 years beginning on April 1, 2002. Under our Sales, Marketing and Distribution Agreement, Sankyo Pharma was required to provide a specialty sales force of 100 people, to conduct a specified number and type of product details to physicians, and to utilize all of its large national primary care sales force during the term of the agreement. Under this new agreement, Sankyo Pharma was also required to pay us an additional $15.0 million in milestone payments, thus bringing total milestone payments, including milestone payments received under the November 2001 Co-Promotion Agreement, to $25.0 million, all of which has been received. In addition, on March 19, 2003 Sankyo Pharma committed to purchase a specific amount of product for the period June 2003 through March 2004.

     For its sales, marketing and distribution activities, Sankyo Pharma was entitled to a margin equivalent to a predetermined percentage of Sankyo Pharma’s net sales to its third-party customers. For Sankyo Pharma to receive its specified margin, the following calculations were made. First, Sankyo Pharma’s net sales were determined by subtracting certain allowed deductions such as rebates, discounts and fees, including TheraCom, Inc.’s costs for product dispensing and patient reimbursement services, from Sankyo Pharma’s gross sales. (TheraCom is a third party with whom Sankyo has contracted to provide product dispensing and patient reimbursement services for our products.) Next, the amount that Sankyo Pharma paid us for the products we shipped to them was subtracted from Sankyo Pharma’s net sales. The sales and marketing commission we owed to Sankyo Pharma was then calculated so that Sankyo Pharma received its specified margin. In periods when the allowed deductions were high relative to Sankyo Pharma’s sales to its third-party customers, the effect of Sankyo Pharma’s being entitled to receive this specified margin was that we might report no, or negative, net product revenues for that period. The predetermined percentage was 15% for net sales in the first year after our first-generation Biographer launch. Beginning April 1, 2003 and continuing for one year, this predetermined percentage increased to 30%. Thereafter, for the remainder of the initial 12-year term of our agreement, the predetermined percentage would have been 40%; however, commencing on January 1, 2007, if Sankyo Pharma’s net sales were to have exceeded $225.0 million in any given calendar year, then the predetermined percentage would have increased to 45% for one year following the given calendar year that sales exceeded this specified amount. Payment of a quarterly sales and marketing commission, which constitutes a portion of this predetermined percentage to which Sankyo Pharma was entitled, for the years 2002 through 2004 can be deferred until at least 2005 and, under certain circumstances, to 2008. As of September 30, 2003, total sales and marketing commissions of $2.3 million have been accrued, the payment of which has been deferred and is included on our condensed consolidated balance sheet under the caption “Long-term portion of amount due to Sankyo Pharma.” These amounts may be subject to adjustments in the future, depending upon the resolution on our litigation with Sankyo Pharma and Sankyo Japan.

     Furthermore, we are no longer obligated to spend promotional funds, as was required in our prior November 28, 2001 Co-Promotion Agreement; however, for 2002, we were required to reimburse Sankyo Pharma for their actual promotional expenses of $6.7 million, and we have a contractual right to defer the payment of such reimbursement to Sankyo Pharma until second quarter 2004. This amount was included in our results of operations for the year ended December 31, 2002. The $6.7 million, together with an amount we owe Sankyo Pharma for customer rebates, is included on our condensed consolidated balance sheet as of September 30, 2003, under the caption “Current portion of amount due to Sankyo Pharma.” These amounts may be subject to adjustments in the future, depending upon the resolution of our litigation with Sankyo Pharma and Sankyo Japan. If the deferral of our commissions and promotional funds had reached a certain specified dollar amount, Sankyo Pharma would have then had a first security interest in certain of our U.S. patents. Our commission deferral and our promotional funds did not reach that specified dollar amount as of September 30, 2003.

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     All assets and liabilities related to Sankyo Pharma as of September 30, 2003 that may be subject to future adjustments depending upon the resolution of our litigation with Sankyo Pharma and Sankyo Japan are as follows (in thousands):

8.

Preferred Share Purchase Rights Plan

     Our Stockholder Rights Plan (“Plan”) expired on September 21, 2003. Previously, pursuant to the Plan, the Board of Directors had declared a dividend distribution of one Preferred Share Purchase Right (“Right”) for each outstanding share of common stock, issuable on or after October 18, 1993, to stockholders of record on that date. All such Rights have expired.

9.

Arbitration Award Obligation

     On December 11, 1997, the International Court of Arbitration issued a Final Award, which was not appealable, in an arbitration matter between Sanofi, S.A., now Sanofi-Synthelabo, and Cygnus related to transdermal hormone replacement therapy systems. This Final Award against Cygnus of $37.0 million was entered as a judgment of the United States District Court for the Northern District of California. An initial payment of $14.0 million was made within 14 days of the Final Award and in 1997 we accrued an aggregate remaining liability of $23.0 million for the following obligations: (i) payments of an aggregate amount equal to $17.0 million as royalty payments for the period 2001 through 2005, payable 60 days after the end of each fiscal year ($2.0 million of which was paid in February 2002 for the year 2001, $3.0 million of which is to be paid for the year 2002, $4.0 million of which is to be paid for the year 2003, $4.0 million of which is to be paid for the year 2004 and $4.0 million of which is to be paid for the year 2005), and (ii) a convertible promissory note bearing interest at 6.5% per annum in the principal amount of $6.0 million, issued in December 1997, which was paid in full in cash with accrued annual interest of $390,000 in January 2002. The underlying agreement, which was the subject matter of the arbitration, was terminated on December 15, 1999. As of September 30, 2003, the aggregate amount payable under this obligation was $12.0 million, of which $4.0 million is included in our current obligations.

     Effective November 3, 2003, we entered into agreements with Sanofi-Synthelabo to extend by one year the periods of time for payment of the remaining arbitration obligations. Under the Amendment to the Final Arbitration Award, the accrued aggregate remaining liability of $12.0 million for the years 2003, 2004 and 2005 will be paid as follows, respectively: (i) $4.0 million is due February 2005, (ii) $4.0 million is due February 2006 and (iii) $4.0 million is due February 2007, and Sanofi-Synthelabo has the possibility of receiving accelerated payments in the event we receive a lump-sum cash payment from our dispute with Sankyo Pharma and Sankyo Japan. Specifically, in the event that we receive a lump-sum cash payment in an amount greater than or equal to $25.0 million but less than or equal to $50.0 million, then (i) $500,000 of such payment would be immediately payable to Sanofi-Synthelabo, (ii) $4.5 million would be due in February, 2005, (iii) $4.0 million would be due in February, 2005, (iii) $4.0 million would be due in February, 2006, and (iv) $3.0 million would be due in February 2007. If, however, we receive a lump-sum cash payment in an amount greater than $50.0 million but less than or equal to $75.0 million, then (i) $1.0 million of such payment would be immediately payable to Sanofi-Synthelabo, (ii) $5.0 million would be due in February, 2005, (iii) $4.0 million would be due in February, 2006, and (iv) $2.0 million would be due in February 2007. If we receive a lump-sum cash payment in an amount greater than $75.0 million but less than or equal to $125.0 million, then (i) $4.0 million of such payment would be immediately payable to Sanofi-Synthelabo, and (ii) $8.0 million would be due in February, 2005. Finally, if we receive a lump-sum cash payment in an amount of greater than $125.0 million, then $12.0, representing the entire payment due to Sanofi-Synthelabo, would be immediately payable. In the event that we receive a lump-sum payment from Sankyo Pharma and/or Sankyo Japan after February 2005, then we will pay a catch-up payment under whichever of the above-described situations has occurred. We also entered into a Security Agreement granting Sanofi-Synthelabo a subordinate security interest in all of our assets (other than U.S. Patents and patent applications then existing or thereafter arising) to secure our obligations under the Amendment to the Final Award.

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10.

Sale of Drug Delivery Business

     On December 15, 1999, we completed the sale of substantially all of our drug delivery business segment assets to Ortho-McNeil Pharmaceutical, Inc. (“Ortho-McNeil”), a Johnson & Johnson company. Under the terms of our agreement, Ortho-McNeil was subject to paying up to an additional $55.0 million in cash, contingent on the achievement of certain milestones. These potential milestone payments are dependent upon the achievement by Ortho-McNeil of certain technical and regulatory accomplishments and timely submissions of regulatory documents related to the Ortho Evra® (Johnson & Johnson, New Brunswick, New Jersey) transdermal contraceptive patch. The achievement of these milestones are not within our control. Of this $55.0 million, $22.5 million potential payments were not received because certain Ortho-McNeil accomplishments were not met, resulting in $32.5 million left in potential milestone payments. Of this amount, $30 million was dependent on Ortho-McNeil achieving certain accomplishments in 2002. In response to our multiple requests for information and documentation relating to the status of activities related to these milestone payments, Ortho-McNeil responded that they did not achieve the necessary accomplishments and that, in their opinion, they did not owe us $30.0 million. Both parties have retained outside legal counsel, and we are evaluating potential courses of action. The remaining $2.5 million in potential milestone payments may be payable to us through 2005.

11.

Warranties and Indemnification

     We offer a one-year warranty on our Biographer from the date of sale to the end-user customer. We accrue for estimated warranty costs and other allowances when the revenues from product sales are recognized. The warranty costs recorded to date have not been significant and are within historical estimates. We periodically assess the adequacy of our recorded warranty liability and adjust the amount as necessary.

     We enter into indemnification provisions under our agreements with other companies in the ordinary course of business, typically with business partners, suppliers, clinical sites, contractors, etc. Under these provisions, we generally indemnify and hold harmless the indemnified party for losses suffered or incurred by the indemnified party as a result of our activities and/or product liabilities. These indemnification provisions generally survive termination of the underlying agreements. In some cases, the maximum potential amount of future payments we could be required to make under these indemnification provisions are unlimited. The estimated fair value of the indemnity obligations of these agreements is minimal. Accordingly, we have no liabilities recorded for these agreements as of September 30, 2003, and we have not incurred material costs to defend lawsuits or settle claims related to these indemnification provisions.

12.

Subsequent Events

     On October 2, 2003, Sankyo Pharma informed us that they were stopping performance of their contractual obligations under our Sales, Marketing and Distribution Agreement and related contracts. On October 6, 2003, we filed a lawsuit against Sankyo Pharma and Sankyo Japan for breach of contract and intentional interference with contract relating to the sales, marketing and distribution of our GlucoWatch Biographer products. On October 9, 2003, we announced a reduction in force of approximately 60% of our work force as a result of Sankyo Pharma’s decision to stop performing under its contracts with us. (See Note 2. “Current Litigation with Sankyo Pharma Inc. and Sankyo Co., Ltd.”)

