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 by 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 October 26, 2004, 22,799,734 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 nine months ended September 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.

Product Sales. Revenue from product sales is recognized when substantially all the risks and rewards of ownership have passed to the customer. Revenues are reduced at the time of sale to reflect expected returns, discounts, rebates, and chargebacks. These estimates are based on terms, historical experience, trend analysis, and market conditions.

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 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, net of amortization of premium on marketable securities, and realized gains and losses on securities are included in “Interest income” in the statements of operations.

Accounts receivable represent amounts due from wholesalers for sales of pharmaceutical products. Allowances for estimated product returns, discounts, and chargebacks are recorded as reductions to accounts receivable. Amounts due for estimated rebates payable to third parties are included in accrued liabilities.

Inventories consist of finished products purchased from third parties and are stated at the lower of cost or market. Cost is determined on the first-in, first-out (FIFO) method.

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 nine months ended September 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.

The Company records revenue from sale of pharmaceutical products (Keflex) and from the recognition of revenue earned under collaboration agreements

Product Sales. The Company’s largest customers are large wholesalers of pharmaceutical products. Three of these large wholesalers accounted for approximately 43.5%, 32.9%, and 19.5% of the Company’s net revenues from product sales in the three-month and nine-month periods ending September 30, 2004.

Collaboration with GlaxoSmithKline (GSK). In July 2003, the Company entered into a development and license agreement with 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, which is being amortized over the expected development period. The Company recognized revenue of $312,500 and $937,500 in the three and nine month periods ended September 30, 2004, respectively, for the amortization of the $5.0 million upfront payment. The Company also received a $3.0 million payment upon achievement of a milestone, which was recognized as revenue in the fourth quarter of 2003. Subsequent to September 30, 2004, GSK notified the Company that it would terminate this agreement, effective December 15, 2004. As a result, the remaining deferred revenue balance of $3,437,500 is expected to be recognized as revenue in the fourth quarter of 2004.

Collaboration with Par Pharmaceutical for Amoxicillin PULSYS. 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 million and a commitment from Par to fund all further development expenses. Development expenses incurred by the Company will be partially funded by quarterly payments aggregating $28 million over the period July 2004 through October 2005, of which up to $14 million is contingently refundable. Revenue related to the receipt of the quarterly payments is recognized based on actual costs incurred as the work is performed, limited to minimum amounts expected to be received under the agreement and excluding amounts contingent on future events or amounts that are contingently refundable, with the balance of cash received in excess of revenue recognized recorded as deferred revenue. The excess of the development costs incurred by the Company over the quarterly payments made by Par will be funded subsequent to commercialization, by the distribution to the Company of Par’s share of operating profits until the excess amount has been reimbursed. The Company does not record any amounts as revenue on a current basis which are dependent on achievement of future operating profits. The $5.0 million upfront payment is being amortized on a straight-line basis through May 2007, with $416,667 and $555,556 recognized as contract revenue for the three and nine month periods ended September 30, 2004, respectively, and $4,444,444 recorded as deferred revenue as of September 30, 2004. Revenue recognized by the Company for reimbursement of development expenses was $1,212,060 and $1,615,126 for the three and nine month periods September 30, 2004, respectively, with $2,884,874 recorded as deferred revenue as of September 30, 2004.

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

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

On June 30, 2004, the Company acquired the U.S. rights to the Keflex brand of cephalexin from Eli Lilly and Company. Lilly provided certain transition services, including warehousing, distribution and financial services related to Keflex to the Company during the two-month period ending August 31, 2004. The receivable from Lilly for the transition period represents the net amount due to the Company from Lilly for certain product sales during the period reduced by amounts due to Lilly from the Company for purchases of inventory and for payment of distribution fees.

The Company’s largest customers are large wholesalers of pharmaceutical products. Three of these large wholesalers accounted for approximately 43.6%, 35.7%, and 16.3% of the Company’s accounts receivable for product sales as of September 30, 2004.

During the nine-month period ended September 30, 2004, the Company expended approximately $4.8 million for the construction of its corporate, research and development facility and purchase of equipment. In addition, the Company made deposits of $367,327 on equipment for the new facility during the nine-month period ended September 30, 2004.

Intangible assets at September 30, 2004 and December 31, 2003 consist of the following:

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 identified intangible assets acquired consisted of the Keflex brand (including brand name, trademarks, copyrights, technology and new drug applications (NDAs) supporting the approval of Keflex) and a non-compete agreement with Lilly. The Company did not acquire customer lists or sales personnel from Lilly.

The fair market values of the individual Keflex intangible assets acquired were evaluated by an independent valuation consulting firm, and the Company has recorded the individual fair market values of these intangible assets accordingly. The allocation of the purchase price was:

Identifiable intangible assets with definite lives are amortized on a straight-line basis over their estimated useful lives. The Keflex brand rights are amortized over 10 years, the non-compete agreement with Lilly is amortized over 5 years and certain acquired patents are amortized over 10 years.

