SECURITIES AND EXCHANGE COMMISSION

Form 10-Q

(Mark One)

OR

Commission File Number: 000-50414

ADVANCIS PHARMACEUTICAL CORPORATION

(301) 944-6600
(Registrant’s telephone number, including area code)

None
(Former name, former address and former
fiscal year - if changed since last report)

Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.
Yes [X]   No [   ]

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

As of May 3, 2004, 22,795,307 shares of common stock of the Registrant were outstanding.

ADVANCIS PHARMACEUTICAL CORPORATION

INDEX

FORM 10-Q

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PART I - FINANCIAL INFORMATION

Item 1. Financial Statements (Unaudited)

ADVANCIS PHARMACEUTICAL CORPORATION

BALANCE SHEETS (Unaudited)

The accompanying notes are an integral part of these financial statements.

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ADVANCIS PHARMACEUTICAL CORPORATION

STATEMENTS OF OPERATIONS (Unaudited)

The accompanying notes are an integral part of these financial statements.

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ADVANCIS PHARMACEUTICAL CORPORATION

STATEMENT OF CHANGES IN STOCKHOLDERS’ EQUITY (Unaudited)

The accompanying notes are an integral part of these financial statements.

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ADVANCIS PHARMACEUTICAL CORPORATION

STATEMENTS OF CASH FLOWS (Unaudited)

The accompanying notes are an integral part of these financial statements.

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ADVANCIS PHARMACEUTICAL CORPORATION

NOTES TO FINANCIAL STATEMENTS

1. Basis of Presentation

     The accompanying unaudited financial statements of Advancis Pharmaceutical Corporation (the “Company”) have been prepared in accordance with accounting principles generally accepted in the United States of America and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by accounting principles generally accepted in the United States of America for complete financial statements. Therefore, these financial statements should be read in conjunction with the Company’s 2003 Annual Report on Form 10-K. The interim financial statements reflect all adjustments which, in the opinion of management, are necessary for a fair statement of financial condition and results of operations for the periods presented. Except as otherwise disclosed, all such adjustments are of a normal recurring nature.

     Operating results for the three months ended March 31, 2004 are not necessarily indicative of the results that may be expected for the fiscal year ending December 31, 2004.

2. Summary of Significant Accounting Policies

Use of Estimates

     The preparation of financial statements in conformity with generally accepted accounting principles in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.

Marketable Securities

     The Company classifies all of its marketable securities as available-for-sale. Available-for-sale securities are carried at fair value, with the unrealized gains and losses reported as a component of stockholders’ equity (deficit) in comprehensive income (loss). Marketable securities available for current operations are classified in the balance sheet as current assets; marketable securities held for long-term purposes are classified as noncurrent assets. Interest income and realized gains and losses on securities are included in “Interest income” in the statements of operations.

Accounting for Stock-Based Compensation

     Employee stock awards under the Company’s compensation plans are accounted for by the intrinsic value method in accordance with Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees,” (APB 25) and related interpretations.

     In accordance with SFAS 148, the following table illustrates the effect on net loss and net loss per share as if the Company had applied the fair value recognition provisions of SFAS 123. Because options vest over several years and additional option grants are expected to be made in future years, the pro forma results are not representative of the pro forma results for future years.

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ADVANCIS PHARMACEUTICAL CORPORATION
 
NOTES TO FINANCIAL STATEMENTS — (Continued)

Earnings Per Share

     Basic earnings per share is computed based on the weighted average number of common shares outstanding during the period. Diluted earnings per share is computed based on the weighted average shares outstanding adjusted for all dilutive potential common shares. The dilutive impact, if any, of common stock equivalents outstanding during the period, including outstanding stock options and warrants, is measured by the treasury stock method. The dilutive impact, if any, of the Company’s redeemable convertible preferred stock is measured using the if-converted method. Potential common shares are not included in the computation of diluted earnings per share if they are antidilutive. The Company incurred net losses for the three months ended March 31, 2004 and 2003, and, accordingly, did not assume exercise or conversion of any of the Company’s outstanding stock options, warrants or redeemable convertible preferred stock because to do so would be antidilutive.

     The following are the securities that could potentially dilute basic earnings per share in the future that were not included in the computation of diluted earnings per share because to do so would have been antidilutive for the periods presented:

Recent Accounting Pronouncements

     In January 2003, the FASB issued FIN 46, “Consolidation of Variable Interest Entities,” an interpretation of Accounting Research Bulletin No. 51, “Consolidated Financial Statements.” FIN 46 establishes accounting guidance for consolidation of variable interest entities that function to support the activities of the primary beneficiary. In December 2003, the FASB issued FIN 46 (revised December

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ADVANCIS PHARMACEUTICAL CORPORATION
 
NOTES TO FINANCIAL STATEMENTS — (Continued)

2003), “Consolidation of Variable Interest Entities.” This revised interpretation is effective for all entities no later than the end of the first reporting period that ends after March 15, 2004. The Company has no investment in or contractual relationship or other business relationship with a variable interest entity and therefore the adoption of this interpretation did not have any impact on the Company’s financial position or results of operations. However, if the Company enters into such an arrangement with a variable interest entity in the future or an entity with which the Company has a relationship is reconsidered based on guidance in FIN 46 to be a variable interest entity, the Company’s financial position or results of operations might be impacted.