     On October 15, 2003, we terminated our second building lease that would have run through December 2003, which we had previously subleased to Maxygen, Inc. We received full payment from Maxygen, Inc. for this early termination, and in turn paid the remaining lease amount to the property owner. This early termination was unrelated to our litigation with Sankyo Pharma and Sankyo Japan.

     Effective November 3, 2003, we entered into agreements with Sanofi-Synthelabo to extend by one year the periods of time for payment of the remaining arbitration obligations with certain accelerations if we receive a lump-sum cash payment from Sankyo Pharma and/or Sankyo Japan and to grant Sanofi-Synthelabo a subordinate security interest in all of our assets (other than U.S. Patents and patent applications then existing or thereafter arising) to secure our obligations. (See Note 9. “Arbitration Award Obligation.”)

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Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations.

     Some of the statements in this report, including in the documents incorporated by reference, are forward-looking statements that involve risks and uncertainties. These forward-looking statements include statements about our plans, objectives, expectations, intentions and assumptions and other statements contained in this report, including in the documents incorporated by reference, that are not statements of historical fact. Forward-looking statements include, but are not limited to, statements about our allegations and expectations regarding our contracts with Sankyo Pharma Inc.; the decision by Sankyo Pharma to stop performing under its contracts with us and the interference of such contracts by Sankyo Co., Ltd., the Japanese parent company; the capabilities and potential of the GlucoWatch Biographer business; our ability to manufacture and commercially scale up the GlucoWatch Biographer; our plans for commercialization alliances; our ability to achieve market acceptance of the GlucoWatch Biographer; and the speed and potential results of the regulatory process. In some cases, you can identify these statements by words such as “may,” “will,” “should,” “estimates,” “predicts,” “potential,” “continues,” “strategy,” “believes,” “anticipates,” “plans,” “expects,” “intends” and similar expressions. We cannot guarantee future results, levels of activity, performance or achievements. Our actual results and the timing of certain events may differ significantly from the results and timing discussed in this report, including those under “Risk Factors” herein, as well as in the documents incorporated by reference.

General

     We develop, manufacture and commercialize new and improved glucose monitoring devices. Our products are designed to provide more data to individuals and their physicians and enable them to make better-informed decisions on how to manage diabetes. We began the U.S. market launch of our first-generation GlucoWatch® Biographer on April 15, 2002. On March 21, 2002, the U.S. Food and Drug Administration (FDA) approved our second generation product, the GlucoWatch® G2™ Biographer. On August 28, 2002, we received approval from the FDA of our supplemental pre-market approval (PMA) application for use of the GlucoWatch G2 Biographer by children and adolescents (ages 7 to 17).

     We launched the GlucoWatch G2 Biographer in the United States on September 16, 2002 under our Sales, Marketing and Distribution Agreement with Sankyo Pharma Inc. (“Sankyo Pharma”), a wholly owned U.S. subsidiary of Sankyo Co., Ltd. (“Sankyo Japan”), a Japanese pharmaceutical and medical products company. Sankyo Pharma contracted with TheraCom, Inc., a subsidiary of AdvancePCS, to provide product dispensing and patient reimbursement services for our products.

     On October 2, 2003, Sankyo Pharma informed us that they were stopping performance of their contractual obligations under our Sales, Marketing and Distribution Agreement and related contracts. On October 6, 2003, we filed a lawsuit against Sankyo Pharma and Sankyo Japan for breach of contract and intentional interference with contract relating to the sales, marketing and distribution of our GlucoWatch Biographer products. On October 9, 2003, we announced a reduction in force of approximately 60% of our work force as a result of Sankyo Pharma’s decision to stop performing under its contracts with us.

     The GlucoWatch Biographer and GlucoWatch G2 Biographer are the only products approved by the FDA that provide frequent, automatic and non-invasive measurement of glucose levels. We believe our products represent the most significant commercial technological advancement in self-monitoring of glucose levels since the advent, approximately 20 years ago, of finger-stick blood glucose measurement. Our GlucoWatch Biographer systems consist of two components: a durable component known as the Biographer and a consumable component known as the AutoSensor. The GlucoWatch Biographers use a low electrical current to extract glucose molecules through the skin, using patented sampling processes. The glucose is extracted from interstitial fluid, which surrounds cells, rather than from blood, eliminating the need for multiple finger pricks to provide frequent glucose readings. The Biographers can be worn on the forearm like a watch and function like a computer, analyzing and responding to data received from the AutoSensors. The AutoSensors use proprietary biosensor technology and snap into the back of the Biographers. The AutoSensors are calibrated with a standard blood glucose measurement after a warm-up period and then frequently, automatically and non-invasively extract and measure glucose for their duration period before requiring replacement.

     Current methods for measuring glucose, in which skin is lanced and a blood sample is obtained for measurement, are painful and inconvenient to the user. Because of this, the vast majority of people with diabetes do

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not perform the frequent glucose testing that is necessary to provide adequate information to manage diabetes, despite substantial clinical evidence of the benefits of more intensive diabetes management. We believe there is an unmet medical need for a device that can provide and track frequent glucose readings automatically and non-invasively. Our GlucoWatch Biographers enable people with diabetes and their physicians to identify trends and track patterns in fluctuating glucose levels that would be difficult to detect with current testing techniques alone. Although our GlucoWatch Biographers are not intended to replace existing painful and inconvenient testing methods and, in the United Sates, are classified as adjunctive devices, we believe the GlucoWatch Biographers will lead to better-informed decisions regarding the way individuals manage their diabetes. Users must first calibrate the GlucoWatch Biographers with a blood glucose measurement and must make major decisions, such as insulin dosing, based on blood glucose measurements, but they are able to identify trends and track patterns by monitoring glucose levels on a more frequent and automatic basis than would be the case if they could only use existing finger stick or other blood glucose measurement devices.

Major Developments Since September 30, 2003

     On October 2, 2003, Sankyo Pharma stated that they were stopping performance of their contractual obligations under our Sales, Marketing and Distribution Agreement and related contracts. In addition, Sankyo Pharma acknowledged that they had not paid invoices owed to us and informed us that they had no intention of remitting payment for such amounts. As of October 10, 2003, these invoices total over $6.0 million. Sankyo Pharma stated that they were relying on California Commercial Code, Section 2609(1) as a purported legal basis for ceasing performance of their contractual obligations. Section 2609(1) generally gives parties the right to demand adequate assurance of due performance by the counterparty of their contractual obligations if reasonable grounds of insecurity arise with respect to performance by the counterparty. Sankyo Pharma has stated that they had grounds for insecurity regarding our financial position and our ability to perform under the Sales, Marketing and Distribution Agreement and related contracts we have with Sankyo Pharma.

     On October 6, 2003, we filed a complaint in the Superior Court of the State of California for the County of San Mateo against Sankyo Pharma and Sankyo Japan for breach of contract and intentional interference with contract relating to the sales, marketing and distribution of our GlucoWatch Biographer products. During the initial 12-year term of our Sales, Marketing and Distribution Agreement with Sankyo Pharma, there are no termination rights except in very specific circumstances, none of which, we believe, has occurred. We are seeking substantial compensatory damages and other relief. The litigation in which we are currently involved may affect, among other things, our ability to sell, market and distribute our products in the United States, our financing activities, and the retention of our remaining personnel. We cannot predict with certainty the eventual outcome of the pending litigation, which may result in a significant adverse jury verdict or punitive damages award, or a judgment that certain of our allegations are invalid or unenforceable. This kind of litigation could be very costly and will divert our management’s attention and resources, and any adverse determination in this litigation, or delay in resolving this litigation, may cause us to cease our operations and/or seek protection under the bankruptcy laws.

     On October 9, 2003, we announced a reduction in force of approximately 60% of our work force as a result of Sankyo Pharma’s decision to stop performing under its contracts with us. We have suspended our manufacturing activities and research and development efforts for future products. We are not likely to continue to manufacture current products or develop new products in the near future. According to Sankyo Pharma, however, they are currently warehousing inventory approximating two years’ sales of our products, and these products remain available for sale in the United States.

     On October 15, 2003, we terminated our second building lease that would have run through December 2003, which we had previously subleased to Maxygen, Inc. We received full payment from Maxygen, Inc. for this early termination, and in turn paid the remaining lease amount to the property owner. This early termination was unrelated to our litigation with Sankyo Pharma and Sankyo Japan.

     On October 16, 2003, we responded to Sankyo Pharma’s request for assurances under California Commercial Code, Section 2609(1). Sankyo Pharma had notified us, as well as certain health care professionals, that they will continue to provide marketing, sales, and distribution support for our GlucoWatch G2 Biographer; however, given their decision to stop performing under their contracts with us and our litigation, the commercial status of our products in the United States is unclear. We have begun looking at alternative sales, marketing and distribution approaches for our products.

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     On October 31, 2003, we completed our PMA supplement submission to the FDA for our third-generation product. This improved Biographer and AutoSensor system reduces the number of skipped glucose measurements while maintaining the accuracy of the glucose data reported to the user and also increases the percentage of successful calibrations after the two-hour warm-up period. We expect that this system will receive FDA approval in first quarter 2004, although there can be no assurances that this approval will occur in this time frame, it at all. Additionally, the FDA is currently reviewing our PMA supplement for pre-treatment with certain topical corticosteroids that show a reduction in skin irritation while maintaining the accuracy of our products. We cannot predict when this supplement will be approved, if at all.

     Effective November 3, 2003, we entered into agreements with Sanofi-Synthelabo to extend by one year the periods of time for payment of the remaining arbitration obligations pursuant to the Final Award issued against Cygnus by the International Court of Arbitration in December 1997 relating to royalties for transdermal hormone replacement therapy systems. Under the Amendment to the Final Arbitration Award, the accrued aggregate remaining liability of $12.0 million for the years 2003, 2004 and 2005 will be paid as follows, respectively: (i) $4.0 million is due February 2005, (ii) $4.0 million is due February 2006 and (iii) $4.0 million is due February 2007, and Sanofi-Synthelabo has the possibility of receiving accelerated payments in the event we receive a lump-sum cash payment from our dispute with Sankyo Pharma and Sankyo Japan. We also entered into a Security Agreement granting Sanofi-Synthelabo a subordinate security interest in all of our assets (other than U.S. Patents and patent applications then existing or thereafter arising) to secure our obligations under the Amendment to the Final Award.

