ADVANCIS PHARMACEUTICAL CORP - 10-Q Quarterly 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 þ No o

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

As of August 3, 2004, 22,799,448 shares of common stock of the Registrant were outstanding.

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 and six months ended June 30, 2004 are not necessarily indicative of the results that may be expected for the fiscal year ending December 31, 2004.

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.

Contract revenues include license fees and milestone payments associated with collaborations with third parties. Revenue from non-refundable, upfront license fees where the Company has continuing involvement is recognized ratably over the development or agreement period. Revenue associated with performance milestones is recognized based upon the achievement of the milestones, as defined in the respective agreements.

Revenue for reimbursement of development costs is recognized as the actual costs to perform the work are incurred. Revenue recognized is limited to minimum amounts expected to be received under the specific agreements and excludes amounts contingent on future events, such as successful commercialization, and amounts that are contingently refundable.

Royalties from licensees are based on third-party sales of licensed products and will be recorded in accordance with contract terms when third-party results are reliably measurable and collectibility is reasonably assured.

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 accumulated other 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.

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.

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 and six months ended June 30, 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:

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.

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. Relative to the GSK agreement, the Company recognized revenue of $312,500 and $625,000 in the three and six months ended June 30, 2004, respectively, which represent amortization of the $5.0 million upfront payment. The remaining balance of $3,750,000 is expected to be amortized to revenue on a straight-line basis through June 2007.

In May 2004, the Company entered into an agreement with Par Pharmaceutical to collaborate in the further development and commercialization of a PULSYS-based amoxicillin product. The Company will conduct the development program, including the manufacture of clinical supplies and the conduct of clinical trials, and be responsible for obtaining regulatory approval for the product. The Company will own the product trademark and manufacture or arrange for supplies of the product for commercial sales. Par will be the sole distributor of the product. Both parties will share commercialization expenses, including pre-marketing costs and promotion costs, on an equal basis. Operating profits from sales of the product will also be shared on an

equal basis. Under the agreement, the Company received an upfront fee of $5.0 million and a commitment from Par to fund all further anticipated development expenses. Development expenses incurred by the Company will be funded by quarterly payments aggregating $28 million over the period from July 2004 through October 2005. Revenue related to the receipt of the quarterly payments is recognized based on actual costs incurred as the work is performed, with the balance of cash received in excess of actual costs incurred recorded as deferred revenue. The excess of the development costs incurred by the Company over the quarterly payments aggregating $28 million to be made by Par will be funded subsequent to commercialization, by the distribution to the Company of Par’s share of operating profits, if any, until the excess amount has been reimbursed. The Company does not record any amounts as revenue on a current basis which are dependant on achievement of future operating profits. Relative to the Par agreement, the $5.0 million upfront payment is being amortized on a straight-line basis through May 2007, with $138,889 recognized as contract revenue for both the three and six month periods ended June 30, 2004, and $4,861,111 recorded as deferred revenue as of June 30, 2004. Revenue recognized by the Company for reimbursement of development expenses for both the three and six month periods ended June 30, 2004 was $403,065.

Marketable securities, including accrued interest, at June 30, 2004 were as follows:

Maturities of the Company’s marketable securities at June 30, 2004 are as follows:

During the six month period ended June 30, 2004, the Company expended approximately $3.6 million for the construction of its corporate, research and development facility and purchase of equipment. In addition, the Company made deposits of $296,510 for the purchase of equipment for the new facility during the six month period ended June 30, 2004.

On June 30, 2004, the Company acquired the U.S. rights to the Keflex brand of cephalexin from Eli Lilly and Company. The purchase price was $11.2 million, including transaction costs, which was paid in cash from the Company’s working capital. The asset purchase includes the exclusive rights to manufacture, market and sell Keflex in the United States (including Puerto Rico). The Company also acquired Keflex trademarks, technology and new drug applications (NDAs) supporting the approval of Keflex.

The fair market values of the individual Keflex intangible assets acquired are currently being evaluated by an independent valuation firm. The Company expects to record the individual fair market values of these intangible assets before September 30, 2004.

In July 2003, the Company entered into a $5.5 million line of credit facility with a bank to finance the purchase of equipment primarily associated with the fit-out of the Company’s corporate, research and development facility. The loan 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 is secured by 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 six month period ended June 30, 2004, the Company drew down $807,249 under the line of credit. The Company drew an additional $582,148 prior to expiration of the line of credit on July 31, 2004. The expiration of the line of credit did not affect the repayment schedules for the draws previously made under the line. The Company is negotiating with the bank to extend and increase the line of credit to fund the purchase of additional equipment.

On February 25, 2004, March 31, 2004, and June 3, 2004, the Company granted stock options to purchase up to 907,850, 181,600 and 144,900 shares of common stock, respectively, to certain employees and directors. The exercise price of the options is the fair market price of the Company’s stock on the grant date.