3. Revenue

     In July 2003, the Company entered into a development and license agreement with GlaxoSmithKline (GSK) pursuant to which the Company has exclusively licensed patents and PULSYS technology to GSK for use on some of its products. Under the agreement, GSK is responsible for the clinical development, manufacture, commercialization and sale of the licensed products. In consideration for the licensing of its technology, the Company received an initial upfront payment of $5.0 million, a $3.0 million payment upon achievement of the first milestone, and can receive additional milestone payments not to exceed $49.0 million over the development period if it achieves specified product development goals. In addition, upon commercialization of any of the products, the Company could receive royalty payments and may receive additional incentive payments of up to $50.0 million if specified annual sales goals are achieved.

     The Company recognized revenue of $313,000 in the three months ended March 31, 2004, which represents amortization of the $5.0 million upfront payment from GSK, which is expected to be amortized into revenue on a straight-line basis through June 2007.

4. Marketable Securities

     Marketable securities, including accrued interest, at March 31, 2004 were as follows:

     Maturities of the Company’s marketable securities at March 31, 2004 are as follows:

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ADVANCIS PHARMACEUTICAL CORPORATION
 
NOTES TO FINANCIAL STATEMENTS — (Continued)

5. Property and Equipment

     Property and equipment consist of the following:

     During the three month period ending March 31, 2004, the Company expended approximately $2.7 million for the construction of its corporate, research and development facility and purchase of equipment. In addition, the Company made deposits of $270,310 on equipment for the new facility during the three-month period ending March 31, 2004.

6. Borrowings

     In July 2003, the Company entered into a $5.5 million line of credit facility with a bank to finance the purchase of equipment associated with the fit-out of the Company’s corporate, research and development facility. The facility has an interest rate of floating 30-day LIBOR plus 280 basis points or fixed cost of funds plus 280 basis points. Each drawing requires monthly repayment of principal plus interest based upon a 36-month repayment schedule for computer equipment or a 48-month repayment schedule for all other equipment. The line of credit has a first lien on all assets purchased with the proceeds of the line. As collateral for the line of credit, the Company maintains a restricted account with the bank in the amount of $500,000. During the three-month period ended March 31, 2004, the Company drew down $807,000 under the line of credit.

7. Accrued Expenses

     Accrued expenses consist of the following:

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ADVANCIS PHARMACEUTICAL CORPORATION
 
NOTES TO FINANCIAL STATEMENTS — (Continued)

8. Stock Option Grants

     On February 25, 2004, and March 31, 2004, the Board of Directors granted stock options to certain employees to purchase up to 907,850 and 181,600 shares of common stock, respectively. The exercise price of the options is the fair market value per share of the Company’s common stock on the grant date.

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Item 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

     The following discussion of our financial condition and results of operations should be read in conjunction with the financial statements and the related notes included elsewhere in this Form 10-Q and the financial statements and related notes and Management’s Discussion and Analysis of Financial Condition and Results of Operations included in our 2003 Annual Report on Form 10-K. This discussion contains forward-looking statements the accuracy of which involve risks and uncertainties. Our actual results could differ materially from those anticipated in the forward-looking statements for many reasons including, but not limited to, those discussed herein and in our 2003 Annual Report. See “Forward-looking Statements.”

Background

     Business. We are a pharmaceutical company focused on developing and commercializing pulsatile drug products that fulfill substantial unmet medical needs in the treatment of infectious disease. We are developing a broad portfolio of drugs based on our novel biological finding that bacteria exposed to antibiotics in front-loaded, sequential bursts, or pulses, are killed more efficiently and effectively than those exposed to standard antibiotic treatment regimens. Based on this finding, we have developed a proprietary, once-a-day pulsatile delivery technology called PULSYS.

     We have focused initially on developing pulsatile formulations of approved and marketed drugs that no longer have patent protection or that have patents expiring in the next three years. As of March 31, 2004, we had four pulsatile drugs in Phase I/II clinical trials, five pulsatile drugs or drug combinations in late stage preclinical development and are exploring pulsatile formulations for a range of other antibiotics. We are also developing a non-pulsatile, generic formulation of the antibiotic Biaxin XL. In April 2004, we moved our pulsatile amoxicillin/clarithromycin combination product into Phase I/II trials. Based on results of our preclinical experiments, we believe that combination products such as amoxicillin/clarithromycin may perform in a fashion superior to either drug alone, particularly when delivered in a pulsatile manner. We expect to move additional preclinical product candidates into Phase I/II trials in the second half of 2004.

     General. Our future operating results will depend largely on the magnitude of payments from our current and potential future corporate partners and the progress of other product candidates currently in our research and development pipeline. The results of our operations will vary significantly from year to year and quarter to quarter and depend on, among other factors, the timing of our entry into new collaborations, the timing of the receipt of payments from collaborators and the cost and outcome of clinical trials.