     On November 6, 2003, Sankyo Pharma filed an answer and cross-claims against us for declaratory relief, breach of contract, and defamation. We have not yet filed a response to these claims. We believe that we have meritorious defenses to the causes of action asserted against us by Sankyo Pharma, and we intend to vigorously defend ourselves against these claims. This litigation is in its early stages, however, and is therefore inherently difficult to assess.

     We have incurred substantial operating losses and negative cash flows from operations since our inception, and we have used cash from equity and debt to supplement our operating cash flow requirements. As of September 30, 2003, we had cash, cash equivalents, and investments of $9.1 million. We expect to incur additional losses from operations in the foreseeable future.

     With Sankyo Pharma’s decision to stop performing under our Sales, Marketing and Distribution Agreement and related contracts, and their refusal both to pay receivables in excess of $6.0 million and to honor the balance of their binding purchase commitment to pay us $28.4 million in cash between October 1, 2003 and March 31, 2004, we will need to conserve cash and find ways to generate additional cash to finance our operations. Our ability to continue as a going concern is dependent on our ability to generate sufficient cash flow to fund our operations and meet our debt and other obligations on a timely basis. Our plans both to conserve and generate cash include further reduction of our expenses and raising additional capital. There is no certainty, however, that we will be able to undertake such measures or that additional funds will be available to us. In addition, we do not believe we will be able to generate additional cash from product sales in any significant amounts in the near term since Sankyo has been, as a practical matter, our only distribution channel. We are currently pursuing various strategic options, including but not limited to pursuing a new partnership and/or selling some or all of our assets and intellectual property. If substantial additional resources are not available, we may need to cease our operations and/or seek protection under the bankruptcy laws. These conditions raise substantial doubt about our ability to continue as a going concern after March 31, 2004.

Critical Accounting Policies

     The preparation of our financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the amounts reported in our financial statements and accompanying notes. Actual results could differ materially from those estimates. Although there are numerous policies associated with the preparation of our financial statements, the following policies are currently considered critical because of the level of management’s estimates and judgments required.

Revenue Recognition

     Product revenues are generated upon the sale of our GlucoWatch Biographer and GlucoWatch G2 Biographers and related accessories in the United States and the United Kingdom. The GlucoWatch Biographer systems consist of two integrated parts: the durable Biographer and the disposable, single-use AutoSensor. After the

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initial sales of the Biographers, revenues will continue to be recorded upon the sale of additional AutoSensors and accessories to support the installed base of Biographers.

     Product sales are recorded when all of the following conditions have been met: product has been shipped, transfer of title has taken place, there is persuasive evidence of an arrangement, the price is fixed or determinable, and collection is reasonably assured. Revenues generated from our shipments of sample and practice Biographers are recognized when all the above conditions are met, typically upon delivery of these products to Sankyo Pharma, as the sales of such products are not subject to future pricing adjustments. With regard to product sales that were made directly by us to third parties, from time to time we allowed customers to return product for credit. In such instances, we deferred revenue until the return period expired. We accrue for estimated warranty costs and other allowances when the revenues from product sales are recognized. The warranty expenses recorded to date have not been significant and are within historical estimates. Revenues in the United States generated from our shipments of product to Sankyo Pharma for resale under our Sales, Marketing and Distribution Agreement were deferred until the product was sold by Sankyo Pharma to its third-party customers, because the net price of our product sales to Sankyo Pharma was subject to certain pricing adjustments, such as rebates, discounts and certain fees offered or paid by Sankyo Pharma to its third-party customers.

     Our contract revenues may include up-front and/or interim milestone payments from co-promotion; sales, marketing and distribution; and development agreements. Milestone payments are recorded as revenue based on the provisions of the underlying agreement and the estimated period of continuing obligations, generally the contract term. If Sankyo Pharma had continued to perform under our Sales, Marketing and Distribution Agreement and related contracts, the $25.0 million in milestones already received under the Co-Promotion Agreement and the Sales, Marketing and Distribution Agreement was to be recognized as revenue over the initial 12-year term of our contractual relationship (from April 1, 2002 until April 1, 2014), with no recognition of revenue until April 1, 2005, since the milestone payments might have needed to be repaid before then if the agreement was terminated because (1) we could not supply product for a specified period of time, or (2) our product was recalled or withdrawn from the market for a specified period of time, or (3) there was a change of control and our successor in interest terminated our agreement with Sankyo Pharma. Consequently, if the agreement had run its full initial term of 12 years, the milestone amounts would have been recognized as revenue beginning April 1, 2005 and continuing over the remaining 12 years. In light of the litigation with Sankyo Pharma and Sankyo Japan, the timing of revenue recognition for the milestones may be subject to adjustment.

     Our contract revenues also include payments received pursuant to research grants. Revenues are recognized based on the performance requirements of the grant contract and as reimbursable expenses are incurred.

Inventory Valuation

     Inventory is stated at standard cost adjusted to approximate the lower of actual cost (first-in, first-out method) or market, after appropriate consideration is given to obsolescence and inventory in excess of anticipated future demand. However, due to the early stage of our product commercialization activities, the estimates required in inventory valuation, including production yields and normal capacity, labor costs incurred in the production of each unit and overhead costs applicable to manufacturing operations, are inherently uncertain. Thus, actual results may differ from those estimates. Also, the valuation of our inventory, as well as reserves for replacement costs for stale-dated AutoSensors held by Sankyo Pharma, depends significantly upon estimates related to our litigation with Sankyo Pharma and Sankyo Japan, and these estimates may substantially change over the course of the litigation.

     Prior to the approval by the FDA of our product and our commercial processes, material was generally charged to research and development expenses upon receipt and was not carried as inventory in the financial statements. Accordingly, at and for the nine months ended September 30, 2003, inventory values and the costs of product revenues do not include previously expensed material.

Impairment of Long-Lived Assets

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     We review equipment and improvements and other long-lived assets for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Recoverability is measured by comparison of carrying amount of the assets to future net cash flows that the assets are expected to generate. If such assets are considered to be impaired, the impairment is recognized and is measured as the amount by which the carrying amount of the assets exceeds the fair value of the assets, evaluated by considering the present value of future net cash flows. In light of our litigation with Sankyo Pharma and Sankyo Japan, the amount of these assets may be subject to future adjustments.

Results of Operations

     Our results of operations have fluctuated from period to period and are expected to continue to fluctuate in the future based upon the progress and ultimate outcome of our litigation with Sankyo Pharma and Sankyo Japan, the demand for our products, product revenues and our costs of product revenues, as well as the level of our expenses during any given period. Historical results should not be viewed as indicative of future operating results. We are also subject to risks common to companies in our industry and at our stage of development, including risks inherent in our litigation with Sankyo Pharma and Sankyo Japan and our need to find alternative approaches for the sales, marketing and distribution of our products in the United States; enforcement of our patents and proprietary rights; need for future capital, particularly in light of our stock currently being listed on the OTC Bulletin Board; potential competition; and uncertainty of future regulatory approvals. We have experienced operating losses since our inception, and we expect to continue to incur operating losses at least until we have significant product sales, if we ever do. We had a net loss of $21.7 million for the nine months ended September 30, 2003. At September 30, 2003, our accumulated deficit and our stockholders’ net capital deficiency were $318.4 million and $64.3 million, respectively.

Comparison for the Three Months and Nine Months Ended September 30, 2003 and 2002

     Net product revenues for the three months ended September 30, 2003 were $1.0 million, compared to $1.5 million for the three months ended September 30, 2002. Net product revenues for the nine months ended September 30, 2003 were $1.8 million, compared to $1.8 million for the nine months ended September 30, 2002. Net product revenues recognized for the three months and nine months ended September 30, 2003 resulted from sales by Sankyo Pharma to its third-party customers of our GlucoWatch Biographers in the United States, which had been deferred in previous periods in accordance with our revenue recognition policy, as well as from our sales to Sankyo Pharma of practice and sample Biographers. Net product revenues for the three months ended September 30, 2002 and nine months ended September 30, 2002 resulted from our initial sales of the GlucoWatch Biographer in the United States and the United Kingdom. Although the revenues recognized for the nine months ended September 30, 2003 and 2002 were similar, revenues for a greater number of AutoSensors were recognized for the nine months ended September 30, 2003. Most of the product revenues in 2003 related to sales by Sankyo Pharma recognized net of sales and marketing commissions, however, most of the AutoSensor sales recognized for the nine months ended September 30, 2002 were for direct sales by us to end-user customers. Our recognized revenue was significantly reduced by sales and marketing commissions we owed to Sankyo for their increased responsibilities in 2003. Deferred sales and marketing commissions for the nine months ended September 30, 2003 were $1.8 million, compared to $167,000 for the nine months ended September 30, 2002.

     Unit shipments of the GlucoWatch Biographers for the three and nine months ended September 30, 2003 were 2,346 and 7,558, respectively. For the three months ended September 30, 2003, substantially all of the Biographers were sample Biographers sold to Sankyo Pharma. During the three and nine months ended September 30, 2003, we shipped approximately 413,000 AutoSensors and 891,000 AutoSensors, respectively, substantially all of which were shipped to Sankyo Pharma. The total invoice amount of our Biographer, AutoSensor and accessory shipments for the three and nine months ended September 30, 2003 was $2.9 million and $7.6 million, respectively. In accordance with our revenue recognition policy, however, for the three and nine months ended September 30, 2003, we have deferred product revenues related to product shipments of approximately $2.2 million and $6.5 million, respectively. The amount of deferred product revenues recognized as revenues is subject to further adjustments for commissions owed to Sankyo Pharma and other pricing adjustments.

     Contract revenues for the three months ended September 30, 2003 were $65,000, compared to $104,000 for the three months ended September 30, 2002. Contract revenues for the nine months ended September 30, 2003 were $217,000, compared to $352,000 for the nine months ended September 30, 2002. Contract revenues for the three months ended September 30, 2003 and 2002 were related to our National Institutes of Health (NIH) Small

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Business Innovative Research (SBIR) Phase I & II grant. Revenues related to our NIH grant are recognized as research activities are performed. The decrease is due to the amount set forth in the grant for each period of time.