In April 2004, the Company’s board of directors increased the aggregate number of shares available for issuance under the stock incentive plan to 6,348,182, of which 1,930,318 shares remain available for issuance as of June 30, 2004.

Effective May 1, 2004, James D. Isbister retired as the chairman of the board of directors. At that time, the Company entered into an agreement with Mr. Isbister which provides for a payment to him of up to $100,000 per year in exchange for consulting services. The initial term of the agreement is for 40 months, and it may be renewed by mutual agreement.

Also on May 1, 2004, Mr. Isbister and the Company entered into an agreement to amend the stock option agreements with Mr. Isbister, to provide for the continued vesting of unvested restricted stock and for accelerated vesting in the event of a termination by the Company of the consulting agreement with Mr. Isbister or a defined change in control of the Company. As a result of his change in status from director to consultant and the Company waiving its right to repurchase the restricted stock issued for options which had been early exercised by Mr. Isbister, the Company recorded a stock-based compensation charge of $489,951.

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.”

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 anti-infective drugs based on our novel biological finding that bacteria exposed to antibiotics in front-loaded, staccato bursts, or “pulses,” are killed more efficiently and effectively than those under 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 June 30, 2004, we had five PULSYS antibiotic compounds in Phase I/ II clinical trials and an additional four PULSYS product candidates in advanced in vitro preclinical development. We are also developing a non-pulsatile, generic formulation of the antibiotic Biaxin XL. In addition, in June 2004 we acquired the U.S. rights to manufacture, market, and sell the Keflex brand of cephalexin from Eli Lilly and Company. We expect to begin development of a once-a-day cephalexin using our PULSYS technology. With the acquisition of Keflex, we now have under development PULSYS versions of three of the top five most-prescribed antibiotics in the United States.

General. Our future operating results will depend largely on the magnitude of payments from our current and potential future collaborative 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, through June 30, 2004, had 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, together with revenue from product sales of Keflex. 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.

To date, we have entered into three collaborative agreements. We received a payment of $5 million from GlaxoSmithKline upon signing of our license agreement in July 2003, which has been deferred and is being 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 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. In May 2004, we entered into an agreement with Par Pharmaceutical to develop and commercialize amoxicillin PULSYS, and we received an upfront payment of $5 million upon signing the agreement which will be amortized over the development period. Par has committed to fund future anticipated development expenses under this agreement.

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 and six month periods ended June 30, 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 share 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. We have entered into an agreement under which Par Pharmaceutical will be responsible for funding the anticipated future development costs of this product. See “Our Collaboration with Par Pharmaceutical for Amoxicillin PULSYS.”

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

Conducting clinical trials is a lengthy, time-consuming and expensive process. As of June 30, 2004, we had five PULSYS antibiotic compounds in Phase I/ II clinical trials and an additional four PULSYS product


	•	completion of preclinical development;

	•	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.

Stock-Based Compensation. We have recorded deferred stock-based compensation expense in connection with the grant of certain 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 $1.0 million and $2.0 million for the three and six-month periods ended June 30, 2004, respectively. In addition, we recorded a one-time charge of $500,000 related to the retirement of our former Chairman.

We recorded stock-based compensation expense of ($153,000) and $125,000 during the three and six month periods ended June 30, 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 June 30, 2004, the balance of unamortized stock-based compensation for options granted to non-employees was approximately $300,000. 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 primarily of interest earned on our cash, cash equivalents and short-term investments. Interest expense consists of interest incurred on borrowings net of interest capitalized.

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 June 30, 2004,

In July 2003, we entered into a license agreement with GlaxoSmithKline (GSK) 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.

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 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. We cannot assure you that we will receive any additional milestone or royalty payments or that our collaboration with Par will result in the approval and marketing of any drug.

In May 2004, we entered into an agreement with Par Pharmaceutical to collaborate in the further development and commercialization of a PULSYS-based amoxicillin product. We will design the develop-

ment program, including the manufacturing of clinical supplies and the conducting of clinical trials, and be responsible for obtaining regulatory approval for the product. We will own the product trademark and manufacture or arrange for supplies of the product for commercial sales. Par will be the sole distributor of the product. Both parties will share commercialization expenses, including pre-marketing costs and promotion costs, on an equal basis. Operating profits from sales of the product will also be shared on an equal basis.

Under the agreement, we received an upfront fee of $5 million and a commitment from Par to fund all further anticipated development expenses. Development expenses incurred by us will be funded by quarterly payments from Par aggregating $28 million over the period from July 2004 through October 2005. The excess of the development costs incurred by us over the quarterly payments aggregating $28 million made by Par will be funded subsequent to commercialization, by the distribution to us of Par’s share of operating profits, if any, until the excess amount has been reimbursed.