Amortization expense for acquired intangible assets with definite lives was $289,419 and $295,419 for the three-month and nine-month periods ended September 30, 2004, respectively, and $3,000 and $9,000 for the three-month and nine-month periods ended September 30, 2003, respectively. For the year ending December 31, 2004, amortization expense for acquired intangible assets with definite lives is expected to be approximately $585,000, and for the next five years, annual amortization expense for acquired intangible assets will be approximately $1.2 million per year.

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 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 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 nine-month period ended September 30, 2004, the Company drew down $1,389,397 under the line of credit, which expired 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, March 31, June 3, and September 15, 2004 the Company granted stock options to purchase up to 907,850, 181,600, 144,900 and 258,150 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.

On October 15, 2004, the Company was notified by GlaxoSmithKline (GSK) of its intent to terminate the Development and License Agreement between the Company and GSK dated July 18, 2003. GSK’s termination was for convenience and is effective December 15, 2004. The Company received a non-refundable $5 million up-front payment upon the signing of the Agreement, which is being amortized over the expected development period, and a subsequent non-refundable payment of $3 million for GSK’s achievement of a milestone, which was recognized as revenue in the fourth quarter of 2003. The Company expects to accelerate the recognition of the remaining unamortized balance of $3.5 million of deferred revenue related to the up-front payment into the fourth quarter of 2004.

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.”

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 September 30, 2004, we had five PULSYS antibiotic compounds in Phase I/ II clinical trials and an additional two PULSYS product candidates, amoxicillin/clarithromycin and cephalexin, in advanced preclinical development. In October 2004, we began dosing patients in our first Phase III trial for our lead PULSYS product candidate, amoxicillin PULSYS. 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.

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.

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. 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 PULSYS products and from receipt of royalties on sales of licensed products.

Product Sales. We acquired the U.S. rights to Keflex in June 2004. We recorded revenue from product sales beginning in July 2004. Our products are sold primarily to large pharmaceutical wholesalers.

Collaborations Revenue. To date, we have entered into three collaborative agreements, which are described in more detail below — see “Collaboration Agreements.” We received a payment of $5 million from GlaxoSmithKline upon signing of our license agreement in July 2003, which was deferred and is being recognized as revenue over the estimated development period of the contract. 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 related to this agreement have been received from Par Pharmaceutical and, due to our decision to discontinue development efforts for the generic clarithromycin product, none are expected. 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 for this product.

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.

Summary of Product Development Initiatives. The following table summarizes our product development initiatives for the three and nine month periods ended September 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.” Phase III dosing commenced October 15, 2004.

(3)	We have entered into an agreement under which GlaxoSmithKline (GSK) will be responsible for funding future clinical development of this product. GSK has notified us that, effective December 15, 2004, it will discontinue its development efforts for this product. See “Our Collaboration with GlaxoSmithKline.”

(4)	We have discontinued development efforts for this product. See “Our Collaboration with Par Pharmaceutical for Generic Clarithromycin.”

Amoxicillin PULSYS Phase III. On October 15, 2004, the first patient was dosed in our Phase III clinical trial designed to support product approval for Amoxicillin PULSYS for the treatment of adolescents and adults with acute pharyngitis and/or tonsillitis due to Group A streptococcal infections. The trial is expected to last from six to nine months and, if successful, the Company expects to file a 505(b)(2) New Drug Application with the FDA for this product in the second half of 2005 and to launch the product by as early as 2006.

Generic Clarithromycin. We are developing a generic formulation of Abbott’s Biaxin XL (extended release clarithromycin). During the third quarter of 2004, we conducted bioequivalence studies on two revised formulations of the generic product, with both formulations failing to achieve bioequivalence. We have concluded that due to the non-core nature of the product, the expense involved in the development of additional formulations, the continued redirection of our resources required to pursue the product, and the reduced market potential given the emergence of competing products, we will discontinue further development work on the product. Advancis and Par are currently in discussions regarding the status of the agreement.

Clinical Trials Risks. Conducting clinical trials is a lengthy, time-consuming and expensive process. Studies in animals and Phase I and Phase II studies in humans may be necessary to determine proper dosage prior to pivotal Phase III clinical efficacy trials. 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.

Selling, 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 sales and marketing costs, product distribution expenses, facility costs not otherwise included in research and development expense, professional fees for legal and accounting services, and amortization of intangible assets.

Employees. 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 $689,000 and $3.2 million for the three and nine-month periods ended September 30, 2004, respectively.

Non-employee Consultants. We recorded stock-based compensation expense of $252,000 and $376,000 during the three and nine month periods ended September 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 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 September 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 consists of interest earned on our cash, cash equivalents and marketable securities. Interest expense consists of interest incurred on borrowings, net of interest expense capitalized.

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 September 30, 2004, we had an accumulated deficit of approximately $72.4 million. We anticipate incurring additional losses, which may increase, for the foreseeable future.

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 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. 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 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.

