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UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Form 10-K

Commission file no. 0-18962

(650) 369-4300

Securities registered pursuant to Section 12(b) of the Act:

Securities registered pursuant to Section 12(g) of the Act:

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

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

      The aggregate market value of the voting stock held by non-affiliates of the Registrant, based upon the last reported sale of its common stock on June 30, 2003 of $0.61 as reported on the Nasdaq OTC Bulletin Board was $23,380,127. Shares of common stock held by each officer and director and person who owns 5% or more of the outstanding common stock have been excluded in that such persons may be deemed to be affiliates. Determination of affiliate status for this purpose is not a determination of affiliate status for any other purpose.

41,009,251

DOCUMENTS INCORPORATED BY REFERENCE

      Portions of the Registrant’s definitive Proxy Statement to be filed pursuant to Regulation 14A for its 2004 Annual Meeting of Stockholders are incorporated by reference into Part III hereof.

CYGNUS, INC.

ANNUAL REPORT ON FORM 10-K

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PART I

Overview

      Some of the statements in this report, including in the documents incorporated by reference, are forward-looking statements that involve risks and uncertainties. These forward-looking statements include statements about our plans, objectives, expectations, intentions and assumptions and other statements contained in this report, including in the documents incorporated by reference, that are not statements of historical fact. Forward-looking statements include but are not limited to statements about our ability to find a new sales, marketing and distribution partner or other strategic alliance, including but not limited to a merger or an acquisition by a third party; the capabilities and potential of the GlucoWatch G2 Biographer business; our ability to achieve market acceptance of the GlucoWatch G2 Biographer; our ability to manufacture the GlucoWatch G2 Biographer; our plans for other commercialization alliances; and the speed and potential results of the regulatory process. In some cases, you can identify these statements by words such as “may,” “will,” “should,” “estimates,” “predicts,” “potential,” “continues,” “strategy,” “believes,” “anticipates,” “plans,” “expects,” “intends” and similar expressions. We cannot guarantee future results, levels of activity, performance or achievements. Our actual results and the timing of certain events may differ significantly from the results and timing discussed in this report, including those under “Risk Factors” herein, as well as in the documents incorporated by reference. All forward-looking statements included in this report are based on information available to us on the date hereof, and we assume no obligation to update any such forward-looking statements.

      Cygnus was incorporated in California in 1985 and was reincorporated as a Delaware corporation in 1995. Our principal executive offices are located at 400 Penobscot Drive, Redwood City, California 94063, our telephone number at that address is (650) 369-4300 and our facsimile number at that address is (650) 369-5318. Additionally, our corporate website is www.cygn.com and our product website is www.glucowatch.com.

      We have developed and manufactured frequent, automatic and non-invasive glucose monitoring devices. Our devices are designed to provide more data to individuals and their physicians and enable them to make better-informed decisions on how to manage diabetes. We began the U.S. market launch of our first-generation GlucoWatch® Biographer on April 15, 2002. On March 21, 2002, the U.S. Food and Drug Administration (FDA) approved our second-generation product, the GlucoWatch G2® Biographer. On August 28, 2002, we received approval from the FDA of our supplemental pre-market approval (PMA) application for use of the GlucoWatch G2 Biographer by children and adolescents (ages 7 to 17). On December 4, 2003, we announced that the FDA approved our third-generation product. Compared with our second-generation product, this improved Biographer and AutoSensor system focuses on enhancing customer satisfaction and ease of use; however, it is not yet commercially available.