     Costs of product revenues for the three months ended September 30, 2003 were $7.5 million, compared to $1.3 million for the three months ended September 30, 2002. Costs of product revenues for the nine months ended September 30, 2003 were $12.6 million, compared to $3.6 million for the nine months ended September 30, 2002. Costs of product revenues for the three months ended September 30, 2003 consisted of material, underabsorbed indirect overhead (including an $831,000 write-off of prepaid component orders to one of our sole source component suppliers) and other production costs associated with the manufacturing of our products and a write-off of approximately $4.9 million of inventory resulting from Sankyo Pharma’s decision to stop performing under our Sales, Marketing and Distribution Agreement and related contracts as well as their instructions to stop product shipment to them. Costs of product revenues were also higher for the three and nine months ended September 30, 2003 because costs were recognized on a greater number of AutoSensors compared to the equivalent periods of 2002.

     The consumable components of our device, the AutoSensors, currently have shelf lives of 18 and 24 months, depending upon when a lot was produced. Under the terms of our agreement with Sankyo Pharma, if requested, we were required to replace AutoSensors that they have not sold and that become stale-dated (have less than six months of shelf life remaining). Based on Sankyo Pharma’s inventory and our estimates of Sankyo Pharma’s sales to its third-party customers, we have accrued estimated costs of replacing stale-dated AutoSensors in the second quarter of 2003. Such additional cost accruals amounted to $1.4 million, of which approximately $821,000 is included as a component of “Deferred revenues from Sankyo Pharma net of deferred costs of product shipments” and the remaining $554,000, the amount by which the original cost and replacement cost of the AutoSensors would exceed revenues, has been recorded as additional costs of product revenues because the total cost of the original AutoSensors and the estimated cost of the replacement AutoSensors were expected to exceed our sales price of these products to Sankyo Pharma. These additional costs have been included in costs of product revenues for the nine months ended September 30, 2003. Whether we will need to replace any stale-dated AutoSensors depends upon the resolution of our dispute with Sankyo Pharma and Sankyo Japan.

     Under normal commercial circumstances, we would expect our product margin to vary from period to period due to the mix of products sold, i.e., Biographers, AutoSensors and accessories, and demand fluctuations in the utilization of our manufacturing facilities.

     For the three months ended September 30, 2003, we deferred costs of product revenues of approximately $1.2 million related to product shipped during this period, and these costs appear as a component of “Deferred revenues from Sankyo Pharma net of deferred costs of product shipments” in the liability section of our condensed consolidated balance sheet. For the nine months ended September 30, 2003, we deferred costs of product revenues of approximately $4.2 million related to deferred product revenues shipped and of approximately $821,000 related to our estimate for stale-dated AutoSensor replacement. Costs of product revenues did not include certain material and other product costs previously written off as research and development or obsolete expenses. If we were to have included material and other product costs previously written off that were later used in the manufacture of our product, our costs of product revenues at current production levels would have been $130,000 greater than the reported amounts for the three months ended September 30, 2003 and $834,000 greater than the reported amounts for the three months ended September 30, 2002. For the nine months ended September 30, 2003 and 2002, these costs would have been $379,000 and $1.2 million higher, respectively. Manufacturing costs included in the cost of each unit are greater at low unit volumes, such as have occurred during initial commercialization in the United States. Any future adjustments of “Deferred revenues from Sankyo Pharma net of deferred costs of product shipments” reflected on our condensed consolidated balance sheet at September 30, 2003 will depend upon the resolution of our dispute with Sankyo Pharma and Sankyo Japan.

     As of September 30, 2003, total revenues of $17.1 million were deferred, along with associated costs of $8.1 million. The net amount of $9.0 million is included on our condensed consolidated balance sheet as of September 30, 2003, under the caption “Deferred revenues from Sankyo Pharma net of deferred costs of product shipments.” This balance was $8.2 million as of December 31, 2002.

     Research and development expenses for the three months ended September 30, 2003 were $860,000, compared to $4.5 million for the three months ended September 30, 2002. Research and development expenses for the nine months ended September 30, 2003 were $4.1 million, compared to $12.1 million for the nine months ended September 30, 2002. Research and development expenses have decreased as our focus on our commercialization

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efforts has increased, allowing us to spend less on material costs related to manufacturing scale-up and process development. In addition, we reversed our bonus accrual for 2003, which had been $358,000 at June 30, 2003. No bonuses are expected to be paid for 2003. We expect a reduction in research and development expenses in the future, given the recent reduction in force due to Sankyo Pharma’s decision to stop performing under our Sales, Marketing and Distribution Agreement and related contracts.

     Sales, marketing, general and administrative expenses for the three months ended September 30, 2003 were $1.3 million, compared to $5.2 million for the three months ended September 30, 2002. Sales, marketing, general and administrative expenses for the nine months ended September 30, 2003 were $5.4 million, compared to $14.3 million for the nine months ended September 30, 2002. This decrease was primarily due to the assumption by Sankyo Pharma of product promotion, education, and training programs for health care professionals and patients, as required under our agreement. In addition, we reversed our bonus accrual for 2003, which had been $340,000 at June 30, 2003. No bonuses are expected to be paid for 2003. Given our litigation with Sankyo Pharma and Sankyo Japan, we expect an increase in our legal expenses in the future; however, our overall sales, marketing, general and administrative expenses are expected to decrease, given the recent reduction in force and other cost-cutting measures.

     Interest and other income (expense), net for the three months ended September 30, 2003 was $25,000, compared to $68,000 for the three months ended September 30, 2002. Interest and other income (expense), net for the nine months ended September 30, 2003 was $103,000, compared to $183,000 for the nine months ended September 30, 2002. This decrease was primarily due to the lower yields on a lower average balance invested.

     Interest expense for the three months ended September 30, 2003 was $516,000, compared to $850,000 for the three months ended September 30, 2002. Interest expense for the nine months ended September 30, 2003 was $1.6 million, compared to $2.5 million for the nine months ended September 30, 2002. Included in interest expense for the nine months ended September 30, 2003 and 2002 were the interest accrued on our convertible debentures and the amortization of the value of the warrants issued in connection with our financing agreements. The decrease is primarily attributable to the reduction of the interest rates on our convertible debentures from 8.5% to 3.5%, effective October 1, 2002, based on our August 21, 2002 amendment to the Convertible Debenture and Warrant Purchase Agreement.

     Provision for income taxes related to U.K. taxes on income in the three and nine months ended September 30, 2003 and 2002 was not material.

Liquidity and Capital Resources

     As of September 30, 2003, our cash, cash equivalents and investments totaled $9.1 million.

     Net cash used in operating activities for the nine months ended September 30, 2003 was $15.4 million, compared to net cash used of $13.7 million for the nine months ended September 30, 2002. Cash used in operating activities during the nine months ended September 30, 2003 was primarily due to the net loss from operations of $21.7 million and our Sanofi-Synthelabo arbitration payments totaling $3.0 million, partially offset by non-cash charges of $2.6 million of depreciation and amortization of fixed assets and financing costs, and the write-off of $6.0 million of inventory and prepaid materials in 2003. Cash used in operating activities during the nine months ended September 30, 2002 was primarily due to the net loss from operations of $30.3 million and our Sanofi-Synthelabo arbitration payments totaling $8.4 million, partially offset by an increase in deferred revenue of $20.0 million and deferred margin on shipments of $2.8 million.

     Net cash provided by investing activities of $2.3 million for the nine months ended September 30, 2003 resulted primarily from the net sales and maturities of investments of $2.4 million, offset by capital expenditures of $108,000. Net cash provided by investing activities of $3.1 million for the nine months ended September 30, 2002 resulted primarily from the net sales and maturities of investments of $3.7 million offset, by capital expenditures of $563,000.

     Net cash used in financing activities totaled $2.1 million for the nine months ended September 30, 2003 and reflected the payment to our Convertible Debenture holders of $2.0 million. Net cash provided by financing activities totaled $15.7 million for the nine months ended September 30, 2002 and related primarily to net proceeds of $14.7 million from our 2002 public stock offering.

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     The level of cash used in operating activities during previous periods is not necessarily indicative of the level of future cash usage. Our long-term cash and capital expenditure requirements will depend upon numerous factors, including but not limited to (i) costs and results of our litigation with Sankyo Pharma and Sankyo Japan, (ii) costs associated with seeking and obtaining alternative approaches for the sales, marketing and distribution of our products in the United States, (iii) the amount of prepayments, if any, to our Convertible Debenture holders, (iv) the time required to obtain regulatory approvals, (v) additional expenditures to support the manufacture of new products, if and when approved, (vi) the progress of our research and development programs, if any, and (vii) possible expansion into new markets and acquisitions of products and technologies.

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     As of September 30, 2003, our contractual obligations are as follows:

(In thousands)

     We have incurred substantial operating losses and negative cash flows from operations since our inception, and we have used cash from equity and debt to supplement our operating cash flow requirements. As of September 30, 2003, we had cash, cash equivalents, and investments of $9.1 million. We expect to incur additional losses from operations in the foreseeable future.

     With Sankyo Pharma’s decision to stop performing under our Sales, Marketing and Distribution Agreement and related contracts, and their refusal both to pay receivables in excess of $6.0 million and to honor the balance of their binding purchase commitment to pay us $28.4 million in cash between October 1, 2003 and March 31, 2004, we will need to conserve cash and find ways to generate additional cash to finance our operations. Our ability to continue as a going concern is dependent on our ability to generate sufficient cash flow to fund our operations and meet our debt and other obligations on a timely basis. Our plans both to conserve and generate cash include further reduction of our expenses and raising additional capital. There is no certainty, however, that we will be able to undertake such measures or that additional funds will be available to us. In addition, we do not believe we will be able to generate additional cash from product sales in any significant amounts in the near term since Sankyo has been, as a practical matter, our only distribution channel. We are currently pursuing various strategic options, including but not limited to pursuing a new partnership and/or selling some or all of our assets and intellectual

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property. If substantial additional resources are not available, we may need to cease our operations and/or seek protection under the bankruptcy laws. These conditions raise substantial doubt about our ability to continue as a going concern after March 31, 2004.

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RISK FACTORS

     In determining whether to invest in our common stock, you should carefully consider the information below in addition to all other information provided to you in this report, including the information incorporated by reference in this report. The statements under this caption are intended to serve as cautionary statements within the meaning of the Private Securities Litigation Reform Act of 1995. The following information is not intended to limit in any way the characterization of other statements or information under other captions as cautionary statements for such purpose.