Following the quarter-end, we were notified that GSK will terminate the collaboration, effective December 15, 2004. We remain confident that pulsatile amoxicillin/clavulanate is technically and commercially viable, and will be exploring other avenues and partners. Additionally, we believe continued progress on our pulsatile version of amoxicillin will help support future productive PULSYS collaborations. To date, Advancis has received a non-refundable $5 million payment upon the signing of the agreement and a subsequent non-refundable $3 million milestone payment recognized in the fourth quarter of 2003. As a result of the termination, the company expects to accelerate the recognition of the remaining deferred revenue of approximately $3.5 million related to the collaboration during the fourth quarter. The termination will have no other effects on the Company’s financial position.

In September 2003, we entered into an agreement pursuant to which we licensed to Par Pharmaceutical the distribution and marketing rights to our generic formulation of Abbott’s Biaxin XL (extended release clarithromycin). 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. 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 milestone or royalty payments or that our collaboration with Par will result in the approval and marketing of any drug.

During the third quarter of 2004, we conducted bioequivalence studies on two revised formulations of the generic product, with both formulations failing to achieve bioequivalence. We have concluded that due to the non-core nature of the product, the expense involved in the development of additional formulations, the continued redirection of our resources required to pursue the product, and the reduced market potential given the emergence of competing products, we will discontinue further development work on the product. Advancis and Par are currently in discussions regarding the status of the agreement.

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 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. 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 development expenses. Development expenses incurred by Advancis will be funded by quarterly payments aggregating $28 million over the period from July 2004 through October 2005. The excess of the development costs incurred by us and the quarterly payments made by Par will be funded subsequent to commercialization, by the distribution to us of Par’s share of operating profits until the excess amount has been reimbursed.

The agreement 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.

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 agreement 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 or enter into our own third-party agreements.

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 $3,074,000 and $313,000 during the three month periods ended September 30, 2004 and 2003, respectively, as follows:

Product sales of Keflex commenced in July 2004, subsequent to the purchase of the brand rights in the U.S. market from Eli Lilly. There were no product sales in 2003.

Revenues recognized in 2003 and 2004 for amortization of upfront licensing fees include the amortization of a $5.0 million upfront payment received from GlaxoSmithKline (GSK) in July 2003, of which the remainder of $3,438,000 is expected to be recognized in the fourth quarter of 2004 due to the termination of the collaboration agreement, 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 in 2004 of $1,212,000 related to the Par Amoxicillin agreement was recognized based on the related costs incurred.

Cost of Product Sales. Cost of product sales represents the purchase cost of the Keflex products sold during the quarter. Cost of product sales was $79,000 in 2004, compared to zero in 2003.

Research and Development Expenses. Research and development expenses increased by $4.3 million, or 86%, to $9.3 million for the three months ended September 30, 2004 compared to $5.0 million for the three months ended September 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 $2.9 million primarily as a result of increases of $2.7 million relating to the development of our pulsatile amoxicillin product candidate, an increase of $0.3 for generic clarithromycin, and an increase of $0.3 million relating to the evaluation of new preclinical product candidates, less decreases in pulsatile clarithromycin and metronidazole of $0.4 million. Increased project staffing levels in 2004 versus 2003 resulted in an increase of $ 0.9 million in personnel, benefits and related costs.

Contract research and development, consulting, materials and other direct costs increased $1.7 million in preparation for our clinical trials, and clinical trials expense increased $0.2 million.

Indirect project costs also increased by $1.4 million, primarily due to an increase in facility-related costs of $0.4 million, depreciation of $0.3 million, and overhead of $0.7 million due to the opening of our new

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.

Selling, General and Administrative Expenses. Selling, general and administrative expenses increased $1.2 million, or 67%, to $3.1 million for the three months ended September 30, 2004 from $1.8 million for the three months ended September 30, 2003.

Net Interest Income (Expense). Net interest income in the three months ended September 30, 2004 was $177,000 compared to net interest expense of $(1,618,000) in the three months ended September 30, 2003. Interest income was higher in 2004 as increased balances in cash, cash equivalents and marketable securities in 2004 generated substantially higher interest income than in 2003. The increase in interest expense in 2004 compared to 2003 is due primarily to the reduction in interest expense in 2003 attributable to the capitalization of interest in connection with the buildout of our corporate, research and development facility. Finally a one-time charge in the form of deemed interest of $1.7 million was incurred in 2003 related to a beneficial conversion feature on our convertible notes; these notes were converted during 2003, and there was no similar charge in 2004.

Revenues. We recorded revenues of $4,241,000 during the nine months ended September 30, 2004 and recorded revenues of $313,000 during the nine months ended September 30, 2003, as follows:

Product sales of Keflex commenced in July 2004, subsequent to the purchase of the brand rights in the U.S. market from Eli Lilly. There were no product sales in 2003.