      On December 23, 2003, we entered into an Agreement for Global Resolution and Mutual Release of All Claims (“Global Resolution”) with Sankyo Pharma Inc. (“Sankyo Pharma”) that resolved and dismissed the pending litigation filed on October 6, 2003, and terminated our Sales, Marketing and Distribution Agreement and all other contractual arrangements with Sankyo Pharma. The Global Resolution provided for Sankyo Pharma to pay us $30.0 million and also specified that neither party owed any payments to the other party, thus allowing us to write off certain liabilities and assets, resulting in a total net gain of $75.8 million. Furthermore, Sankyo Pharma transferred title to us of more than 20,000 GlucoWatch G2 Biographers and more than 1.0 million AutoSensors that we had previously sold and shipped to them. Sankyo Pharma is to provide certain transition services related to distribution and customer services until the earlier of June 30, 2004 or when we notify Sankyo Pharma that they may discontinue such services, and we are entitled to receive 30% of all monies received from product sales by Sankyo Pharma during this transition period. In light of these developments, we are not likely to manufacture our G2 Biographer or third-generation product or develop new products in the near future.

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      We are currently seeking a new sales, marketing and distribution partner or other strategic alliance, and we are exploring the possibility of selling the company to a third party. We have retained a financial advisor to lead this process.

Cygnus in the Year 2003

      In May 2003, we entered into a new lease with the property owners for our facility located in Redwood City, California. The lease, which runs through April 30, 2009, is for a building with approximately 38,000 square feet that is used by us for administrative offices, laboratory space and the final assembly lines for the Biographer.

      In October 2003, we filed a complaint in the Superior Court of the State of California for the County of San Mateo against Sankyo Pharma and Sankyo Co., Ltd. (“Sankyo Japan”) for breach of contract and intentional interference with contract, respectively, relating to the sales, marketing and distribution of our GlucoWatch Biographer products. Thereafter, Sankyo Pharma filed cross-claims against us for declaratory relief, breach of contract and defamation.

      Also in October 2003, we announced a reduction in force of approximately 60% of our work force, and we suspended our manufacturing activities and research and development efforts for future products.

      In October 2003, we terminated our second building lease, which would have run through December 2003 and which we had previously subleased to Maxygen, Inc. We received full payment from Maxygen, Inc. for this early termination, and in turn paid the remaining lease amount to the property owner.

      In November 2003, we announced the restructuring of our arbitration payments to Sanofi-Synthelabo to extend each of the payment periods by one year, with the possibility of accelerated payments in the event that a settlement was reached with Sankyo Pharma. In light of our $30.0 million cash settlement from Sankyo Pharma, we paid $500,000 to Sanofi-Synthelabo on December 30, 2003. The balance of $11.5 million as of December 31, 2003 will be paid as follows: $4.5 million is due in February 2005, $4.0 million is due in February 2006, and $3.0 million is due in February 2007. We also entered into Security Agreements granting Sanofi-Synthelabo a subordinate security interest in all of our assets, including our U.S. Patents and patent applications then existing or thereafter arising, to secure our obligation under the Amendment to the Final Award.

      In December 2003, we announced that the FDA approved our third-generation GlucoWatch Biographer; however, this device is not yet commercially available.

      In December 2003, we entered into the Global Resolution with Sankyo Pharma that resolved and dismissed the pending litigation filed on October 6, 2003, and terminated our Sales, Marketing and Distribution Agreement and all other contractual arrangements. The Global Resolution provided for Sankyo Pharma to pay us $30.0 million and also specified that neither party owed any payments to the other, thus allowing us to write off certain liabilities and assets, resulting in a total net gain of $75.8 million. Furthermore, Sankyo Pharma transferred title to us of more than 20,000 GlucoWatch G2 Biographers and more than 1.0 million AutoSensors that we had previously sold and shipped to them. Sankyo Pharma is to provide certain transition services related to distribution and customer services until the earlier of June 30, 2004 or when we notify Sankyo Pharma that they may discontinue such services, and we are entitled to receive 30% of all monies received from product sales by Sankyo Pharma during this transition period.

      Also in December 2003, we dissolved Cygnus International, Inc., a Delaware corporation and a wholly owned subsidiary of Cygnus, Inc., which was established in March 2001 for possible future international operations.

      In 2003, the U.S. Patent and Trademark Office issued to us 10 patents relating to our glucose monitoring systems, including the GlucoWatch G2 Biographer. We also received 7 patents from the European Patent Office and 1 patent from the Japanese Patent office in 2003 that relate to our glucose monitoring systems.