The agreement may be terminated by Par, either for cause, in the event of material increases in development costs or delays in program timing, or for other reasons. In the event that Par terminates the agreement for cause, no further quarterly development payments will be due to us; further, if we commercialize the product subsequent to Par’s termination and if Par has funded at least $20 million in development payments at the time of termination, Par will have a right to be paid a percentage of its development payments from future net operating profits on product sales, if any. In the event of termination for other reasons, Par will be required to pay to us the lesser of (1) the excess of our cumulative development costs over the cumulative quarterly payments made by Par or (2) the difference between the cumulative quarterly payments actually made by Par through the termination date and the total of the quarterly payments specified in the agreement. We cannot assure you that we will receive any additional payments or that our collaboration with Par will result in the approval and marketing of any drug.

For accounting purposes, we are recognizing revenue for the upfront fee on a straight line basis over the estimated development period. We are recognizing revenue for reimbursement of development costs as the actual costs to perform the work are incurred. Revenue recognized is limited to minimum amounts expected to be received under the specific agreements and excludes amounts contingent on future events, such as successful commercialization, and amounts that are contingently refundable.

On June 30, 2004, we acquired the U.S. rights to the Keflex brand of cephalexin from Eli Lilly and Company. The purchase price was $11.2 million, including transaction costs, which was paid in cash from our working capital. The asset purchase includes the exclusive rights to manufacture, market and sell Keflex in the United States (including Puerto Rico). We also acquired Keflex trademarks, technology and new drug applications (NDAs) supporting the approval of Keflex. In addition, on June 30, 2004, we entered into a manufacturing supply agreement with Eli Lilly, under which Lilly has agreed to sell certain Keflex product inventory to us and to continue to manufacture and supply Keflex products for us for a transition period, unless we terminate the agreement at an earlier date. Any manufacturing orders are subject to minimum and maximum quantities, and purchase prices are fixed in the agreement. After the transition period, we will assume manufacturing responsibility, and we initially plan to enter into our own third-party agreements. We cannot assure you that we will be able to enter into satisfactory third-party manufacturing agreements for the manufacture and supply of Keflex products or that any agreements entered into will result in an adequate supply of Keflex products for us to sell and distribute.

In addition to assuming sales and marketing responsibilities for Keflex, we expect to begin clinical development of an enhanced cephalexin utilizing Advancis’ proprietary once-a-day pulsatile dosing technology called PULSYS. In the event we are able to develop and commercialize a PULSYS-based Keflex product, another cephalexin product relying on the acquired NDAs, or other pharmaceutical products using the acquired trademarks, Eli Lilly will be entitled to royalties on these new products. Royalties are payable on a new product by new product basis for five years following the first commercial sale for each new product, up to a maximum aggregate royalty per calendar year. All royalty obligations with respect to any defined new product cease after the 15th anniversary of the first commercial sale of the first defined new product.

Revenues. We recorded revenues of $854,000 during the three months ended June 30, 2004 and did not record any revenues during the three months ended June 30, 2003, as follows:

Revenues recognized in 2004 for upfront licensing fees include 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, and the amortization of a $5.0 million upfront payment received from Par Pharmaceutical in May 2004, which is expected to be amortized into revenue on a straight-line basis through May 2007.

Reimbursement of development costs revenue of $403,000 related to the Par amoxicillin agreement was recognized based on the related costs incurred.

Research and Development Expenses. Research and development expenses increased by $3.4 million, or 111%, to $6.4 million for the three months ended June 30, 2004 compared to $3.0 million for the three months ended June 30, 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 $2.3 million primarily as a result of increases of $2.3 million relating to the development of our pulsatile amoxicillin and pulsatile metronidazole product candidates, plus an increase of $0.4 million relating to the evaluation of new preclinical product candidates, less decreases in generic and pulsatile clarithromycin of $0.4 million. Increased project staffing levels in 2004 versus 2003 resulted in an increase of $1.3 million in personnel, benefits and related costs. Stock-based compensation decreased $0.4 million in 2004 primarily due to the effect of the Company’s lower stock price on the variable element of the calculation.

Contract research and development, consulting, materials and other direct costs increased $0.7 million in preparation for our clinical trials. Our clinical trials expense increased $0.7 million primarily due to completion of an adult pulsatile amoxicillin/clarithromycin combination product study during the three months ending June 30, 2004, versus no trials performed within the three months ended June 30, 2003.

Indirect project costs also increased by $1.1 million, primarily due to an increase in facility-related costs of $0.4 million, depreciation of $0.3 million, and overhead of $0.5 million due to the opening of our new corporate, research and development facility. Patent expense declined $0.1 million during the quarter.