Revenues recognized in 2004 for upfront licensing fees represent the amortization of a $5.0 million upfront payment received from GlaxoSmithKline in July 2003, of which the remainder is expected to be recognized as revenue in the fourth quarter of 2004 due to termination of the agreement, 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 in 2004 of $1,615,000 related to the Par Amoxicillin agreement was recognized based on the related costs incurred. An additional $2,885,000 of cost-based revenue was deferred and will be recognized upon the removal of future contact contingencies related to termination provisions of the contract and when the related costs are incurred.

Cost of Product Sales. Cost of product sales represents the purchase cost of the Keflex products sold during the nine months ended September 30, 2004. Cost of product sales was $79,000 in 2004, compared to zero in 2003.

Research and Development Expenses. Research and development expenses increased by $13.1 million, or 124%, to $23.6 million for the nine months ended September 30, 2004 compared to $10.5 million for the nine months ended September 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 $9.5 million primarily as a result of increases of $8.5 million relating to the development of our pulsatile amoxicillin, pulsatile metronidazole and generic clarithromycin product candidates, plus an increase of $1.6 million relating to the evaluation of new preclinical product candidates, partially offset by a decrease of $0.6 million relating to the development of our pulsatile clarithromycin product candidate. Increased research and development staffing resulted in increases of $3.2 million in personnel, benefits and related costs and $ 0.3 million attributable to stock-based compensation. An additional $3.5 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 $2.4 million due to an increase in the number of subjects dosed. We conducted a total of 11 Phase I/ II clinical trials in the nine months ended September 30, 2004, consisting of four for our pulsatile amoxicillin adult product, three for our pulsatile amoxicillin pediatric product, one for our pulsatile metronidazole product, and three for our generic clarithromycin product candidate. In the nine months ended September 30, 2003, we conducted two Phase I/II clinical trials for our generic clarithromycin product candidate.

Indirect project costs increased by $3.6 million to $5.5 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 the remainder of 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.

Selling, General and Administrative Expenses. Selling, general and administrative expenses increased $5.7 million, or 155%, to $9.4 million for the nine months ended September 30, 2004 from $3.7 million for the nine months ended September 30, 2003.

Selling, general and administrative expenses consist of salaries and related costs for executive and other administrative personnel, selling and product distribution costs, professional fees and facility costs. Salaries, benefits and related costs for personnel increased $1.0 million in 2004 due to higher compensation and benefits expenses related to new hires, as well as higher recruiting costs. Stock-based compensation increased $1.5 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 $1.0 million due to increased legal support activities in 2004 primarily related to collaboration contract effort and SEC filings, as well as annual report costs and consulting fees incurred in support of investor relations. Other expenses increased $2.2 million from the prior year, including $0.6 million in increased facilities costs resulting from the opening of our facility in Germantown, Maryland. Accounting and auditing costs, directors fees, annual report expense, investor relations and insurance costs increased $0.7 million due to our change in status from private to public SEC registrant. Travel, business development and marketing increased $0.5 million as we explored potential product opportunities.

Net Interest Income (Expense). Net interest income in the nine months ended September 30, 2004 was $524,000 compared to net interest expense of ($1,716,000) in the nine months ended September 30, 2003. The increase in net interest income of $2,240,000 was primarily due to the charge of $1.7 million taken in 2003 for interest expense associated with the beneficial conversion feature on preferred stock, partly offset by the impact of increases in cash, cash equivalents and marketable securities in 2004, which generated an increase in

interest income of $0.5 million. 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 $9.5 million from GlaxoSmithKline and Par Pharmaceutical, respectively, as a result of collaboration agreements for the development of new products.

At September 30, 2004, cash, cash equivalents and marketable securities were $36.5 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 nine-month periods ending September 30, 2004 and 2003.

Net cash used in operating activities in the nine-month period ending September 30, 2004 was $11.4 million, primarily due to the net loss of $28.3 million as adjusted for noncash charges and the timing of revenue recognition. Cash used in operating activities is less than the net loss for accounting purposes by $16.9 million for the following reasons:


	•	Cash receipts exceeded revenue recognized by $8.3 million, due to timing of revenue recognized under collaboration contracts for accounting purposes, primarily attributable to deferred recognition of upfront payments received;

	•	Cash expenditures were approximately $7.5 million less than expenses for accounting purposes, primarily due to noncash expenses for depreciation, amortization, and stock-based compensation; and

	•	Interest income received in cash was $1.1 million higher than interest income for accounting purposes, as the premium paid for marketable securities with relatively high interest rates is charged against interest income.

Net cash used in operating activities in the nine-month period ending September 30, 2003 was $6.0 million, primarily due to the net loss of $15.6 million as adjusted for noncash charges and the timing of revenue recognition. Cash used in operating activities is less than the net loss for accounting purposes by $9.6 million for the following reasons:


	•	Cash receipts exceeded revenue recognized by $4.7 million, due to timing of revenue recognized under collaboration contracts for accounting purposes, primarily attributable to deferred recognition of the $5.0 million upfront payment received from GSK;

	•	Cash expenditures were approximately $3.2 million less than expenses for accounting purposes, primarily due to noncash expenses for depreciation, amortization, and stock-based compensation; and

	•	Interest income (expense), net, received in cash was $1.7 million higher than interest income (expense) for accounting purposes, as the deemed interest on the beneficial conversion feature of the convertible notes and the interest accrued on the convertible notes prior to conversion were not paid in cash.