     Revenues. Since we began our operations in January 2000, we have devoted substantially all of our resources to the discovery and development of pharmaceutical products for the treatment of bacterial infections. We have generated minimal operating revenues since our inception, and have not generated any revenues from product sales. Any revenues that we may receive in the near future are expected to consist primarily of license fees, milestone payments and research reimbursement payments to be received from collaborative partners. If our development efforts result in clinical success, regulatory approval and successful commercialization of our products, we could generate revenues from sales of our products and from receipt of royalties on sales of licensed products. We received a payment of $5 million from GlaxoSmithKline upon signing of our license agreement in July 2003, which has been deferred and recognized as revenue throughout the estimated development period of the contract. Remaining milestone payments under this agreement will be recognized as revenue in accordance with our revenue recognition policies set forth in Note 2 to the financial statements included in our Annual Report on Form 10-K. In September 2003, we entered into an agreement pursuant to which we licensed

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to Par Pharmaceutical the distribution and marketing rights to our generic clarithromycin product. We are entitled to receive milestone payments from Par Pharmaceutical not to exceed an aggregate of $6 million upon achievement of certain goals. To date, no milestone payments from Par Pharmaceutical have been received.

     Research and Development Expenses. We expect our research and development expenses to increase as we continue to develop our product candidates. These expenses consist primarily of salaries and related expenses for personnel, fees paid to professional service providers in conjunction with independently monitoring our clinical trials and acquiring and evaluating data in conjunction with our clinical trials, costs of contract manufacturing services, costs of materials used in clinical trials and research and development, depreciation of capital resources used to develop our products, costs of facilities and the legal costs of pursuing patent protection of our intellectual property. We expense research and development costs as incurred. We believe that significant investment in product development is a competitive necessity and plan to continue these investments in order to be in a position to realize the potential of our product candidates and proprietary technologies. We expect to incur licensing costs in the future that could be substantial, as we increase our efforts to license existing product candidates.

     The following table summarizes our product development initiatives for the three months ended March 31, 2004 and 2003. Included in this table is the research and development expense recognized in connection with each product candidate currently in clinical development and all preclinical product candidates as a group.

(1)

Many of our research and development costs are not attributable to any individual project because we use resources across several development projects. We record direct costs, including personnel costs and related benefits and stock-based compensation, on a project-by-project basis. We record indirect costs that support a number of our research and development activities in the aggregate.

(2)

We have both pediatric and adult amoxicillin formulations in clinical development.

(3)

We have entered into an agreement under which GlaxoSmithKline will be responsible for funding future clinical development of this product.

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     Conducting clinical trials is a lengthy, time-consuming and expensive process. As of March 31, 2004 we have four pulsatile drug products in Phase I/II clinical trials and we have not completed such trials and additional studies in animals to extrapolate proper dosage for Phase III clinical efficacy trials in humans. The commencement and rate of completion of clinical trials for our products may be delayed by many factors, including:

•

lack of efficacy during the clinical trials;

•

unforeseen safety issues;

•

slower than expected rate of patient recruitment; or

•

government or regulatory delays.

     In addition, we may encounter regulatory delays or rejections as a result of many factors, including results that do not support our claims, perceived defects in the design of clinical trials and changes in regulatory policy during the period of product development. Our business, financial condition and results of operations may be materially adversely affected by any delays in, or termination of, our clinical trials or a determination by the FDA that the results of our trials are inadequate to justify regulatory approval. As part of our commercialization strategy, we may seek to establish collaborative relationships for some of our products in order to help us develop and market some of these product candidates. There can be no assurance that we will be successful in doing so. As a result of these risks and uncertainties, we are unable to estimate the specific timing and future costs of our clinical development programs or the timing of material cash inflows, if any, from our product candidates.

     General and Administrative Expenses. General and administrative expenses consist primarily of salaries and other related costs for personnel serving executive, finance, accounting, information technology and human resource functions. Other costs include facility costs not otherwise included in research and development expense and professional fees for legal and accounting services. We expect that our general and administrative expenses will increase as we add personnel and become subject to the reporting obligations applicable to public companies. Our general and administrative expenses have increased as a result of our expansion into a new facility in the second half of 2003.

     Stock-Based Compensation. We have recorded deferred stock-based compensation expense in connection with the grant of stock options to employees. Deferred stock-based compensation for options granted to employees is the difference between the fair value for financial reporting purposes of our common stock on the date such options were granted and their exercise price. We recorded amortization of deferred stock-based compensation related to employees of approximately $1.1 million for the three-month period ended March 31, 2004.

     We recorded stock-based compensation expense of $278,000 during the three-month period ended March 31, 2004, for options granted to non-employee consultants and scientific advisory board (''SAB’’) members in accordance with Statement of Financial Accounting Standards No. 123 based on the fair value of the equity instruments issued. Stock-based compensation for options granted to non-employee consultants and SAB members is periodically remeasured as the underlying options vest in accordance with Emerging Issues Task Force Issue No. 96-18. We will recognize an expense for such options throughout the vesting period as the services are provided by the non-employee consultants and SAB members. As of March 31, 2004, the balance of unamortized stock-based compensation for options granted to non-employees was approximately $500,000. This amount will be adjusted based on changes in the fair value of the options at the end of each reporting period.