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 $2.0 million, or 176%, to $3.1 million for the three months ended June 30, 2004 from $1.1 million for the three months ended June 30, 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 $0.3 million in 2004 due to higher compensation and benefits expenses related to new hires, as well as higher recruiting costs. Stock-based compensation increased $0.9 million, due to the effect of stock option awards in the second half of 2003 and a one-time charge in 2004 of $0.5 million related to the retirement of James Isbister, our former Chairman. Legal and consulting costs increased $0.2 million due to increased legal support activities in 2004 primarily related to collaboration contracts and SEC filings, as well as consulting fees incurred in support of investor relations, none of which were incurred in the prior year. Other expenses increased $0.6 million, primarily due to higher accounting and audit fees, increased insurance premiums, and business development costs.

Net Interest Income (Expense). Net interest income in the three months ended June 30, 2004 was $157,000 compared to net interest expense of $83,000 in the three months ended June 30, 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. Higher interest expense in 2003 versus 2004 primarily related to convertible notes payable outstanding in the second quarter of 2003, but converted in July 2003.

Revenues. We recorded revenues of $1,167,000 during the six months ended June 30, 2004 and did not record any revenues during the six months ended June 30, 2003, as follows:

Revenues recognized in 2004 for upfront licensing fees represent the amortization of a $5.0 million upfront payment received from GlaxoSmithKline in July 2003, which is expected to be amortized into revenue on a straight-line basis through June 2007, and a $5.0 million upfront payment received from Par Pharmaceutical in May 2004, which is expected to be amortized into revenue on a straight-line basis through May 2007.

R&D cost reimbursement revenue of $403,000 related to the Par amoxicillin agreement was recognized based on the related costs incurred. An additional $403,000 of cost-based revenue was deferred and will be recognized upon the removal of future contact contingencies related to termination provisions of the contract.

Research and Development Expenses. Research and development expenses increased by $8.8 million, or 158%, to $14.3 million for the six months ended June 30, 2004 compared to $5.5 million for the six months ended June 30, 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 $6.6 million primarily as a result of increases of $5.7 million relating to the development of our pulsatile amoxicillin, pulsatile metronidazole and generic clarithromycin product candidates, plus an increase of $1.3 million relating to the evaluation of new preclinical product candidates, partially offset by a decrease of $0.4 million relating to the development of our pulsatile clarithromycin product candidate. Increased research and development staffing resulted in increases of $2.3 million in personnel, benefits and related costs and $0.3 million attributable to stock-based compensation. An additional $1.8 million in expenses above 2003 levels was incurred for supplies, materials and contract manufacturing in preparation for our clinical trials. Our clinical trials expense increased $2.2 million due to an increase in the number of subjects dosed. We conducted a total of six Phase I/ II clinical trials in the six months ended

June 30, 2004, consisting of one for our pulsatile amoxicillin adult product, three for our pulsatile amoxicillin pediatric product, one for our pulsatile amoxicillin/clarithromycin combination product, and one for our pulsatile metronidazole product. In the six months ended June 30, 2003, we conducted two Phase I/ II clinical trials for our generic clarithromycin product candidate.

Indirect project costs increased by $2.2 million to $3.2 million primarily due to increased facility related costs, depreciation and overhead resulting from the expansion in the third quarter 2003 of our corporate, research and development facilities.

During 2004, and thereafter, we expect that research and development expenses will increase substantially as we increase the number of products for which we conduct clinical trials and move into later stage development.

General and Administrative Expenses. General and administrative expenses increased $4.5 million, or 241%, to $6.3 million for the six months ended June 30, 2004 from $1.9 million for the six months ended June 30, 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 $0.7 million in 2004 due to higher compensation and benefits expenses related to new hires, as well as higher recruiting costs. Stock-based compensation increased $1.6 million, due to the effect of stock option awards in the second half of 2003 and a one-time charge in 2004 of $0.5 million related to the retirement of James Isbister, our former Chairman. Legal and consulting costs increased $0.8 million due to increased legal support activities in 2004 primarily related to collaboration contract efforts and SEC filings, as well as annual report costs and consulting fees incurred in support of investor relations, none of which were incurred in the prior year. Other expenses increased $1.4 million from the prior year,attributable to $0.2 million in increased facilities costs resulting from the opening of our facility in Germantown, Maryland, increased expenses of $0.6 million for accounting and auditing costs, directors fees, investor relations and insurance costs due to our change in status from private to public SEC registrant, and $0.6 million for business development and other expenses.

Net Interest Income (Expense). Net interest income in the six months ended June 30, 2004 was $347,000 compared to net interest expense of $98,000 in the six months ended June 30, 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. Higher interest expense in 2003 versus 2004 primarily related to convertible notes payable outstanding in the first half of 2003, but converted in July 2003.