Risks Related to Our Business

     We were dependent on Sankyo Pharma to sell, market and distribute our products in the United States. In light of Sankyo Pharma’s decision to stop performing under our Sales, Marketing and Distribution Agreement and related contracts, our business has been materially adversely affected and we may not be able to continue our operations.

     Under our July 8, 2002 Sales, Marketing and Distribution Agreement with Sankyo Pharma, we were totally dependent upon Sankyo Pharma for the sales, marketing and distribution of our products in the United States. On October 2, 2003, Sankyo Pharma informed us of their decision to stop performing under the Sales, Marketing and Distribution Agreement and related contracts. Their unilateral decision has materially adversely affected our business. Furthermore, Sankyo Pharma’s refusal both to pay receivables in excess of $6.0 million and to honor the balance of their binding purchase commitment to pay us $28.4 million in cash between October 1, 2003 and March 31, 2004 has caused material financial and commercial harm to our business. We entered into our contracts with Sankyo Pharma rather than develop and/or expand such capabilities in-house. Because Sankyo Pharma has decided to stop performing under their contracts with us, we are currently unable to successfully commercialize our products in the United States. Furthermore, we may experience delays in commercialization due to the necessity of seeking an alternative third party or parties to perform the functions previously handled by Sankyo Pharma or we may need to develop these capabilities ourselves at considerable expense. Developing such capabilities ourselves is not possible in the near term, in light of our recent 60% reduction in work force and our need to conserve cash as a result of Sankyo Pharma’s decision to stop performing under its contracts with us.

     Under our current situation, we must conserve and generate cash to finance our operations. Our ability to continue as a going concern is dependent on our ability to generate sufficient cash flow to fund our operations and meet our debt and other obligations on a timely basis. Our plans both to conserve and generate cash include further reduction of our expenses and raising additional capital. There is no certainty, however, that we will be able to undertake such measures or that additional funds will be available to us. In addition, we do not believe we will be able to generate additional cash from product sales in any significant amounts in the near term since Sankyo has been, as a practical matter, our only distribution channel. We are currently pursuing various strategic options, including but not limited to pursuing a new partnership and/or selling some or all of our assets and intellectual property. If substantial additional resources are not available, we may need to cease our operations and/or seek protection under the bankruptcy laws. These conditions raise substantial doubt about our ability to continue as a going concern after March 31, 2004.

     We continue to evaluate alternative means of financing to meet our needs on terms that are acceptable to us. However, we may be unable to obtain necessary financing on favorable terms or at all. For example, we may need to enter into financing arrangements or modify our existing payment obligations that may include sales of our common stock at significant discounts to the market price. To obtain such funding or modifications, we may need to relinquish rights to our remaining assets. In addition, we have discussed the possibility of reducing the minimum conversion price in effect for our Convertible Debentures, which would cause significant dilution to our existing stockholders, although neither we nor the Debenture holders have committed to any such amendment or conversion to date.

     The outcome of, and costs relating to, our litigation with Sankyo Pharma and Sankyo Japan are uncertain.

     On October 6, 2003, we filed a complaint in the Superior Court of the State of California for the County of San Mateo against Sankyo Pharma and Sankyo Japan for breach of contract and intentional interference with contract relating to the sales, marketing and distribution of our GlucoWatch Biographer products. On November 6,

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2003, Sankyo Pharma filed an answer and cross-claims against us for declaratory relief, breach of contract, and defamation. We have not yet filed a response to these claims. We believe that we have meritorious defenses to the causes of action asserted against us by Sankyo Pharma, and we intend to vigorously defend ourselves against these claims. This litigation is in its early stages, however, and is therefore inherently difficult to assess. The litigation in which we are currently involved and the reduction in force may affect, among other things, our ability to sell, market and distribute our products in the United States, our financing activities, the retention of personnel and our ability to continue as a going concern. We cannot predict with certainty the eventual outcome of pending litigation, which may result in a significant adverse jury verdict or punitive damages award, or a judgment that certain of our allegations are invalid or unenforceable. Furthermore, this kind of litigation could be very costly and divert our management’s attention and resources, and any adverse determination in this litigation, or delay in resolving this litigation, may cause us to cease our operations and/or seek protection under the bankruptcy laws.

     We have recently experienced a significant reduction in our workforce, which has had a material impact on our ability to manufacture our products and conduct research and development on future products.

     On October 9, 2003, we announced a reduction in force of approximately 60% of our workforce as a result of Sankyo Pharma’s decision to stop performing under their contracts with us. Because of the magnitude of the workforce reductions, these layoffs have had a material adverse impact on our ability to manufacture our products and our ability to conduct research and development and to expand our operations in the future to meet the needs of our customers. As a result of this reduction in force, we are not currently producing any products and our manufacturing operations have been suspended.

     We have incurred substantial losses, have a history of operating losses, have an accumulated deficit and stockholders’ net capital deficiency and expect continued operating losses.

     We had a net loss of $21.7 million for the nine months ended September 30, 2003. At September 30, 2003, our accumulated deficit and stockholders’ net capital deficiency were $318.4 million and $64.3 million, respectively. We have experienced operating losses since our inception, and we expect to continue to incur operating losses at least until we have significant product sales, if we ever do. We may fail in our efforts to secure replacement sales, marketing and distribution functions in the United States in light of Sankyo Pharma’s decision to stop performing under our Sales, Marketing and Distribution Agreement and related contracts. Our products may never gain market acceptance, and we may never generate significant revenues or achieve profitability.

     We believe, as a practical matter, we will not be able to draw on our remaining equity line agreement for the foreseeable future. Additionally, our equity line may be suspended or terminated and we may not be able to replace it. If adequate funds are not available or are not available on acceptable terms, we may be unable to continue our operations.

     In order to continue commercialization of our GlucoWatch Biographers, as well as continue to develop our product line, we will require substantial additional resources. We may seek additional funding through public or private financings, including debt or equity financings. Furthermore, since our stock is not listed on either the Nasdaq National Market or Nasdaq SmallCap Market, our investors under the equity line agreement may elect to suspend or terminate this agreement, in which case we will not be able to utilize the $29.0 million available under this equity line agreement. Even if these investors elect not to suspend or terminate our equity line agreement, we believe, as a practical matter, we will not be able to draw on the equity line agreement for the foreseeable future. So long as we are not listed on a national exchange or quoted on the Nasdaq National Market or the SmallCap Market, we believe that it will not be practical for us to draw on our equity line in light of (i) the penny stock rules that require the underwriter to undertake relatively burdensome disclosure obligations in connection with issuances of penny stock securities such as ours, (ii) our need to individually comply with each state’s blue sky laws governing unlisted securities issuances, and (iii) the relatively high level of dilution that issuances would have at current market prices for our stock. As a result, we may need to seek other financing arrangements. Any additional equity financings are likely to dilute the holdings of current stockholders. Debt financing, if available, may have restrictive covenants. We may not be able to obtain adequate funds when we need them from financial markets or other sources. In particular, our ability to raise funds through the capital markets may be materially adversely affected as a result of our litigation with Sankyo Pharma and Sankyo Japan. Even if funds are available, they may not be available on acceptable terms. If we cannot obtain sufficient additional funds, we may have to cease operations or declare bankruptcy or, at a minimum, delay, scale back or eliminate some or all of our ongoing activities or license or sell products or technologies.

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     We are highly leveraged and may be unable to service our debt or satisfy our other obligations. If we cannot pay amounts due under our obligations, we may need to refinance all or a portion of our existing debt, sell equity securities, sell all or a portion of our assets, cease our operations and/or seek protection under the bankruptcy laws.

     As of September 30, 2003, we had total liabilities of $81.5 million (net of unamortized debt discount of $1.0 million), of which $70.2 million were current liabilities. This amount of $70.2 million includes $45.5 million related to Sankyo Pharma, including $25.0 million in deferred revenues from Sankyo Pharma and $9.0 million in deferred revenues from Sankyo Pharma net of deferred costs of product shipments. Our ability to meet our debt service obligations and other liabilities depends upon our future performance, which will depend upon financial, business and other factors, many of which are beyond our control. We may fail to generate sufficient cash flows in the future to cover our fixed charges or to permit us to satisfy any redemption obligations pursuant to our indebtedness. Historically, we have experienced significant negative cash flows from operations. If we cannot generate sufficient cash flows in the future to cover our fixed charges or to permit us to satisfy any redemption obligations pursuant to our indebtedness and we are unable to borrow sufficient funds under our credit facilities or from other sources, we may need to refinance all or a portion of our existing debt, sell equity securities or sell all or a portion of our assets. We may not successfully complete any of these courses of action. The degree to which we are leveraged could exacerbate limitations on our ability to obtain financing for working capital, commercialization of products or other purposes and could make us more vulnerable to industry downturns and competitive pressures. In the event of insolvency, bankruptcy, liquidation, reorganization, dissolution or winding-up of our business or upon default or acceleration related to our debt obligations, our assets would first be available to pay the amounts due under our debt obligations. Holders of our common stock would only receive any assets remaining after satisfaction in full of all indebtedness and preferred stock liquidation preferences, if any.

     If patients do not receive reimbursement from third-party health care payors, we may be unsuccessful in selling our products to a broad range of customers.

     Successful commercialization of our products will depend in large part on whether patients who purchase our products will be reimbursed for the expense by third-party payors, which include private insurance plans, Medicare, Medicaid and other federal health care programs. Currently, our products do not have widespread reimbursement. There can be no assurance that such reimbursement will be available in a sufficient time frame, or at all. Furthermore, Sankyo Pharma had responsibility for this function under our Sales, Marketing and Distribution Agreement and had contracted with TheraCom, Inc. to assist customers on a patient-by-patient basis in obtaining reimbursement as well as utilizing its managed care group to work with third-party health care payor organizations in order to obtain broad reimbursement coverage. In light of Sankyo Pharma’s decision to stop performing under their contracts with us, we will need to find another approach to securing such reimbursement, or will need to rely on non-reimbursed sales only. Third-party payors, including federal health care programs and managed care and other private insurance plans, are increasingly seeking to contain health care costs by limiting the coverage of, and the amount of reimbursement for, new diagnostic products. As a result, adequate levels of reimbursement may not be available for patients, many of whom may therefore not purchase our products. If meaningful reimbursement from third-party payors is not available, we may not be able to achieve a level of market acceptance of our products, and we may not be able to maintain price levels sufficient to realize an adequate return on our investment. In the United States and other countries, the period of time needed to obtain approval for the reimbursement of our products to patients can be lengthy. We may need to delay the launch of our products in some countries until we have established eligibility for reimbursement. This delay could potentially harm our business.