Net cash used in investing activities during the nine-month period ending September 30, 2004 was $15.0 million. The most significant investing activities included the acquisition of Keflex intangibles for $11.2 million, and purchases of and deposits on property and equipment of $5.2 million. Net purchases and sales of marketable securities provided $1.4 million during the period.

Net cash used in investing activities during the nine-month period ending September, 2003 was $12.6 million. $7.9 million was used for the purchase of equipment for the Company’s research and development operations, and $5.2 million was invested in marketable securities. $0.8 was provided by the landlord as a lease concession.

Net cash provided by financing activities for the nine-month period ending September 30, 2004 was $0.4 million. The major financing activities included loan draws of $1.4 million for equipment financing in connection with the fit-out of the Company’s new corporate, research and development facility and repayments of $1.0 million on the Company’s existing borrowings.

Net cash provided by financing activities for the nine-month period ending September 30, 2003 was $26.4 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, and additional proceeds of $20.8 million from the issuance of 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, $2.9 million was outstanding as of September 30, 2004, as summarized in the following table:

In the third quarter we made our final draw of $0.6 million prior to expiration of the bank credit line on July 31, 2004. We are currently negotiating with financial institutions to obtain a new line of credit to fund the purchase of additional equipment. We do not currently hedge variable rate borrowings.

At September 30, 2004, restricted cash was $1.9 million compared to $1.8 million at December 31, 2003. The increase of $133,000 was primarily due to changes in cash deposits that collateralize letters of credit provided to the landlords of our two leased facilities in Germantown, Maryland.

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.

In August, 2004, we entered into a new lease for additional research and development space, in a building adjacent to the Company’s existing headquarters in Germantown, Maryland. This lease calls for monthly payments totaling $6.0 million over a 6 year period from January, 2005 through December, 2010.

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 selling, 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.

At our current spending level, 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 12 months. However, in 2005 we intend to significantly increase our product development expenses, including Phase III clinical trials, and capital expenditures associated with preparation for product launch, and, accordingly, additional funds, either from collaboration partners or from additional debt or equity transactions, will be required to achieve our desired timing for the products in our development pipeline. Alternatively, if such additional funds are not obtained, we intend to reduce our rates of expenditure and capital investment, which may delay the development or commercialization of products in our development pipeline.

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, effect changes to our facilities or personnel, 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.

We recognize revenue for the sale of pharmaceutical products and for payments received under collaboration agreements for licensing, milestones, and reimbursement of development costs.

Product Sales. Revenue from product sales, net of estimated provisions, is recognized when there is persuasive evidence that an arrangement exists, delivery has occurred, the selling price is fixed or determinable, and collectibility is reasonably probable. Our customers consist primarily of large pharmaceutical wholesalers who sell directly into the retail channel. Provisions for sales discounts, and estimates for chargebacks, rebates, and product returns are established as a reduction of product sales revenue at the time revenues are recognized, based on historical experience adjusted to reflect known changes in the factors that impact these reserves. These revenue reductions are generally reflected either as a direct reduction to accounts receivable through an allowance, or as an addition to accrued expenses if the payment is due to a party other than the wholesaler.

Chargebacks and rebates are based on the difference between the prices at which we sell our products to wholesalers and the sales price ultimately paid under fixed price contracts by third party payers, including governmental agencies. We record an estimate at the time of sale to the wholesaler of the amount to be charged back to us or rebated to the end user. We have recorded reserves for chargebacks and rebates based upon various factors, including current contract prices, historical trends, and our future expectations. Although we have a limited history of selling Keflex products, we are also able to utilize in our analysis historical data for chargebacks and rebates obtained from the seller as part of our due diligence prior to acquiring the brand. The amount of actual chargebacks and rebates claimed could be either higher or lower than the amounts we accrued. Changes in our estimates would be recorded in the income statement in the period of the change.

Product returns. In the pharmaceutical industry, customers are normally granted the right to return product for a refund if the product has not been used prior to its expiration date, which for our Keflex product is typically three years from the date of manufacture. Our return policy typically allows product returns for products within an eighteen-month window from six months prior to the expiration date and up to twelve months after the expiration date. We believe that we have sufficient data to estimate future returns at the time of sale. Although we have a limited history of selling Keflex products, we are also able to utilize in our analysis historical data for product returns obtained from the seller as part of our due diligence prior to acquiring the brand, and our returns policy is generally the same as the seller’s. We estimate the level of sales which will ultimately be returned pursuant to our return policy, and record a related reserve at the time of sale. These amounts are deducted from our gross sales to determine our net revenues. Our estimates take into consideration historical returns of our products and our future expectations. We periodically review the reserves established for returns and adjust them based on actual experience. The amount of actual product return could be either higher or lower than the amounts we accrued. Changes in our estimates would be recorded in the income statement in the period of the change. If we over or under estimate the quantity of product which will ultimately be returned, there may be a material impact to our financial statements.