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. Additionally, we have received funding of $8.0 million and $5.0 million from GlaxoSmithKline and Par Pharmaceutical, respectively, as a result of collaboration agreements for the development of new products.

At June 30, 2004, cash, cash equivalents and marketable securities were $41.2 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 limit the investment portfolio to a maximum average duration of approximately one year, with no individual investment exceeding a two year duration.

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.

The following table summarizes our sources and uses of cash and cash equivalents for the six-month periods ending June 30, 2004 and 2003.

Net cash used in operating activities in the six-month period ending June 30, 2004 was $8.1 million, primarily due to the net loss of $19.1 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 $1.2 million, although cash receipts in 2004 were $8.0 million. The difference of $6.8 million is due to timing of revenue recognition compared to collection of cash. Cash receipts of $8.0 million in 2004 consist of a milestone payment of $3.0 million from GSK, which was fully recognized as revenue in 2003 when the milestone was achieved, and an upfront payment of $5.0 million from Par for amoxicillin PULSYS, which has been deferred and is being amortized into revenue over the estimated development period. Revenue in 2004 of $1.2 million consists


	of a total of $0.8 million for amortization of upfront payments and $0.4 million for reimbursement of amoxicillin PULSYS development costs.

	Expenses/ Cash Expenditures: Expenses included in the net loss were $20.3 million, compared to cash expenditures for operating activities of $16.1 million. The difference of $4.2 million is attributable to non-cash expense charges of $4.3 million and working capital account changes related to expenses of ($0.1) million. The non-cash expense charges of $4.2 million primarily consist of depreciation, stock-based compensation, and amortization of premium on marketable securities.

Net cash used in operating activities in the six-month period ending June 30, 2003 was $3.4 million, primarily due to the net loss of $7.5 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 $7.5 million includes noncash expenses of $1.1 million for depreciation and stock-based compensation, expenses of $3.1 million recorded in accounts payable and accrued liabilities, and accrued interest of $0.1 million. Thus, the net cash used in operating activities in the period was $3.4 million.

Net cash used in investing activities during the six-month period ending June 30, 2004 was $20.9 million. The most significant investing activities included the acquisition of Keflex for $11.2 million, and $19.1 million for the purchase of marketable securities, as the Company re-invested the cash obtained from securities reaching maturity as well as invested excess cash. Also, the Company spent $3.9 million for purchases and deposits on 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 six-month period ending June, 2003 was $5.1 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 six-month period ending June 30, 2004 was $0.2 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 $0.6 million on the Company’s existing borrowings.

Net cash provided by financing activities for the six-month period ending June 30, 2003 was $4.7 million. The major financing activities included the issuance of $5.0 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.

We are a party to four credit facilities for an aggregate amount of $5.9 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, $2.6 million was outstanding as of June 30, 2004 and $3.3 million was available for future draws, as summarized in the following table:

We drew $0.6 million of the remaining amount available of $3.3 million under our $5.5 million bank credit line to finance the purchase of additional equipment prior to expiration of the bank credit line on

During the three-month period ending June 30, 2004, we spent approximately $3.6 million for capital expenditures, primarily for leasehold improvements and equipment for our new corporate, research and development facility. We expect to acquire an additional $1.2 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 $0.6 million of this equipment.

In connection with our purchase of Keflex intangibles from Eli Lilly and Company on June 30, 2004, we also agreed to purchase certain finished product inventory by August 31, 2004. The maximum value of this purchase commitment is approximately $0.3 million.

Our amoxicillin development and commercialization agreement with Par may be terminated by Par, either for cause, in the event of increases in development costs or delays in program timing, or for other reasons. In the event that Par terminates the agreement for cause, no further quarterly development payments will be due to us; further, if we commercialize the product subsequent to Par’s termination and if Par has funded at least $20 million in development payments at the time of termination, Par will have a right to be paid a percentage of its development payments from future net operating profits on product sales, if any. In the event of termination for other reasons, Par will be required to pay to us the lesser of (1) the excess of our cumulative development costs over the cumulative quarterly payments made by Par or (2) the difference between the cumulative quarterly payments actually made by Par through the termination date and the total of the quarterly payments specified in the agreement. We cannot assure you that we will receive any additional payments or that our collaboration with Par will result in the approval and marketing of any drug.

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.

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. Up-front payments are recorded as deferred revenue. We estimate the length of the remaining development period and amortize an up-front payment over that development period.