     We depend on third-party suppliers for the manufacturing of our Biographer and AutoSensor components. Any interruption in the supply of system components or an increase in the pricing of these components could prevent us from manufacturing our products or adversely affect our margins.

     Our Biographer and AutoSensor are manufactured from components purchased from outside suppliers, most of whom are our single source for such components. Some of these companies are small enterprises that may encounter financial difficulties because of their size. We have been notified by one of our sole source component suppliers that they are encountering financial difficulties. Prior to Sankyo Pharma’s decision to stop performing under their contracts with us, we had begun the process of identifying and qualifying an alternative supplier for this component; however, we have stopped these efforts in light of the two-year inventory currently warehoused by Sankyo Pharma. In the future, if we are unable, for whatever reason, to obtain these components from our suppliers or if the components obtained from these suppliers do not pass quality standards, we will be required to obtain the

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components from alternative suppliers. Additionally, in the event a current supplier is unable to meet our component requirements, we might not be able to rapidly find another supplier of the particular component or an alternative supply of the particular component at the same price or lead time. Sankyo Pharma has informed us that they currently are warehousing a two-year inventory of our products; however, an interruption in the supply of Biographer or AutoSensor components or excessive pricing of these components could prevent us from manufacturing our products in the future or could adversely affect our margins and significantly impact our ability to achieve a successful U.S. market penetration.

     Third-party suppliers may, for competitive reasons, support directly or indirectly a company or product that competes with one of our products. If such a third-party supplier terminates an arrangement, cannot fund or otherwise satisfy its obligations under its arrangements or disputes or breaches a contractual commitment, then we would likely be required to seek an alternative third-party supplier. If we were unable to find a replacement third-party supplier, our capital requirements could increase substantially and our business and financial condition could be materially adversely affected. If we were required to develop our own capabilities, we would continue to incur significant start-up expenses and we would compete with other companies that have experienced and well-funded operations.

     If we recommence product manufacturing in the future, we will continue to rely on existing supply agreements, including those with Hydrogel Design Systems, Inc., Key Tronic Corporation, Sanmina Corporation and E.I. du Pont de Nemours and Company, among others.

     Our very limited medical device manufacturing experience may prevent us from successfully commercializing our product.

     We have suspended manufacturing in light of Sankyo Pharma’s decision to stop performing under their contracts with us, and we may encounter problems in recommencing manufacturing of our GlucoWatch Biographer and AutoSensors, particularly in light of our recent reduction in force. We were responsible for manufacturing the GlucoWatch Biographer and we contracted with a third party, Corium International, to manufacture our AutoSensors. Thus, we were dependent upon Corium International for such manufacturing. Our GlucoWatch Biographers and AutoSensors have been manufactured for commercial sale on a limited basis, and we have no experience manufacturing the volumes that would be necessary for us to achieve significant commercial sales. In the past, we initially experienced problems in scaling up our now-discontinued transdermal drug delivery products. There can be no assurance that similar problems will not be encountered in the future with our Biographers, our AutoSensors and our potential future products, if any. To successfully commercialize the Biographer and the AutoSensors, we will have to manufacture these products in compliance with regulatory requirements, in a timely manner and in sufficient quantities, while maintaining performance and quality of the products and a commercially feasible cost of manufacturing. There can be no assurance that we will be able to expand and then maintain reliable, full-scale manufacturing of the Biographer and the AutoSensors at commercially reasonable prices if we were to recommence product manufacturing. Manufacturers often encounter difficulties in scaling up production of new products, including problems involving product performance, production yields, quality control and assurance and personnel staffing levels. In addition, manufacturing facilities will be subject to extensive regulations, including those of the FDA, international quality standards and other regulatory requirements. Because we have contracted with a third party for manufacturing our AutoSensors, there are normal business risks associated with outsourcing this function to a third party. Difficulties encountered in manufacturing scale-up or failure by us or a third party to implement and maintain manufacturing facilities in accordance with FDA regulations, international quality standards or other regulatory requirements could result in a delay or termination of production, which could have a material adverse effect on our business, financial condition and results of operations.

     Due to the early stage of our product commercialization activities, the estimates required in inventory valuation, including production yields and normal capacity, labor costs incurred in the production of each unit and overhead costs applicable to manufacturing operations, are inherently uncertain, thus actual results may differ from those estimates. Write-offs for potential obsolescence or for inventories in excess of demand and estimates for replacement costs of any stale-dated AutoSensor inventory held by Sankyo Pharma are also determined based on significant estimates, which may be significantly impacted by our litigation with Sankyo Pharma and Sankyo Japan.

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     Our products are based on new technology and may not be accepted by the market. This uncertainty has been compounded by Sankyo Pharma’s decision to stop performing under their contracts with us.

     We were focusing our efforts on a line of frequent, automatic and non-invasive glucose monitoring devices based on novel technologies prior to the litigation with Sankyo Pharma and Sankyo Japan. Sankyo Pharma has been solely responsible for the marketing of our products in the United States. Given Sankyo Pharma’s decision to stop performing under their contracts with us, physicians may be hesitant to prescribe our products for their patients. Our litigation has already caused substantial uncertainty relating to product availability, warranty fulfillment, and the like. Furthermore, the market may not accept our products, given that they are different from the established finger-stick blood glucose monitors currently on the market. In addition, because our products are based on novel technologies, there can be no assurance that unforeseen problems will not develop with these technologies or that we will be able to successfully address technological challenges that we may encounter.

     We may be subject to product recalls or product liability claims that are costly to defend and could limit our ability to sell our products in the future or could damage our reputation.

     The design, development, manufacture and use of our medical products involve an inherent risk of product recalls and product liability claims and associated adverse publicity. Makers of medical products may face substantial liability for damages in the event of product failure or allegations that the product caused harm. Product liability insurance is expensive and, although we presently have such insurance, it is difficult to maintain as well as to expand coverage under it. We may become subject to product liability claims, our current insurance may not cover potential claims and adequate insurance may not be available on acceptable terms in the future. We also could be held liable for damages in excess of the limits of our insurance coverage. Regardless of insurance coverage, any claim or product recall could result in non-compliance with FDA regulations, force us to stop selling our products and create significant adverse publicity that could harm our credibility and decrease market acceptance of our products.

     Our product pipeline is severely limited, so the failure of our glucose monitoring products could result in the failure of our entire business.

     We are exclusively focused on a line of frequent, automatic and non-invasive glucose monitoring devices. This narrow range of products subjects us to the risk of not having alternative sources of revenue if we are unable to commercialize these products. We may not be successful with a non-diversified line of products. A failure of our initial products could cut off our only potential source of revenue and result in the failure of our entire business, as could the failure of any of our future products.

     To be successful, we will need to continue to develop glucose monitoring products that address the needs of people with diabetes; however, in light of our recent reduction in force and expenses associated with our litigation with Sankyo Pharma and Sankyo Japan, our ability to develop new products has been materially impaired. From time to time, we have experienced delays or setbacks in the development of certain of our products. For example, in the past, we experienced development delays in the miniaturization of the first-generation GlucoWatch Biographer. There can be no assurance that we will be able to successfully address problems that may arise during development and commercialization processes. In addition, there can be no assurance that GlucoWatch Biographer enhancements or future products can or will be successfully developed, prove to be safe and effective in clinical trials, meet applicable regulatory standards, be manufactured in commercial quantities at a reasonable cost, be marketed successfully or achieve market acceptance. If our future development programs, if any, are not successfully completed, required regulatory approvals or clearances are not obtained or products for which approvals or clearances are obtained are not commercially successful, our business, financial condition and results of operations may be materially adversely affected

     We may not continue to receive regulatory approval of our products from the FDA or foreign agencies. If we do not receive regulatory approval from an agency, we will not be able to sell our products or generate revenue in that agency’s jurisdiction.

     The design, manufacturing, labeling, distribution and marketing of our products are subject to extensive and rigorous government regulation in the United States and certain other countries, where the process of obtaining and maintaining required regulatory clearance or approvals is lengthy, expensive and uncertain. Our third-generation product is currently under review by the FDA. The FDA may not approve this new product or additional future enhancements and possible manufacturing changes to the Biographers and the AutoSensors or it may require us to

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file one or more new PMA applications rather than allowing us to supplement our existing PMA application. Even if the FDA grants us expedited review status on an application for approval, obtaining approval of a PMA or a PMA supplement could take a substantial period of time, and the FDA may not ultimately grant such approval. Moreover, even if regulatory approval is granted, such approval may include significant limitations on intended uses for which any such products could be marketed.

     A medical device and its manufacturer are subject to continual review after approval, and later discovery of previously unknown problems with a product or the manufacturing process may result in restrictions on such product or the manufacturer, including withdrawal of the product from the market. Failure to comply with applicable regulatory requirements may result in, among other things, fines, suspensions of regulatory approvals, product recalls, operating restrictions and criminal prosecution. In addition, new government regulations may be established that could delay or prevent regulatory approval of our potential products. We are also subject to federal, state and local regulations regarding workplace safety, environmental protection and hazardous material controls, among others, and failure to comply with these regulations may result in similar consequences.

     In order for us to market our products in foreign jurisdictions, we and our distributors and agents must obtain required regulatory registrations or approvals and otherwise comply with extensive regulations regarding safety, efficacy and quality in those jurisdictions. Specifically, certain foreign regulatory bodies have adopted various regulations governing product standards, packaging requirements, labeling requirements, import restrictions, tariff regulations, duties and tax requirements. These regulations vary from country to country. There can be no assurance that we will obtain required regulatory registrations or approvals in such countries or that we will not be required to incur significant costs in obtaining or maintaining such regulatory registrations or approvals. Delays in obtaining any registrations or approvals required to market our products, failure to receive these registrations or approvals or future loss of previously obtained registrations or approvals could have a material adverse effect on our business, financial condition and results of operations.

     If we fail to adequately protect our intellectual property, our competitive position could be harmed.

     Development and protection of our intellectual property are critical to our business. If we do not adequately protect our intellectual property, both in the United States and abroad, competitors may be able to use our technologies. Our success depends in part on our ability to:

	•		obtain patent protection for our products and processes in both the United States and other countries;
	•		protect trade secrets; and
	•		prevent others from infringing on our proprietary rights.