     Interest Income (Expense). Interest income consists of interest earned on our cash, cash equivalents and short-term investments. Interest expense consists of interest incurred on borrowings net of interest capitalized.

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     Net Losses. We have a limited history of operations. We anticipate that our quarterly results of operations will fluctuate for the foreseeable future due to several factors, including payments made or received pursuant to licensing or collaboration agreements, progress of our research and development efforts, and the timing and outcome of regulatory approvals. Our limited operating history makes predictions of future operations difficult or impossible. Since our inception, we have incurred significant losses. As of March 31, 2004, we had an accumulated deficit of approximately $54.7 million. We anticipate incurring additional losses, which may increase, for the foreseeable future.

Collaboration Agreements

Our Collaboration with GlaxoSmithKline

     In July 2003, we entered into a license agreement with GlaxoSmithKline pursuant to which we licensed patents and PULSYS technology to GSK for use with its Augmentin (amoxicillin/clavulanate combination) products and with limited other amoxicillin products. Under the agreement, GSK will be responsible, at its cost and expense, to use commercially reasonable efforts for the clinical development, manufacture and sale of the licensed products. We received an initial non-refundable, non-creditable payment of $5 million from GSK upon signing of the agreement, a $3 million payment upon achievement of the first milestone, and would be entitled to receive additional milestone payments from GSK not to exceed an aggregate of $49 million if it achieves certain product development goals, including commencement of clinical trials and the filing and approval of an NDA with the FDA. In addition, we will receive royalty payments on the commercial sale of products developed under the agreement. We may also receive sales milestone payments of up to $50 million if specified annual sales goals are achieved. The agreement provides for the payment of royalties in each country for at least ten years from the date of the first commercial sale of any licensed product in such country, but the agreement may be terminated at any time by GSK upon relatively short notice or terminated by either party upon a material breach of the agreement by, or the bankruptcy of, the other party. Our receipt of milestone payments, royalty payments and sales milestone payments under the agreement will depend on the ability of GSK to develop and commercialize the products covered by the agreement and is subject to certain conditions and limitations. We cannot assure you that we will receive any additional milestone or royalty payments or that our collaboration with GSK will result in the approval and marketing of any drug.

Our Collaborations with Par Pharmaceutical

     In September 2003, we entered into an agreement pursuant to which we licensed to Par Pharmaceutical the distribution and marketing rights to our generic clarithromycin product. We expect that the new formulation and subsequent bioequivalence studies will involve an expanded relationship with Par, whereby Par will assume many of the clinical manufacturing responsibilities for the generic product and the filing of the abbreviated new drug application (ANDA). We are entitled to receive milestone payments from Par Pharmaceutical not to exceed an aggregate of $6 million upon achievement of certain goals, including acceptance of an ANDA by the FDA and commercial launch of the product. In addition, we will receive royalty payments equal to over 50% of the net profits from the sale of the product, which royalty rate may be reduced to an amount as low as 25% at our election, upon the assumption by Par Pharmaceutical of certain of our obligations and risks relating to the development of the product. The agreement has an indefinite term, but may be terminated at any time by Par Pharmaceutical upon relatively short notice. Our receipt of milestone and royalty payments under the agreement are subject to certain conditions and limitations and will depend on our success in developing the product and the ability of Par Pharmaceutical to commercialize and sell the product. We cannot assure you that we will receive any milestone or royalty payments or that our collaboration with Par Pharmaceutical will result in the marketing of any drug. Par Pharmaceutical has the right to refrain from marketing activities upon the occurrence of certain events, such as the assertion of patent infringement

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claims. In addition, subject to a limited exception, we will be obligated to pay for one-half of any costs, expenses or damages resulting from any claims for patent infringement.

     In March 2004, we signed a letter of intent with Par Pharmaceutical as our strategic partner to develop and commercialize our pulsatile amoxicillin products. Under the terms of the letter of intent, we would receive a fee of $5 million and a commitment from Par Pharmaceutical to fund all further development expenses in exchange for granting Par Pharmaceutical the exclusive right to sell Amoxicillin PULSYS and the co-exclusive right to market the products. The two parties intend to jointly fund and run the marketing and sales program and to share operating profits from product sales on an equal basis. We would be responsible for the manufacturing program, would retain all patents and trademarks, and would be responsible for patent and trademark enforcement. The parties expect to negotiate and finalize a definitive agreement, but cannot assure you that a definitive agreement will be entered into in accordance with these terms, or at all.

Results of Operations

Three months ended March 31, 2004 compared to three months ended March 31, 2003

     Revenues. We recorded revenues of $313,000 during the three months ended March 31, 2004 and did not record any revenues during the three months ended March 31, 2003. Revenues in 2004 represent the amortization of a $5.0 million upfront payment received from GlaxoSmithKline (GSK) in July 2003, which is expected to be amortized into revenue on a straight-line basis through June 2007.