      In 2003, 5 scientific articles relating to our GlucoWatch Biographers were published, 10 GlucoWatch Biographer presentations were made at the American Diabetes Association (ADA) meeting in New Orleans,

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Recent Developments

      On January 30, 2004, we filed an application to dissolve our U.K. subsidiary, Cygnus (UK) Limited, which provided sales support and other administrative functions for us. We now handle these functions directly from the United States. This application to strike-off was filed with the Companies House and published on March 16, 2004; we expect our application to be granted in early third quarter 2004.

      On February 12, 2004, we have retained First Albany Capital Inc. to act as our exclusive financial advisor in connection with a possible merger, consolidation, reorganization, business combination, sale of a substantial portion of our assets or sale of more than 50% of our stock, or acquisition of the company. First Albany will receive fees that are customary for this type of transaction, including a market-rate contingent fee in the event that such a transaction is consummated.

      On February 23, 2004, using outside counsel, we invoked the mediation provisions set forth in our Asset Purchase Agreement with Ortho-McNeil Pharmaceutical, Inc. (“Ortho-McNeil”), a Johnson & Johnson company, relating to $34.6 million in potential milestone payments, which are under dispute between the parties.

      On February 25, 2004, the FDA approved our PMA supplement that expanded our G2 Biographer labeling to include a description of pre-treatment products and a method to minimize effects of skin irritation without affecting the accuracy of G2 Biographer glucose measurements. These pre-treatment products are Kenalog® (Westwood-Squibb Pharmaceuticals, Inc., Buffalo NY) aerosol spray and Cortizone-10 Quick Shot® (Pfizer Inc., New York NY) spray.

      On March 23, 2004, we entered into an Exchange Agreement with the debenture holders and retired all of our outstanding Convertible Debentures in exchange for an aggregate of $13.8 million in cash and 2.5 million shares of our common stock. The shares received by the Convertible Debenture holders are freely transferable pursuant to Rule 144(k) under the Securities Act of 1933, as amended. As a result of this exchange, $18.8 million in principal and interest that was to be paid under the Convertible Debentures will not have to be paid. In connection with the exchange, we also canceled all outstanding warrants to purchase our common stock that had been issued to the debenture holders and terminated the registration rights agreement associated with the Convertible Debentures. Additionally, the security interests in our assets held by the debenture holders have been terminated.

      On March 24, 2004, we notified our counterparty that we have elected to terminate our remaining equity line agreement, which had a commitment period ending December 31, 2004, in light of the fact that we do not believe we would have been able to draw on this facility anytime in the foreseeable future.

Diabetes

      Diabetes typically is a chronic, progressively debilitating disease in which the body loses its ability to maintain normal glucose levels. Diabetes is a leading cause of death by disease in the United States. Under normal conditions, the body maintains proper glucose levels by releasing insulin, a hormone secreted by the pancreas, in response to increases in blood sugar. Insulin is a hormone that regulates the storage and metabolism of glucose. Glucose levels must be maintained within a specific concentration range to ensure optimal cellular function and health. Diabetes develops when the pancreas is unable to produce sufficient levels of insulin or the body is unable to utilize insulin to effectively control glucose metabolism. Diabetes can lead to severe long-term health complications, including blindness, kidney disease, heart disease, stroke, nerve damage and peripheral vascular disease, potentially leading to amputation.

      Diabetes usually is classified as Type 1 or Type 2. Type 1 diabetes is characterized by a severe lack of insulin secretion by the body’s pancreas. Type 1 diabetes generally occurs during childhood or adolescence, but can occur at any age. Individuals with Type 1 diabetes require daily insulin injections to survive. Type 2 diabetes is the most common form of the disease and is characterized by the body’s inability to produce

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      The ADA estimates that, in 2002, 18.2 million people, or 6.3% of the population, in the United States had diabetes, and that 29% of these people are undiagnosed. The ADA reports that 1.3 million new cases of diabetes are diagnosed in the United States each year in people ages 20 and older. The risk of diabetes increases with age, and the ADA reports that 18.3% of people ages 60 and older in the United States have diabetes. In a 2002 report, the World Health Organization (WHO) estimated that 177 million people suffer from diabetes worldwide. The WHO report anticipates that this number will increase to at least 300 million by 2025.