     There are numerous risks and uncertainties that we face with respect to our patents and other proprietary rights. Currently, most pending patent applications in the United States are maintained in secrecy until issuance, and publication of discoveries in the scientific or patent literature tends to lag behind actual discovery by several months. Thus, we may not have been the first to file patent applications on our inventions. Our patent applications may not issue into any patents. Once granted, the claims of any issued patents may not afford meaningful protection for our technologies or products. In addition, patents issued to us or our licensors may not provide competitive advantages for our products or may be challenged by our competitors and subsequently narrowed, invalidated or circumvented. Competitors may also independently develop similar or alternative technologies or duplicate any of our technologies.

     Litigation, interference proceedings, oppositions or other proceedings that we may become involved in with respect to our proprietary technologies could result in substantial cost to us. Patent litigation is widespread in our industry, and any patent litigation could harm our business. Costly litigation might be necessary to protect our proprietary rights, and we may not have the required resources to pursue such litigation or to protect our rights. An adverse outcome in litigation with respect to the validity of any of our patents could subject us to significant liabilities to third parties, divert the attention of management and technical personnel from other business and development concerns, require disputed rights to be licensed to or from third parties or require us to cease using a product or technology or lose our exclusive rights with respect to such technology.

     We also rely upon trade secrets, proprietary know-how and continuing technological innovation to remain competitive. Confidentiality agreements with our employees, consultants and corporate partners with access to proprietary information could be breached, and we might not have adequate remedies for any such breach.

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Additionally, our trade secrets and know-how could otherwise become known or be independently developed by third parties.

     Our products could infringe on the intellectual property rights of others, possibly causing us to engage in costly litigation and, if we are not successful, causing us to pay substantial damages and prohibiting us from selling our products.

     Third parties may assert infringement or other intellectual property claims against us based on their patents or other intellectual property claims. We may have to pay substantial damages, possibly including treble damages, for past infringement if it is ultimately determined that our products infringe a third party’s patents. Furthermore, we may be prohibited from selling our products before we obtain a license that, if available at all, may require us to pay substantial royalties. Even if infringement claims against us are without merit, defending a lawsuit takes significant time, may be expensive and may divert management’s attention from other business concerns and also divert efforts of our technical personnel.

     We may be unable to build brand loyalty because our trademarks and trade names may not be protected.

     Our registered or unregistered trademarks or trade names, such as the marks “GlucoWatch” and “G2,” may be challenged, canceled, infringed upon, circumvented, declared generic or determined to be infringing on other marks. We may not be able to protect our rights to these trademarks and trade names, without which we may be unable to build brand loyalty. Brand recognition is critical to our short-term and long-term marketing strategies, especially as we commercialize future enhancements to our products. Moreover, if our trademarks are found to infringe on marks belonging to third parties, we may be forced to market our products under a different name, possibly requiring a costly and difficult re-branding effort, and we could be ordered to pay damages to a third party.

     If any of our license agreements or other contracts for intellectual property related to our products are terminated or made non-exclusive, our ability to develop, manufacture or market our products may be materially impaired.

     We have entered into agreements with various third parties, including The Regents of the University of California, for licenses of certain intellectual property related to the Biographers and the AutoSensors. Pursuant to these agreements, we have been granted rights to certain technologies related to our products. These agreements impose on us specific obligations, including, in the case of the University of California, license, royalty payments and commercialization milestones. If we fail to meet our obligations under any of these agreements, the license or other rights may be terminated or, in the case of an exclusive arrangement, be made non-exclusive. Additionally, in the event we decide to seek bankruptcy protection, patent holders who license their technology to us, including the University of California, may assert rights to terminate their licenses with us or to contest the transfer or sale of such licenses in the bankruptcy process. Although we would challenge any such assertions, there can be no assurances that our challenge would be successful. If any such license or other right is terminated, we may lose our ability to incorporate the applicable technology into our products or to use such technology in the manufacture of our products, possibly impairing our ability to produce or market the GlucoWatch Biographer or other products. If any such license or other right is made non-exclusive, we may be unable to prevent others from developing, manufacturing and marketing devices based on the same or similar technologies.

     We do business on a limited basis in the United Kingdom and may not enter other international markets; thus, the success of our business depends on our success in the U.S. market.

     We currently market and sell the GlucoWatch G2 Biographer on a limited basis in the United Kingdom, which has a National Health Service (NHS); our products are not currently reimbursed by the NHS. We have established a contract with a third-party authorized representative in the United Kingdom, although the product ordering, logistics, and technical support functions are handled by us. If we are unable to support these necessary functions, we may not be able to sell our products or generate revenue in the United Kingdom.

     We may never be able to secure necessary commercialization agreements in countries other than the United States and the United Kingdom, despite the fact that we have CE certification in the European Community. If we are unable to secure these necessary agreements for other countries, we may not be able to sell our products or, even if such sales are possible, to broadly launch our products in other countries. Even if we do expand into other international markets, our operations there may be limited or disrupted by any or all of the following factors:

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	•		obligations to comply with a wide variety of foreign laws and other regulatory requirements;
	•		political or economic instability;
	•		trade restrictions;
	•		changes in tariffs;
	•		restrictions on repatriating profits;
	•		reduced protection for intellectual property rights;
	•		potentially adverse tax consequences;
	•		difficulties in staffing and managing international operations; and
	•		fluctuating exchange rates.

Risks Related to Our Industry

     Intense competition in the market for glucose diagnostic products could prevent us from increasing or sustaining our revenues and prevent us from achieving or sustaining profitability.

     The medical device industry, particularly the market encompassing our GlucoWatch Biographer, is intensely competitive, and we will compete with other providers of personal glucose monitors. Currently the market is dominated by finger-stick blood glucose monitoring products sold by a few major companies. These companies have established products and distribution channels. In addition, several companies are marketing alternative-site devices to monitor glucose levels in a painless manner or in a manner involving less pain than that associated with finger sticking. Furthermore, companies are attempting to develop a variety of methods to extract interstitial fluid and measure the glucose concentration therein, as well as developing devices to monitor glucose on a frequent and automatic basis. Another technology that some companies are pursuing utilizes infrared spectroscopy, which uses radiation to measure glucose levels. There can be no assurance that other products will not be accepted more readily in the marketplace than the GlucoWatch Biographer or will not render our current or future devices noncompetitive or obsolete. Additionally, the GlucoWatch Biographer or our other enhanced products under development may fail to replace any currently used devices or systems.

     Furthermore, a number of companies have developed or are seeking to develop new diabetes drugs or treatments that could reduce or eliminate demand for all glucose monitoring systems. In addition, many of our competitors and potential competitors have substantially greater resources, larger research and development staffs and facilities and significantly greater experience in developing, manufacturing and marketing glucose monitoring devices than we do. Competition within the glucose monitoring industry could result in price reductions for glucose monitoring devices such that we may not be able to sell our products at a price level adequate for us to realize a return on our investment.

     Competition for qualified personnel exists in our industry and in northern California. If we are unable to retain or hire key personnel, we may not be able to sustain or grow our business.

     Our ability to operate successfully and manage our potential future growth depends significantly upon retaining key scientific, manufacturing, technical, managerial and financial personnel, and also attracting and retaining additional highly qualified personnel in these areas. We face competition for such personnel, and we may not be able to attract and retain these individuals, particularly in light of the uncertainty surrounding our litigation with Sankyo Pharma and Sankyo Japan. We compete with numerous pharmaceutical, health care and software companies, as well as universities and non-profit research organizations, in the northern California business area. The loss of key personnel or our inability to hire and retain additional qualified personnel in the future could prevent us from sustaining or growing our business. There can be no assurance that we will continue to be able to attract and retain sufficient qualified personnel.

Risks Related to Our Common Stock

     Our common stock is subject to the requirements for penny stocks, which could adversely affect our stockholders’ ability to sell and the market price of their shares.

     Our stock fits the definition of a penny stock. The Securities Exchange Act of 1934, as amended, defines a penny stock as any equity security that is not traded on a national securities exchange or authorized for quotation on the Nasdaq National Market and that has a market price of less than $5.00 per share, with certain exceptions. Penny stocks are subject to Rule 15(g) under the Securities and Exchange Act of 1934, as amended, which imposes

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additional sales practice disclosure and market-making requirements on broker/dealers who sell or make a market in such securities. The rules require that, prior to a transaction in a penny stock not otherwise exempt from the rules, the broker/dealer must:

	•		deliver a standardized risk disclosure document that provides information about penny stocks and the risks in the penny stock market;
	•		provide the customer with current bid and offer quotations for the penny stock;
	•		disclose the compensation of the broker/dealer and its salesperson in connection with the transaction;
	•		provide the customer monthly account statements showing the market value of each penny stock held in the customer’s account; and
	•		make a special written determination that the penny stock is a suitable investment for the customer and receive the customer’s written agreement to the transaction.

     These requirements may have the effect of reducing the liquidity and trading volume of our stock. As a result, it may be more difficult for stockholders to sell their shares of our stock and these requirements may adversely affect the price other investors are willing to pay for our stock.

     Our stock price is volatile and stockholders may not be able to resell Cygnus shares at or above the price they paid, or at all.

     The market price for shares of our common stock has been highly volatile. Factors such as the current litigation with Sankyo Pharma and Sankyo Japan, performance of commercialization functions, new product introductions by our competitors, levels of sales to end-user customers, regulatory approvals or delays or recalls of our products or those of our competitors, developments relating to our patents or proprietary rights or those of our competitors, and the results of clinical trials for products of our competitors, as well as period-to-period fluctuations in financial results, may have a significant impact on the market price of the common stock. Additionally, following periods of volatility in the market price for a company’s securities, securities class action litigation may be instituted. Such litigation could result in substantial costs to us and further divert management’s attention and resources.

     Additional issuances of our common stock pursuant to the conversion of the Convertible Debentures could greatly dilute the ownership interest of our existing stockholders and lower our stock price.

     We have approximately 56.5 million authorized and unissued shares of common stock. As of September 30, 2003, we had $20.3 million outstanding under both the 8.5% Convertible Debentures due June 29, 2004, as amended, and the 8.5% Convertible Debentures due September 29, 2004, as amended. Under these Convertible Debentures, each month the holders of the Convertible Debentures may collectively convert up to $500,000 of said Convertible Debentures into common stock, subject to certain pricing and volume restrictions. In the event that the conversion price is more than $3.50 per share, the holders of the Convertible Debentures may convert more than the $500,000 monthly limit, subject to certain volume restrictions. The total number of shares that may be issued under the Convertible Debentures depends on the market price of our common stock at the time that the shares are sold.