     Research and Development Expenses. Research and development expenses increased by $5.4 million, or 215%, to $7.9 million for the three months ended March 31, 2004 compared to $2.5 million for the three months ended March 31, 2003. Research and development expense consists of direct costs which include salaries and related costs of research and development personnel, and the costs of consultants, materials and supplies associated with research and development projects, as well as clinical studies. Indirect research and development costs include facilities, depreciation, patents and other indirect overhead costs.

     The following table discloses the components of research and development expenses reflecting all of our project expenses.

     Direct costs increased $4.3 million primarily as a result of increases of $3.5 million relating to the development of our pulsatile amoxicillin, pulsatile metronidazole and generic clarithromycin product candidates, plus an increase of $0.9 million relating to the evaluation of new preclinical product candidates. Increased project staffing levels in 2004 versus 2003 resulted in an increase of $ 1.1 in personnel, benefits and related costs. Stock-based compensation of $ 0.7 million in 2004 is related to both employees and non-employee consultants.

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     Contract research and development, consulting, materials and other direct costs increased $1.1 million in preparation for our clinical trials. Our clinical trials expense increased $1.5 million due to an increase in the number of subjects dosed. We conducted a total of five Phase I/II clinical trials in the three months ended March 31, 2004, consisting of one for our pulsatile amoxicillin adult product, three for our pulsatile amoxicillin pediatric product, and one for our pulsatile metronidazole product. In the three months ended March 31, 2003, we conducted two Phase I/II clinical trials for our generic clarithromycin product candidate.

     Indirect project costs also increased by $1.1 million, primarily due to an increase in facility-related costs of $0.4 million, depreciation of $0.2 million, and overhead of $0.5 million due to the opening of our new corporate, research and development facility.

     During the remainder of 2004, and thereafter, research and development expense is expected to increase substantially as we conduct an increased number of clinical trials.

     General and Administrative Expenses. General and administrative expenses increased $2.5 million, or 341%, to $3.2 million for the three months ended March 31, 2004 from $0.7 million for the three months ended March 31, 2003.

     General and administrative expenses consist of salaries and related costs for executive and other administrative personnel, as well as professional fees and facility costs. Salaries, benefits and related costs for personnel increased $0.5 million in 2004 due to higher compensation and benefits expenses related to new hires, as well as higher recruiting costs. Stock-based compensation related to employees was $0.7 million in 2004, while there was no similar expense in the same period in 2003. Legal and consulting costs increased $0.6 million due to increased legal support activities in 2004 primarily related to our transition to a publicly-listed corporation, as well as consulting fees incurred in support of business development and other activities. Other expenses increased $0.8 million, primarily due to increased business development and market research costs of $0.3 million, increased audit fees of $0.1 million, higher costs related to the new corporate, research and development facility of $0.1 million, and increased insurance and other expenses of $0.3 million.

     Net Interest Income (Expense). Net interest income in the three months ended March 31, 2004 was $190,000 compared to net interest expense of $15,000 in the three months ended March 31, 2003. The increase in net interest income was primarily due to the increase in cash, cash equivalents and marketable securities in 2004, which generated substantially higher interest income.

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Liquidity and Capital Resources

     We have funded our operations principally with the proceeds of $54.5 million from a series of five preferred stock offerings and one issue of convertible notes over the period 2000 through 2003 and the net proceeds of $54.3 million from our initial public offering in October 2003.

Cash and Marketable Securities

     At March 31, 2004, cash, cash equivalents and marketable securities were $56.8 million compared to $65.1 million at December 31, 2003.

     Our cash and cash equivalents are highly liquid investments with a maturity of 90 days or less at date of purchase and consist of time deposits, investments in money market funds with commercial banks and financial institutions, and commercial paper of high-quality corporate issuers. Our marketable securities are also highly-liquid investments and are classified as available-for-sale, as they can be utilized for current operations. Our investment policy requires the selection of high-quality issuers, with bond ratings of AAA to A1+/ P1. Our objective is to maintain its investment portfolio at an average duration of approximately one year.

     Also, we maintain cash balances with financial institutions in excess of insured limits. We do not anticipate any losses with respect to such cash balances.

Cash Flow

     The following table summarizes our sources and uses of cash and cash equivalents for the three-month periods ending March 31, 2004 and 2003.

     Net cash used in operating activities in the three-month period ending March 31, 2004 was $5.5 million, primarily due to the net loss of $10.6 million as adjusted for noncash charges and the timing of revenue recognition. The differences between revenue in the net loss and cash receipts and between expenses in the net loss and cash expenditures are explained as follows:

Revenue / Cash Receipts: Revenue included in the net loss was $0.3 million, although cash receipts in 2004 were $3.0 million. The difference of $2.7 million results from two factors: First, the revenue of $0.3 million represents the amortization in 2004 of a $5.0 million cash payment from GSK received in July 2003. Second, cash received from GSK in 2004 of $3.0 million was previously recognized as revenue in 2003, when the milestone was achieved, and a receivable was recorded at that time. The $2.7 million difference between revenue and cash

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receipts is included in the working capital account changes of $3.0 million in accounts receivable and $0.3 million in deferred contract revenue.