Contract Revenue. 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.

Reimbursement of Development Costs. 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 minimum 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.

Acquired Intangible Assets. We acquired the U.S. rights to Keflex brand of cephalexin in 2004. We may acquire additional pharmaceutical products in the future that include license agreements, product rights and other identifiable intangible assets. When intangible assets are acquired, we review and identify the individual intangible assets acquired and record them based on relative fair values. Each identifiable intangible asset is then reviewed to determine if it has a definite life or indefinite life, and definite-lived intangible assets are amortized over their estimated useful lives.

Impairment. We assess the impairment of identifiable intangibles on an annual basis or when events or changes in circumstances indicate that the carrying value may not be recoverable. Some factors we consider important which could trigger an impairment review include significant underperformance compared to historical or projected future operating results, significant changes in our use of the acquired assets or the strategy for our overall business, or significant negative industry or economic trends. If we determine that the carrying value of intangible assets may not be recoverable based upon the existence of one or more of these factors, we first perform an assessment of the asset’s recoverability based on expected undiscounted future net cash flow, and if the amount is less than the asset’s value, we measure any impairment based on a projected discounted cash flow method using a discount rate determined by our management to be commensurate with the risk inherent in our current business model.

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.

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.

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 nine months ended September 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 September 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 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.

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 September 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 September 30, 2004, and has concluded that there was no change that occurred during the quarterly period ended September 30, 2004 that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

We are not a party to any material pending legal proceedings, other than ordinary routine litigation incidental to our business.

In December 2003, Aventis and Aventis Pharmaceuticals Inc. brought an action against the Company in the U.S. District Court for the District of Delaware. The Complaint contains six counts, based upon both federal and state law, alleging, in essence, that the Company has infringed on the plaintiffs’ trademark. The plaintiffs seek injunctive relief, as well as unspecified monetary damages. The case is in the discovery stage. It is the opinion of management that the ultimate outcome of this matter will not have a material adverse effect upon the Company’s financial position, results of operations, or cash flows.

From October 15, 2003, the effective date of our Registration Statement on Form S-1 (File No. 333-107599) to September 30, 2004, we have used approximately $16.1 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.


*	Incorporated by reference to our Current Report on Form 8-K dated July 15, 2004.


+	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.

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, PH.D.



	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


*	Incorporated by reference to our Current Report on Form 8-K dated July 15, 2004.


+	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 September 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		20876
(Address of principal executive offices)		(Zip Code)


			Page

PART I — FINANCIAL INFORMATION
	Item 1.	Financial Statements (Unaudited):
		Balance Sheets at September 30, 2004 and December 31, 2003		2
		Statements of Operations for the three and nine months ended September 30, 2004 and 2003		3
		Statement of Changes in Stockholders’ Equity for the nine months ended September 30, 2004		4
		Statements of Cash Flows for the nine months ended September 30, 2004 and 2003		5
		Notes to Financial Statements		6
	Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations		13
	Item 3.	Quantitative and Qualitative Disclosures About Market Risk		29
	Item 4.	Controls and Procedures		30
PART II — OTHER INFORMATION
	Item 1.	Legal Proceedings		31
	Item 2.	Unregistered Sales of Securities and Use of Proceeds		31
	Item 3.	Defaults Upon Senior Securities		31
	Item 4.	Submission of Matters to a Vote of Security Holders		31
	Item 5.	Other Information		31
	Item 6.	Exhibits		32
Signatures				33
Exhibit Index				34


			September 30, 2004			December 31, 2003


			(Unaudited)
ASSETS
Current assets:
	Cash and cash equivalents		$	11,440,806		$	37,450,490
	Marketable securities			25,044,815			27,636,632
	Accounts receivable, net			790,878			3,000,000
	Inventories			218,734			—
	Prepaid expenses and other current assets			472,674			1,127,464

		Total current assets		37,967,907			69,214,586
Property and equipment, net				15,097,478			12,512,792
Restricted cash				1,909,843			1,776,569
Deposits				496,699			477,396
Notes receivable				121,500			121,500
Intangible assets, net				10,982,098			72,000

		Total assets	$	66,575,525		$	84,174,843


LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities:
	Accounts payable		$	2,024,830		$	2,683,713
	Accrued expenses			4,590,917			3,757,863
	Lines of credit — current portion			1,047,296			953,984
	Deferred contract revenue			3,551,541			1,250,000

		Total current liabilities		11,214,584			8,645,560
Lines of credit — noncurrent portion				1,742,207			1,411,604
Note payable				75,000			75,000
Deferred contract revenue				7,215,278			3,125,000
Deferred rent and credit on lease concession				978,809			767,759