We record revenue for reimbursement of development costs as the actual costs to perform the work are incurred. We are required to use judgment in recognizing reimbursement revenue in cases where the agreement provides for funding to us that is not dependent on actual costs we incur within a specific fiscal period. For our collaboration with Par Pharmaceutical for amoxicillin PULSYS, for example, we are entitled to quarterly payments in pre-established amounts that fund our development work. Our policy is to limit revenue recognized to the miminum amounts expected under a specific collaboration agreement and to exclude amounts contingent on future events, such as successful commercialization and future profit-sharing, and amounts that are contingently refundable. Revenue recognized is limited to cumulative amounts under each contract such that, at any time, if a termination of the agreement were to occur, revenue previously recognized would not need to be reversed. Cash received in excess of revenue recognized is recorded as deferred revenue, with the deferred revenue recognized as revenue at the time future events occur that remove the contingencies.

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 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 six months ended June 30, 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 June 30, 2004.

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


	•	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.

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.

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.

Our management, including our principal executive and principal financial officers, has evaluated the effectiveness of our disclosure controls and procedures as of June 30, 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 June 30, 2004, and has concluded that there was no change that occurred during the quarterly period ended June 30, 2004 that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

From October 15, 2003, the effective date of our Registration Statement on Form S-1 (File No. 333-107599) to June 30, 2004, we have used approximately $13.1 million of the net offering proceeds from our initial public offering, as follows:

We currently intend to use the remaining 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 remaining proceeds, as described above, we have invested the proceeds in short-term, investment-grade, interest-bearing securities.

At our Annual Meeting of Stockholders, held on June 3, 2004, the following members were re-elected to the Board of Directors:


+	Confidential treatment requested for certain portions of this Exhibit pursuant to Rule 24b-2 of the Securities Exchange Act of 1934, as amended, which portions are omitted and filed separately with the Securities and Exchange Commission.

We filed a Current Report on Form 8-K, on July 15, 2004, relating to our acquisition from Eli Lilly and Company of the exclusive rights to manufacture, market and sell the Keflex brand of cephalexin in the United States. We filed a Current Report on Form 8-K, on July 29, 2004, furnishing our financial results for the three months ended June 30, 2004.

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.


	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


+	Confidential treatment requested for certain portions of this Exhibit pursuant to Rule 24b-2 of the Securities Exchange Act of 1934, as amended, which portions are omitted and filed separately with the Securities and Exchange Commission.


(Mark One)

þ		QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

		For the quarterly period ended June 30, 2004

or

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

		For the transition period from to


Delaware		52-2208264
(State or other jurisdiction of incorporation or organization)		(I.R.S. employer Identification Number)

20425 Seneca Meadows Parkway Germantown, Maryland (Address of principal executive offices)		20876 (Zip Code)


			Page

PART I — FINANCIAL INFORMATION
	Item 1.	Financial Statements (Unaudited):
		Balance Sheets at June 30, 2004 and December 31, 2003		2
		Statements of Operations for the three and six months ended June 30, 2004 and 2003		3
		Statement of Changes in Stockholders’ Equity for the six months ended June 30, 2004		4
		Statements of Cash Flows for the six months ended June 30, 2004 and 2003		5
		Notes to Financial Statements		6
	Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations		12
	Item 3.	Quantitative and Qualitative Disclosures About Market Risk		26
	Item 4.	Controls and Procedures		26
PART II — OTHER INFORMATION
	Item 1.	Legal Proceedings		27
	Item 2.	Changes in Securities, Use of Proceeds, and Issuer Purchases of Equity Securities		27
	Item 3.	Defaults Upon Senior Securities		27
	Item 4.	Submission of Matters to a Vote of Security Holders		27
	Item 5.	Other Information		28
	Item 6.	Exhibits and Reports on Form 8-K		28
Signatures				29
Exhibit Index				30


			June 30, 2004			December 31, 2003


			(Unaudited)
ASSETS
Current assets:
	Cash and cash equivalents		$	8,722,267		$	37,450,490
	Marketable securities			32,517,430			27,636,632
	Accounts receivable			806,130			3,000,000
	Prepaid expenses and other current assets			1,009,360			1,127,464

		Total current assets		43,055,187			69,214,586
Property and equipment, net				14,603,851			12,512,792
Restricted cash				1,787,705			1,776,569
Deposits				398,930			477,396
Notes receivable				121,500			121,500
Intangible assets, net				11,271,517			72,000

		Total assets	$	71,238,690		$	84,174,843


LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities:
	Accounts payable		$	1,567,329		$	2,683,713
	Accrued expenses			3,599,691			3,757,863
	Lines of credit — current portion			967,946			953,984
	Deferred contract revenue			2,916,667			1,250,000

		Total current liabilities		9,051,633			8,645,560
Lines of credit — non current portion				1,598,885			1,411,604
Note payable				75,000			75,000
Deferred contract revenue				6,097,509			3,125,000
Deferred rent and credit on lease concession				822,099			767,759