Expenses / Cash Expenditures: Expenses included in the net loss were $10.9 million, compared to cash expenditures for operating activities of $8.5 million. The difference of $2.4 million is attributable to non-cash expense charges of $2.1 million and working capital account changes related to expenses of $0.3 million. The non-cash expense charges of $2.4 million primarily consist of depreciation, stock-based compensation, and amortization of premium on marketable securities.

     Net cash used in operating activities in the three-month period ending March 31, 2003 was $2.5 million, primarily due to the net loss of $3.2 million. The net loss in 2003 did not include the recognition of any revenue, and the company did not receive any upfront or milestone cash payments. The net loss of $3.2 million includes a noncash expense of $0.1 million for depreciation, and expenses of $0.6 million which were recorded in accounts payable and accrued liabilities. Thus, the net cash used in operating activities in the period was $2.5 million.

     Net cash used in investing activities during the three-month period ending March 31, 2004 was $16.9 million. The most significant investing activity was $13.9 million for the purchase of marketable securities, as the Company invested the cash obtained from its October 2003 initial public offering in longer duration securities. Also, the Company spent $3.0 million for purchases of property and equipment, primarily for the build-out of its corporate, research and development facility in Germantown, Maryland.

     Net cash used in investing activities during the three-month period ending March 31, 2003 was $0.8 million. This amount was primarily used for the purchase of equipment for the Company’s research and development operations.

     Net cash provided by financing activities for the three-month period ending March 31, 2004 was $0.6 million. The major financing activities included a loan draw of $0.8 million for equipment financing in connection with the fit-out of the Company’s new corporate, research and development facility and payments of $0.2 million on the Company’s existing borrowings.

     Net cash provided by financing activities for the three-month period ending March 31, 2003 was $4.3 million. The major financing activities included the issuance of $4.5 million of convertible notes in March 2003 to certain of the Company’s existing preferred stockholders. These notes were subsequently converted into Series E Convertible Preferred Stock in July 2003.

Borrowings

     We are a party to four credit facilities for an aggregate amount of $6.4 million used to finance the purchase of equipment and to one loan agreement for $75,000 with a local government development fund. Of the total amount, $3.0 million was outstanding as of March 31, 2004 and $3.4 million was available for future draws, as summarized in the following table:

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     We expect to draw the remaining amount available of $3.3 million under our $5.5 million bank credit line to finance the purchase of additional equipment for our new corporate, research and development facility. We do not currently hedge variable rate borrowings.

Contractual Obligations

     During the three-month period ending March 31, 2004, we spent approximately $2.7 million for capital expenditures, primarily for leasehold improvements and equipment for our new corporate, research and development facility. We expect to acquire an additional $3.3 million of equipment in the remainder of fiscal 2004 to complete the initial fit-out of our corporate, research and development facility. Our $5.5 million line of credit established in July 2003 will be the primary source of funds for this equipment.

Prospective Information

     We expect to incur losses from operations for the foreseeable future. We expect to incur increasing research and development expenses, including expenses related to additions to personnel and clinical trials. We expect that our general and administrative expenses will increase in the future as we expand our business development, legal and accounting staff, add infrastructure and incur a full fiscal year of the additional costs related to being a public company, including directors’ and officers’ insurance, investor relations programs and increased professional fees. Our future capital requirements will depend on a number of factors, including the continued progress of our research and development of product candidates, the timing and outcome of regulatory approvals, payments received or made under current or anticipated collaborative agreements, the costs involved in preparing, filing, prosecuting, maintaining, defending and enforcing patent claims and other intellectual property rights, the acquisition of licenses to new products or compounds, the status of competitive products, the availability of financing and our or our partners’ success in developing markets for our product candidates. We believe our existing cash, cash equivalents and marketable securities will be sufficient to fund our operating expenses, debt repayments and capital equipment requirements for at least the next two years.

     Except for the equipment lines of credit described above, we have no credit facility or other committed sources of capital. To the extent our capital resources are insufficient to meet future capital requirements, we will need to raise additional capital or incur indebtedness to fund our operations. There can be no assurance that additional debt or equity financing will be available on acceptable terms, if at all. If adequate funds are not available, we may be required to delay, reduce the scope of or eliminate our research and development programs, reduce our commercialization efforts or obtain funds through arrangements with collaborative partners or others that may require us to relinquish rights to certain product candidates that we might otherwise seek to develop or commercialize independently. Any future funding may dilute the ownership of our equity investors.

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Recent Accounting Pronouncements

     In January 2003, the FASB issued FIN 46, “Consolidation of Variable Interest Entities,” an interpretation of Accounting Research Bulletin No. 51, “Consolidated Financial Statements.” FIN 46 establishes accounting guidance for consolidation of variable interest entities that function to support the activities of the primary beneficiary. In December 2003, the FASB issued FIN 46 (revised December 2003), “Consolidation of Variable Interest Entities.” This revised interpretation is effective for all entities no later than the end of the first reporting period that ends after March 15, 2004. The Company has no investment in or contractual relationship or other business relationship with a variable interest entity and therefore the adoption of this interpretation did not have any impact on the Company’s financial position or results of operations. However, if the Company enters into such an arrangement with a variable interest entity in the future or an entity with which the Company has a relationship is reconsidered based on guidance in FIN 46 to be a variable interest entity, the Company’s financial position or results of operations might be impacted.