		Total liabilities		21,225,878			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 September 30, 2004 and December 31, 2003			—			—
	Common stock, $0.01 par value; 225,000,000 shares authorized; 22,690,181 shares and 22,639,344 shares issued and outstanding at September 30, 2004 and December 31, 2003, respectively			226,902			226,394
	Capital in excess of par value			120,963,947			120,141,450
	Deferred stock-based compensation			(3,328,517	)		(6,126,286	)
	Accumulated deficit			(72,441,051	)		(44,102,018	)
	Accumulated other comprehensive income (loss)			(71,634	)		10,380

		Total stockholders’ equity		45,349,647			70,149,920

		Total liabilities and stockholders’ equity	$	66,575,525		$	84,174,843



			Three Months Ended September 30,						Nine Months Ended September 30,

			2004			2003			2004			2003


						(Unaudited)
Revenue:
	Product sales		$	1,132,513		$	—		$	1,132,513		$	—
	Contract revenue			729,167			312,500			1,493,056			312,500
	Reimbursement of development costs			1,212,060			—			1,615,125			—

		Total revenue		3,073,740			312,500			4,240,694			312,500

Cost and expenses:
	Cost of product sales			78,928			—			78,928			—
	Research and development			9,327,378			5,009,969			23,632,238			10,547,935
	Selling, general and administrative			3,072,925			1,837,024			9,392,726			3,690,366

		Total expenses		12,479,231			6,846,993			33,103,892			14,238,301

Loss from operations				(9,405,491	)		(6,534,493	)		(28,863,198	)		(13,925,801	)
Interest income				209,987			48,450			619,674			83,901
Interest expense				(32,577	)		—			(95,509	)		(133,606	)
Beneficial conversion feature — deemed interest expense				—			(1,666,667	)		—			(1,666,667	)

Net loss				(9,228,081	)		(8,152,710	)		(28,339,033	)		(15,642,173	)
Accretion of issuance costs of mandatorily redeemable convertible preferred stock				—			(75,640	)		—			(113,001	)
Beneficial conversion feature — deemed dividend to preferred stockholders				—			(20,907,620	)		—			(20,907,620	)

Net loss applicable to common stockholders			$	(9,228,081	)	$	(29,135,970	)	$	(28,339,033	)	$	(36,662,794	)

Basic and diluted net loss per share applicable to common stockholders			$	(0.41	)	$	(20.19	)	$	(1.25	)	$	(31.55	)

Shares used in calculation of basic and diluted net loss per share				22,689,895			1,442,784			22,680,461			1,161,873


																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				10,266		103		5,976		—			—			—			6,079
	Issuance of restricted stock				40,571		405		24,305		—			—			—			24,710
	Issuance of stock options for services				—		—		376,075		—			—			—			376,075
	Stock-based compensation for retired director				—		—		416,141		73,810			—			—			489,951
	Amortization of deferred stock based compensation				—		—		—		2,723,959			—			—			2,723,959
	Comprehensive income (loss):
		Net loss			—		—		—		—			(28,339,033	)		—			(28,339,033	)
		Unrealized loss on marketable securities			—		—		—		—			—			(82,014	)		(82,014	)

			Total comprehensive loss																	(28,421,047	)

	Balance at September 30, 2004				22,690,181	$	226,902	$	120,963,947	$	(3,328,517	)	$	(72,441,051	)	$	(71,634	)	$	45,349,647



		September 30,

(Number of Underlying Common Shares)		2004		2003


		(Unaudited)
Preferred stock			—		15,062,486
Stock options			3,708,421		1,668,283
Nonvested restricted stock			237,689		424,289
Warrants			—		36,524

	Total		3,946,110		17,191,582



		September 30, 2004

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

Marketable securities:
	Corporate debt securities	$	22,088,118	$	—	$	(64,306	)	$	22,023,812
	Government agency securities		3,028,331		—		(7,328	)		3,021,003

		$	25,116,449	$	—	$	(71,634	)	$	25,044,815



		September 30, 2004

Available-for-sale		Amortized Cost		Fair Value

Maturities of marketable securities:
	Less than one year	$	19,499,089	$	19,453,117
	One to two years		5,617,360		5,591,698

		$	25,116,449	$	25,044,815


			September 30,			December 31,
			2004			2003

			(Unaudited)
Accounts receivable for product sales, gross			$	582,915		$	—
Allowances for discounts, returns, and chargebacks				(130,327	)		—

		Accounts receivable for product sales, net		452,588			—
Receivable for contract milestone achieved				—			3,000,000
Receivable from Lilly for transition period, net				338,290			—

	Accounts receivable, net		$	790,878		$	3,000,000


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

Construction in progress				$	64,034		$	2,526,977
Computer equipment			3		943,672			645,310
Furniture and fixtures			5		1,312,900			1,073,915
Equipment			3-10		6,840,426			2,886,199
Leasehold improvements			10		8,736,576			6,850,448