		Total liabilities		17,645,126			14,024,923

Commitments and contingencies
Stockholders’ equity:
	Preferred stock, $0.01 par value; 25,000,000 shares authorized; no shares issued and outstanding at June 30, 2004 and December 31, 2003			—			—
	Common stock, $0.01 par value; 225,000,000 shares authorized; 22,687,982 shares and 22,639,344 shares issued and outstanding at June 30, 2004 and December 31, 2003, respectively			226,880			226,394
	Capital in excess of par value			120,711,440			120,141,450
	Deferred stock-based compensation			(4,017,629	)		(6,126,286	)
	Accumulated deficit			(63,212,970	)		(44,102,018	)
	Accumulated other comprehensive income (loss)			(114,157	)		10,380

		Total stockholders’ equity		53,593,564			70,149,920

		Total liabilities and stockholders’ equity	$	71,238,690		$	84,174,843



			Three Months Ended June 30,						Six Months Ended June 30,

			2004			2003			2004			2003


			(Unaudited)
Revenue:
	Contract revenue		$	451,389		$	—		$	763,889		$	—
	Reimbursement of development costs			403,065			—			403,065

		Total revenue		854,454			—			1,166,954			—

Cost and expenses:
	Research and development			6,415,037			3,033,898			14,304,860			5,537,966
	General and administrative			3,086,198			1,120,028			6,319,801			1,853,342

		Total expenses		9,501,235			4,153,926			20,624,661			7,391,308

Loss from operations				(8,646,781	)		(4,153,926	)		(19,457,707	)		(7,391,308	)
Interest income				195,270			16,811			409,687			35,451
Interest expense				(38,641	)		(99,164	)		(62,932	)		(133,606	)

Net loss				(8,490,152	)		(4,236,279	)		(19,110,952	)		(7,489,463	)
Accretion of issuance costs of mandatorily redeemable convertible preferred stock				—			(18,783	)		—			(37,361	)

Net loss applicable to common stockholders			$	(8,490,152	)	$	(4,255,062	)	$	(19,110,952	)	$	(7,526,824	)

Basic and diluted net loss per share applicable to common stockholders			$	(0.37	)	$	(4.02	)	$	(0.84	)	$	(7.37	)

Shares used in calculation of basic and diluted net loss per share				22,685,258			1,059,571			22,675,743			1,021,418


																Accumulated
																Other
								Capital in		Deferred						Comprehensive			Total
				Common		Par		Excess of		Stock-Based			Accumulated			Income			Stockholders’
				Shares		Value		Par Value		Compensation			Deficit			(Loss)			Equity


				(Unaudited)
Balance at December 31, 2003					22,639,344	$	226,394	$	120,141,450	$	(6,126,286	)	$	(44,102,018	)	$	10,380		$	70,149,920
	Exercise of stock options				9,707		97		5,528		—			—			—			5,625
	Issuance of restricted stock				38,931		389		23,748		—			—			—			24,137
	Issuance of stock options for services				—		—		124,573		—			—			—			124,573
	Stock-based compensation for retired director				—		—		416,141		73,810			—			—			489,951
	Amortization of deferred stock based compensation				—		—		—		2,034,847			—			—			2,034,847
	Comprehensive income (loss):
		Net loss			—		—		—		—			(19,110,952	)		—			(19,110,952	)
		Unrealized loss on marketable securities			—		—		—		—			—			(124,537	)		(124,537	)

			Total comprehensive loss																	(19,235,489	)

Balance at June 30, 2004					22,687,982	$	226,880	$	120,711,440	$	(4,017,629	)	$	(63,212,970	)	$	(114,157	)	$	53,593,564



		June 30,

(Number of Underlying Common Shares)		2004		2003


		(Unaudited)
Preferred stock			—		8,748,251
Stock options			3,451,330		1,530,603
Nonvested restricted stock			257,087		309,139
Warrants			—		36,524
Convertible Notes			—		1,236,707

	Total		3,708,417		11,861,224



		June 30, 2004

				Gross		Gross
		Amortized		Unrealized		Unrealized			Fair
Available-for-sale		Cost		Gains		Losses			Value

Marketable securities:
	Corporate debt securities	$	29,619,915	$	—	$	(99,669	)	$	29,520,246
	Government agency securities		3,011,672		—		(14,488	)		2,997,184

		$	32,631,587	$	—	$	(114,157	)	$	32,517,430


	Estimated
	Useful Life		June 30,			December 31,
	(Years)		2004			2003

Construction in progress			$	1,938,733		$	2,526,977
Computer equipment		3		785,354			645,310
Furniture and fixtures		5		1,301,840			1,073,915
Equipment		3-10		5,996,850			2,886,199
Leasehold improvements		10		6,850,448			6,850,448