Critical Accounting Policies and Estimates

     Our discussion and analysis of our financial condition and results of operations are based on our financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities and expenses. On an ongoing basis, we evaluate our estimates and judgments, including those related to accrued expenses, fair valuation of stock related to stock-based compensation and income taxes. We based our estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions.

     We believe the following critical accounting policies affect our more significant judgments and estimates used in the preparation of our financial statements.

     Revenue Recognition. We use the milestone payment method of revenue recognition when all milestones in respect of payments to be received under contractual arrangements are determined to be substantive, at-risk and the culmination of an earnings process. Substantive milestones are payments that are conditioned upon events requiring substantive effort, when the amounts of the milestones are reasonable relative to the time, effort and risk involved in achieving them and when the milestones are reasonable relative to each other and the amount of any up-front payment. If these criteria are not met, the timing of the recognition of revenue from the milestone payment may vary.

     Accrued Expenses. As part of the process of preparing financial statements, we are required to estimate accrued expenses for services performed and liabilities incurred. This process involves identifying services that have been performed on our behalf and estimating the level of service performed and the associated cost incurred for such service as of each balance sheet date in our financial statements. Examples of estimated accrued expenses for services include professional service fees, such as lawyers and accountants, contract service fees, such as amounts paid to clinical monitors, data management organizations and investigators in conjunction with clinical trials, and fees paid to contract manufacturers in conjunction with the production of clinical materials. In connection with such service fees, our estimates are most affected by our understanding of the status and timing of services provided relative to the actual levels of services incurred by such service providers. The majority of our service providers invoice us monthly in arrears for services performed. In the event that we do not identify certain costs that have begun to be incurred or we under- or over-estimate the level of services performed or the costs of such services, our reported expenses for such period would be too low or too high. The date on which certain services commence, the level of services performed on or before a given date and the cost of such

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services are often judgmental. We make these judgments based upon the facts and circumstances known to us in accordance with generally accepted accounting principles. We also make estimates for other liabilities incurred, including health insurance costs for our employees. We are self-insured for claims made under our health insurance program and record an estimate at the end of a period for claims not yet reported. Our risk exposure is limited, as claims over a maximum amount are covered by an aggregate stop loss insurance policy.

     Stock-Based Compensation. We have elected to follow APB Opinion No. 25, Accounting for Stock Issued to Employees, and related interpretations, in accounting for our stock-based compensation plans, rather than the alternative fair value accounting method provided for under SFAS No. 123, “Accounting for Stock-Based Compensation.” In the notes to our financial statements we provide pro forma disclosures in accordance with SFAS No. 148 and related pronouncements. We account for transactions in which services are received in exchange for equity instruments based on the fair value of such services received from non-employees or of the equity instruments issued, whichever is more reliably measured, in accordance with SFAS No. 123 and EITF Issue No. 96-18. The factors which are most likely to affect charges or credits to operations related to stock-based compensation are the fair value of the common stock underlying stock options for which stock-based compensation is recorded and the volatility of such fair value. Since the Company’s initial public offering in October 2003, we have used the quoted market price of our common stock as the fair value, and we have established an estimate for volatility by considering the volatility of the stock of other comparable public companies.

     Income Taxes. As part of the process of preparing our financial statements we are required to estimate our income taxes in each of the jurisdictions in which we operate. We account for income taxes by the liability method. Under this method, deferred income taxes are recognized for tax consequences in future years of differences between the tax bases of assets and liabilities and their financial reporting amounts at each year-end, based on enacted laws and statutory tax rates applicable to the periods in which the differences are expected to affect taxable income. Valuation allowances are provided if, based upon the weight of available evidence, it is more likely than not that some or all of the deferred tax assets will not be realized. We have not recorded any tax provision or benefit for the the three months ended March 31, 2004 and 2003. We have provided a valuation allowance for the full amount of our net deferred tax assets since realization of any future benefit from deductible temporary differences and net operating loss carry forwards cannot be sufficiently assured at December 31, 2003 and March 31, 2004.

Forward-looking Statements

     This report contains forward-looking statements. These statements relate to future events or to our future financial performance, and involve known and unknown risks, uncertainties and other factors that may cause our actual results, levels of activity, performance or achievements to be materially different from any future results, levels of activity, performance or achievements expressed or implied by these forward-looking statements. In some cases, forward-looking statements may be identified by the use of words such as “may,” “could,” “expect,” “intend,” “plan,” “seek,” “anticipate,” “believe,” “estimate,” “predict,” “potential,” “continue,” or the negative of these terms or other comparable terminology. You should not place undue reliance on forward-looking statements since they involve known and unknown risks, uncertainties and other factors which are, in some cases, beyond our control and which could materially affect actual results, levels of activity, performance or achievements. Factors that may cause actual results to differ materially from current expectations include, but are not limited to:

•

general economic and business conditions;

•

changes in governmental laws and regulations relating to the development and commercialization of pharmaceutical products;

•

the financial condition of our collaborative partners; and

•

competition in our industry.