	Property and equipment, gross				17,897,608			13,982,849
Less — accumulated depreciation					(2,800,130	)		(1,470,057	)

	Property and equipment, net			$	15,097,478		$	12,512,792



		September 30, 2004

		Gross Carrying		Accumulated			Net Carrying
		Amount		Amortization			Amount


		(Unaudited)
Keflex brand rights		$	10,954,272	$	(273,858	)	$	10,680,414
Keflex non-compete agreement			251,245		(12,561	)		238,684
Patents acquired			120,000		(57,000	)		63,000

	Intangible assets	$	11,325,517	$	(343,419	)	$	10,982,098


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



		Three Months Ended				Nine Months Ended				Total Expenses
		September 30,				September 30,				Incurred as of		Clinical
										September 30,		Development
		2004		2003		2004		2003		2004		Phase

Direct Project Costs(1)
Amoxicillin(2)		$	4,118,000	$	1,443,000	$	10,273,000	$	2,880,000	$	18,148,000		Phase I/II
Clarithromycin			18,000		257,000		226,000		847,000		5,341,000		Phase I/II
Metronidazole			22,000		128,000		711,000		198,000		2,636,000		Phase I/II
Amoxicillin/ Clavulanate(3)			—		20,000		3,000		22,000		92,000		Phase I/II
Generic Clarithromycin(4)			2,475,000		2,152,000		4,713,000		4,078,000		14,733,000		Phase I/II
Other Product Candidates			461,000		161,000		2,234,000		664,000		4,953,000		Preclinical

	Total Direct Project Costs		7,094,000		4,161,000		18,160,000		8,689,000		45,903,000

Indirect Project Costs(1)
Facility			901,000		419,000		1,974,000		675,000		4,382,000
Depreciation			481,000		179,000		1,206,000		429,000		2,546,000
Patent			92,000		95,000		260,000		313,000		1,116,000
Other Indirect Overhead			759,000		156,000		2,032,000		442,000		3,563,000

	Total Indirect Expense		2,233,000		849,000		5,472,000		1,859,000		11,607,000

Total Research & Development Expense		$	9,327,000	$	5,010,000	$	23,632,000	$	10,548,000	$	57,510,000


	*Our Collaboration with Par Pharmaceutical for Generic Clarithromycin*


Item 1.	*Financial Statements (Unaudited)*


1.	Basis of Presentation


2.	Summary of Significant Accounting Policies


	*Use of Estimates*


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



		Three Months Ended
		September 30,

Research and Development Expenses		2004		2003

Direct project costs:
	Personnel, benefits and related costs	$	2,404,000	$	1,462,000
	Stock-based compensation		498,000		411,000
	Contract R&D, consultants, materials and other costs		3,047,000		1,385,000
	Clinical trials		1,145,000		906,000

	Total direct costs		7,094,000		4,164,000
Indirect project costs			2,233,000		846,000

Total		$	9,327,000	$	5,010,000



		Three Months Ended
		September 30,

Selling, General and Administrative Expenses		2004		2003

Salaries, benefits and related costs		$	716,000	$	482,000
Stock-based compensation			443,000		535,000
Legal and consulting expenses			688,000		393,000
Other expenses			1,226,000		427,000

	Total	$	3,073,000	$	1,837,000


	*Nine months ended September 30, 2004 compared to nine months ended September 30, 2003*



	As of September 30, 2004

					Remaining
			Amount		Amount
Debt Obligations	Interest Rates		Outstanding		Available

Fixed rate borrowings		5.00% – 11.62%	$	411,000	$	—
Variable rate borrowings	LIBOR or Fixed Cost of Funds plus 250 – 280 basis points			2,453,000		—

Totals			$	2,864,000	$	—


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


Item 2.	*Unregistered Sales of Securities and Use of Proceeds*


Purchase of Keflex intangible assets		$	11,206,000
Purchases of property and equipment			1,306,000
Cash used in operating activities			3,559,000

	Total	$	16,071,000


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



	2.1			Asset Purchase Agreement between the Company and Eli Lilly and Company, dated as of June 30, 2004.*+
	10.1			Manufacturing Agreement between the Company and Eli Lilly and Company, dated as of June 30, 2004.*+
	10.2			Transition Services Agreement between the Company and Eli Lilly and Company, dated as of June 30, 2004.*+
	10.3			Executive Employment Agreement between the Company and Donald C. Anderson, M.D., dated as of October 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.


Exhibit
Page
Number

	2.1	Asset Purchase Agreement between the Company and Eli Lilly and Company, dated as of June 30, 2004.*+
	10.1	Manufacturing Agreement between the Company and Eli Lilly and Company, dated as of June 30, 2004.*+
	10.2	Transition Services Agreement between the Company and Eli Lilly and Company, dated as of June 30, 2004.*+
	10.3	Executive Employment Agreement between the Company and Donald C. Anderson, M.D., dated as of October 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.