     From April 1, 2003 and for the remaining term of the Convertible Debentures, the conversion price, calculated using Bloomberg’s volume average pricing function or a similar pricing method, referred to as the VWAP, is equal to 107% of any VWAP that is less than or equal to $2.00 per share, and 101% of any VWAP greater than $2.00 per share, subject to the minimum conversion price of $1.054 per share. In no instance will the conversion price be less than $1.054 per share.

     The following table illustrates hypothetically the effect that variations in the market price in our common stock and resulting variations in conversion prices would have on the number of shares issued in a one-month period:

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     If we or our stockholders sell substantial amounts of our common stock, whether or not as part of a Convertible Debenture transaction, the market price of our common stock may fall. These sales also might make it more difficult for us to sell equity or equity-related securities in the future at a time and price that we deem appropriate. In addition, we have discussed the possibility of restructuring our payment schedule under the Convertible Debentures and possibly reducing the minimum conversion price in effect for our Convertible Debentures, which would cause significant dilution to our existing stockholders, although neither we nor the Debenture holders have committed to any such amendment or conversion to date.

     Although it is highly unlikely that we will be able to draw on our equity line agreement, additional issuances of our common stock under the equity line agreement could greatly dilute the ownership interest of our existing stockholders and lower our stock price.

     Since we are not currently listed on either the Nasdaq National Market or the SmallCap Market, the investors under our remaining equity line agreement may elect to suspend or terminate this agreement, in which case we would not be able to utilize the $29.0 million available under this equity line agreement. Even if these investors elect not to suspend or terminate this agreement, we believe, as a practical matter, we will not be able to draw on this equity line agreement for the foreseeable future. So long as we are not listed on a national exchange or quoted on the Nasdaq National Market or the SmallCap Market, we believe that it will not be practical for us to draw on our equity line in light of (i) the penny stock rules that require the underwriter to undertake relatively burdensome disclosure obligations in connection with issuances of penny stock securities such as ours, (ii) our need to individually comply with each state’s blue sky laws governing unlisted securities issuances, and (iii) the relatively high level of dilution that issuances would have at current market prices for our stock. However, in the event that we transfer back to the Nasdaq Stock Market, provided our equity line agreement has not been terminated or suspended prior to such transfer, the $29.0 million under this equity line agreement would become available to us again. In such instance, subject to certain requirements, we may then choose to sell up to $4.0 million of common stock per 30-day period (or $2.0 million of common stock per 15-day period) and our investors may then exercise their option to purchase, subject to our approval, up to an additional $3.0 million of common stock per 30-day period. The total number of shares that may be issued under our equity line agreement depends on the market price of our common stock at the time that the shares are sold, on whether we choose to sell shares and on the number of shares we choose to sell. The following table illustrates hypothetically the effect that variations in the market price in our common stock and resulting variations in sales prices would have on the number of shares issued in a 30-day period, assuming that we would choose to sell all possible shares under our equity line agreement.

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     Under our equity line agreement, we have agreed to issue warrants to Cripple Creek Securities, LLC to purchase shares in an amount equal to 10% of the number of shares issued under the equity line agreement in any given year. The warrants are to be issued after the end of each calendar year and will be exercisable for five years from the date they are issued at an exercise price based on the weighted average price at which shares were sold during the preceding calendar year. Moreover, we have agreed to register the shares underlying these warrants to enable such shares to be freely resold immediately after the warrants are exercised.

     In addition to issuances of common stock under our equity line agreement, if we or our stockholders sell substantial amounts of our common stock, including shares issued upon the exercise of outstanding options and warrants, the market price of our common stock may fall. These sales also may make it more difficult for us to sell equity or equity-related securities in the future at a time and price that we deem appropriate.

     Issuances by us of authorized preferred stock can have adverse effects, including dilution and discouragement of takeovers.

     Our certificate of incorporation contains certain provisions that may delay or prevent a takeover. The Company currently has 5,000,000 shares of authorized and unissued Preferred Stock. Our Board of Directors has the authority to determine the price, rights, preferences and restrictions, including voting and conversion rights, of these shares without any further action or vote by the stockholders. The rights of the holders of common stock will be subject to, and may be adversely affected by, the rights of the holders of preferred stock that may be issued in the future. Such provisions could adversely affect the holders of common stock in a variety of ways, including by potentially discouraging, delaying or preventing a takeover of Cygnus and by diluting stockholder ownership.

     Provisions of our charter documents and Delaware law may inhibit a takeover, thus limiting the price investors might be willing to pay in the future for our common stock.

     Provisions in our Restated Certificate of Incorporation and Bylaws may have the effect of delaying or preventing an acquisition of our Company or a merger in which we are not the surviving company and may otherwise prevent or slow changes in our Board of Directors and management. In addition, because we are incorporated in Delaware, we are governed by the provisions of Section 203 of the Delaware General Corporation Law. These provisions could discourage an acquisition of our company or other change in control transaction and thereby negatively impact the price that investors might be willing to pay in the future for our common stock.

     We do not pay cash dividends and do not anticipate paying any dividends in the future, so any short-term return on stockholders’ investment will depend on the market price of our shares, which is volatile.

     We have never paid any cash dividends on our capital stock. We anticipate that we will retain our earnings, if any, to support operations and to finance the growth and development of our business. Therefore, we do not expect to pay cash dividends in the foreseeable future. Any short-term return on stockholders’ investment will depend only on the market price of our shares and stockholders’ ability to liquidate their investment.

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Item 3. Quantitative and Qualitative Disclosures About Market Risk.

     The Company has no material changes to the disclosure made on this matter in the Company’s Annual Report on Form 10-K/A for the year ended December 31, 2002.

Item 4. Controls and Procedures.

     (a)  Evaluation of disclosure controls and procedures. Our Chief Executive Officer and our Chief Financial Officer, after evaluating the effectiveness of Cygnus’ “disclosure controls and procedures” (as defined in the Securities Exchange Act of 1934, as amended, Rules 13a-15(e) and 15d-15(e)) as of the end of the period covered by this Quarterly Report on Form 10-Q based on such evaluation, we believe that there are adequate controls and procedures in place to ensure that information relating to the Company and our consolidated subsidiaries that is required to be disclosed by us in the reports that we file or submit under the Securities Exchange Act of 1934, as amended, is properly disclosed as required by the Securities Exchange Act of 1934, as amended.

     (b)  Changes in internal controls. There were no significant changes in the internal controls over financial reporting that occurred during our last fiscal quarter that have materially affected, or are reasonably likely to materially affect, our internal controls over financial reporting.

     It should be noted that any system of controls, however well-designed and operated, can provide only reasonable and not absolute assurance that the objectives of the system are met. In addition, the design of any control system is based in part upon certain assumptions about the likelihood of future events. Because of these and other inherent limitations of control systems, there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions, regardless of how remote.

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PART II. OTHER INFORMATION

Item 1. Legal Proceedings.

     On October 2, 2003, Sankyo Pharma stated that they were stopping performance of their contractual obligations. In addition, Sankyo Pharma acknowledged that they had not paid invoices owed to us and informed us that they had no intention of remitting payment for such amounts. As of October 10, 2003, these invoices total over $6.0 million. Sankyo Pharma stated that they were relying on California Commercial Code, Section 2609(1) as a purported legal basis for ceasing performance of their contractual obligations. Section 2609(1) generally gives parties the right to demand adequate assurance of due performance by their counterparty of its contractual obligations if reasonable grounds of insecurity arise with respect to performance by the counterparty. Sankyo Pharma has stated that they had grounds for insecurity regarding our financial position and our ability to perform under the Sales, Marketing and Distribution Agreement and related contracts we have with Sankyo Pharma.

     On October 6, 2003, we filed a complaint in the Superior Court of the State of California for the County of San Mateo against Sankyo Pharma and Sankyo Japan for breach of contract and intentional interference with contract relating to the sales, marketing and distribution of our GlucoWatch Biographer products. During the initial 12-year term of our Sales, Marketing and Distribution Agreement with Sankyo Pharma, there are no termination rights except in very specific circumstances, none of which, we believe, has occurred. We are seeking substantial compensatory damages and other relief. The litigation in which we are currently involved may affect, among other things, our ability to sell, market and distribute our products in the United States, our financing activities, the retention of our remaining personnel and our ability to continue as a going concern. We cannot predict with certainty the eventual outcome of the pending litigation, which may result in a significant adverse jury verdict or punitive damages award, or a judgment that certain of our allegations are invalid or unenforceable. This kind of litigation could be very costly and will divert our management’s attention and resources, and any adverse determination in this litigation, or delay in resolving this litigation, may cause us to cease operations and/or seek protection under the bankruptcy laws.

     On October 9, 2003, we announced a reduction in force of approximately 60% of our work force as a result of Sankyo Pharma’s decision to stop performing under its contracts with us. We have suspended our manufacturing activities and research and development efforts for future products. We are not likely to continue to manufacture current products or develop new products in the near future. According to Sankyo Pharma, however, they are currently warehousing inventory approximating two years’ sales of our products, and these products remain available for sale in the United States.

     On October 16, 2003, we responded to Sankyo Pharma’s request for assurances under California Commercial Code, Section 2609(1). Sankyo Pharma had notified us, as well as certain health care professionals, that they will continue to provide marketing, sales, and distribution support for our GlucoWatch G2 Biographer; however, given their decision to stop performing under their contracts with us and our litigation, the commercial status of our products in the United States is unclear. We have begun looking at alternative sales, marketing and distribution approaches for our products.

     On November 6, 2003, Sankyo Pharma filed an answer and cross-claims against us for declaratory relief, breach of contract, and defamation. We have not yet filed a response to these claims. We believe that we have meritorious defenses to the causes of action asserted against us by Sankyo Pharma, and we intend to vigorously defend ourselves against these claims. This litigation is in its early stages, however, and is therefore inherently difficult to assess.

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

a)

Exhibits

The following exhibits are filed herewith or incorporated by reference:

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b)

Current Reports on Form 8-K

     The following Current Report on Form 8-K was filed during the three months ended September 30, 2003:

     On August 14, 2003, we filed a Current Report on Form 8-K, reporting under Item 12 the Company’s financial results for the quarter ended June 30, 2003.

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SIGNATURES

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

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EXHIBIT INDEX

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