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     All written and oral forward-looking statements made in connection with this report on Form 10-Q which are attributable to us or persons acting on our behalf are expressly qualified in their entirety by the “Risk Factors” and other cautionary statements included in our 2003 Annual Report on Form 10-K. We disclaim any obligation to update information contained in any forward-looking statement.

Item 3. Quantitative and Qualitative Disclosures About Market Risk

     Our exposure to market risk is currently confined to our cash and cash equivalents, marketable securities, and restricted cash that generally have maturities of less than one year. We currently do not hedge interest rate exposure. We have not used derivative financial instruments for speculation or trading purposes. Because of the short-term maturities of our cash, cash equivalents and marketable securities, we do not believe that an increase in market rates would have any significant impact on the realized value of our investments, but may increase the interest expense associated with our debt.

     Our most liquid assets are cash, cash equivalents and marketable securities. Because of their liquidity, these assets are not directly affected by inflation. We also believe that we have intangible assets in the value of our intellectual property. In accordance with generally accepted accounting principles, we have not capitalized the value of this intellectual property on our balance sheet. Due to the nature of this intellectual property, we believe that these intangible assets are not affected by inflation. Because we intend to retain and continue to use our equipment, furniture and fixtures and leasehold improvements, we believe that the incremental inflation related to replacement costs of such items will not materially affect our operations. However, the rate of inflation affects our expenses, such as those for employee compensation and contract services, which could increase our level of expenses and the rate at which we use our resources.

Item 4. Controls and Procedures

     Our management, including our principal executive and principal financial officers, has evaluated the effectiveness of our disclosure controls and procedures as of March 31, 2004. Our disclosure controls and procedures are designed to provide reasonable assurance that the information required to be disclosed in this Form 10-Q quarterly report has been appropriately recorded, processed, summarized and reported. Based on that evaluation, our principal executive and principal financial officers have concluded that our disclosure controls and procedures are effective at the reasonable assurance level.

     Our management, including our principal executive and principal financial officers, has evaluated any changes in our internal control over financial reporting that occurred during the quarterly period ended March 31, 2004, and has concluded that there was no change that occurred during the quarterly period ended March 31, 2004 that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

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PART II - OTHER INFORMATION

Item 1. Legal Proceedings.

     None

Item 2. Changes in Securities, Use of Proceeds, and Issuer Purchases of Equity Securities

     From October 15, 2003, the effective date of our Registration Statement on Form S-1 (File No. 333-107599) to March 31, 2004, we have not used any of the net offering proceeds from our initial public offering, as we have funded our net cash used in operating activities and our capital expenditures with cash on hand prior to the offering.

     We currently intend to use the proceeds of the offering for research and development activities, including clinical trials for our product candidates, purchases of capital equipment, licensing activities and other general corporate purposes. The amount and timing of our actual expenditures will depend on numerous factors, including the progress of our research and development activities and clinical trials, the number and breadth of our product development programs, our ability to establish and maintain corporate collaborations and other arrangements, and the amount of cash, if any, generated by our operations. We will retain broad discretion in the allocation and use of the proceeds of the offering. Pending application of the proceeds, as described above, we have invested the proceeds in short-term, investment-grade, interest-bearing securities.

Item 3. Defaults Upon Senior Securities

     None

Item 4. Submission of Matters to Vote of Security Holders

     None

Item 5. Other Information

     None

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Item 6. Exhibits and Reports on Form 8-K

(a)

Exhibits

	10.1		Executive Employment Agreement between the Company and Barry Hafkin, M.D. dated March 15, 2004.
	31.1		Rule 13a-14(a) Certification of Principal Executive Officer.
	31.2		Rule 13a-14(a) Certification of Principal Financial Officer.
	32.1		Section 1350 Certification of Chief Executive Officer.
	32.2		Section 1350 Certification of Chief Financial Officer.

(b)

Reports on Form 8-K

     We filed a Current Report on Form 8-K, on February 12, 2004, furnishing our financial results for the year ended December 31, 2003. We filed a Current Report on Form 8-K, on April 29, 2004, furnishing our financial results for the three months ended March 31, 2004.

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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.

	ADVANCIS PHARMACEUTICAL CORPORATION
	By:	/s/ EDWARD M. RUDNIC
		Edward M. Rudnic, Ph.D.
		Chairman of the Board, President and Chief Executive Officer
	By:	/s/ STEVEN A. SHALLCROSS
		Steven A. Shallcross
		Senior Vice President and Chief Financial Officer

Dated: May 7, 2004

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EXHIBIT INDEX

Exhibit Number
10.1		Executive Employment Agreement between the Company and Barry Hafkin, M.D. dated March 15, 2004.
31.1		Rule 13a-14(a) Certification of Principal Executive Officer.
31.2		Rule 13a-14(a) Certification of Principal Financial Officer.
32.1		Section 1350 Certification of Chief Executive Officer.
32.2		Section 1350 Certification of Chief Financial Officer.