				16,873,225			13,982,849
Less — accumulated depreciation				(2,269,374	)		(1,470,057	)

			$	14,603,851		$	12,512,792


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



		Three Months Ended				Six Months Ended				Total Expenses
		June 30,				June 30,				Incurred as of		Clinical
										June 30,		Development
		2004		2003		2004		2003		2004		Phase

Direct Project Costs(1)
Amoxicillin(2)		$	3,039,000	$	888,000	$	6,155,000	$	1,437,000	$	14,030,000		Phase I/II
Clarithromycin			79,000		356,000		208,000		590,000		5,323,000		Phase I/II
Metronidazole			165,000		23,000		689,000		70,000		2,614,000		Phase I/II
Amoxicillin/ Clavulanate
	Potassium(3)		1,000		1,000		3,000		2,000		92,000		Phase I/II
Generic Clarithromycin			769,000		940,000		2,238,000		1,926,000		12,258,000		Phase I/II
Other Product Candidates			723,000		300,000		1,820,000		503,000		4,539,000		Preclinical

	Total Direct Project Costs		4,776,000		2,508,000		11,113,000		4,528,000		38,856,000

Indirect Project Costs(1)
Facility			594,000		131,000		1,124,000		256,000		3,532,000
Depreciation			379,000		129,000		725,000		250,000		2,065,000
Patent			58,000		155,000		168,000		218,000		1,024,000
Other Indirect Overhead			608,000		111,000		1,175,000		286,000		2,706,000

	Total Indirect Expense		1,639,000		526,000		3,192,000		1,010,000		9,327,000

Total Research & Development Expense		$	6,415,000	$	3,034,000	$	14,305,000	$	5,538,000	$	48,183,000


	*Our Collaboration with Par Pharmaceutical for Generic Clarithromycin*


	*Three months ended June 30, 2004 compared to three months ended June 30, 2003*



			Three Months Ended
			June 30

			2004		2003

Amortization of upfront licensing fees:
	GSK		$	312,000	$	—
	Par — amoxicillin			139,000		—
Reimbursement of development costs — Par amoxicillin				403,000		—

		Total	$	854,000	$	—



		Three Months Ended
		June 30,

Research and Development Expenses		2004		2003

Direct project costs:
	Personnel, benefits and related costs	$	2,415,000	$	1,151,000
	Stock-based compensation		193,000		608,000
	Contract R&D, consultants, materials and other costs		1,417,000		703,000
	Clinical trials		751,000		46,000

	Total direct costs		4,776,000		2,508,000
Indirect project costs			1,639,000		526,000

Total		$	6,415,000	$	3,034,000


Item 1.	*Financial Statements (Unaudited)*


1.	Basis of Presentation


2.	Summary of Significant Accounting Policies


	*Use of Estimates*


	*Six months ended June 30, 2004 compared to six months ended June 30, 2003*



	As of June 30, 2004

					Remaining
			Amount		Amount
Debt Obligations	Interest Rates		Outstanding		Available

Fixed rate borrowings		5.00% – 11.62%	$	572,000	$	—
Variable rate borrowings	LIBOR or Fixed Cost of Funds plus 250 – 280 basis points			2,070,000		3,347,000

Totals			$	2,642,000	$	3,347,000


Item 3.	*Quantitative and Qualitative Disclosures About Market Risk*


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


Purchase of Keflex intangible assets		$	11,206,000
Purchases of property and equipment			912,000
Cash used in operating activities			955,000

	Total	$	13,073,000


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


	Affirmative		Votes
	Votes		Withheld

Terms expiring in 2007
R. Gordon Douglas, M.D.		20,554,654		52,206
Harold R. Werner		20,554,654		52,206


	Affirmative		Negative				Broker
	Votes		Votes		Abstentions		Non-Votes

Ratification of the selection of PricewaterhouseCoopers LLP as the Company’s independent auditors for the fiscal year ending December 31, 2004		20,602,470		3,405		985		—
Approval of the Amended and Restated Advancis Pharmaceutical Corporation Stock Incentive Plan		15,735,899		1,446,912		704,204		2,719,845



	10.1			Development and Commercialization Agreement between the Company and Par Pharmaceutical, Inc. dated May 28, 2004.+
	10.2			Executive Employment Agreement between the Company and Donald Treacy dated March 19, 2004.
	10.3			Executive Employment Agreement between the Company and David Kudla dated July 1, 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.


Exhibit
Page
Number

	10.1	Development and Commercialization Agreement between the Company and Par Pharmaceutical, Inc. dated May 28, 2004.+
	10.2	Executive Employment Agreement between the Company and Donald Treacy dated March 19, 2004.
	10.3	Executive Employment Agreement between the Company and David Kudla dated July 1, 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.