      The ADA estimates that annual total U.S. health care expenditures incurred by people with diabetes climbed from $98 billion in 1997 to $132 billion in 2002, including annual per-capita health care costs for people with diabetes of $13,243 in 2002, compared with $2,560 for people without diabetes in 2002. Of the $132 billion in annual expenditures, direct medical expenditures accounted for approximately $92 billion and indirect costs, such as lost workdays, mortality, and permanent disability, totaled approximately $40 billion.

Managing Diabetes with Glucose Monitoring

      Every person’s glucose level varies during the course of the day, depending upon factors such as diet, insulin availability, exercise, illness and stress. To limit the short-term and long-term effects of diabetes, people with diabetes must maintain glucose levels within the proper range. To do this, they must first measure their glucose levels and then manage these levels by adjusting insulin intake, oral medication, diet and exercise. They must then take additional glucose measurements to gauge their individual response to the adjustments. The more frequently people with diabetes test their glucose levels and track their activities and food intake, the better they will be able to understand and manage their diabetes. Despite the benefits of frequent monitoring, the ADA estimates that on average people with diagnosed diabetes test only slightly more than once per day. We believe there is a medical need for an improved device that enables individuals and physicians to make better-informed diabetes management decisions.

      To obtain a glucose sample with current monitoring systems, users generally are required to prick one of their fingertips, or an alternative site such as the forearm or base of the thumb, with a lancing device, which typically consists of a spring-loaded lancet that penetrates a measured distance. After drawing a blood sample, users generally are required to drop the blood sample on a disposable test strip or bring the test strip into contact with the blood sample. To obtain additional blood glucose readings, this process must be repeated during the course of the day and can be inconvenient and disruptive to an individual’s lifestyle, as well as painful, although alternative-site sampling reduces pain. We believe these alternative-site methods are still inconvenient for the user and do not provide the recommended frequent testing.

      Numerous clinical studies validate the importance of more intensive diabetes management, which includes more frequent testing and more frequent insulin injections. The landmark Diabetes Control and Complications Trial (DCCT), sponsored by the National Institutes of Health (NIH) and published in 1993, showed that long-term intensive glucose monitoring and therapy slowed the onset and progression of eye, kidney and nerve disease in people with Type 1 diabetes. In the DCCT study, the protocol for intensive glucose management called for blood glucose testing at least four times per day by people with Type 1 diabetes. The DCCT demonstrated that the risk of complications could be reduced by 76% for eye disease, 50% for kidney disease and 60% for nerve disease by intensively managing glucose levels. Similar studies in the United Kingdom and Japan involving people with Type 2 diabetes support the importance of intensive glucose control.

      Despite the apparent long-term benefits of intensive glucose monitoring and therapy, the DCCT also showed that such intensive management resulted in approximately a three-fold increase in severe low blood sugar, or hypoglycemia (defined by the DCCT as requiring third-party assistance), sometimes resulting in seizure or coma and often leading to hospitalization. These events are particularly likely to occur during sleep,

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Our GlucoWatch G2 Biographer Solution

      Our GlucoWatch G2 Biographer provides readings frequently, automatically and non-invasively, up to six times an hour, for up to 13 hours, day or night, and is designed to enable people with diabetes and their physicians and other caregivers to identify trends and track patterns in glucose levels that would be difficult to detect with current testing techniques. The frequency of the measurements provides more complete information about fluctuations in glucose levels, which we believe enables better-informed decisions regarding diet, medications and physical activities. The GlucoWatch G2 Biographer is not intended to replace existing glucose measurement methods, but is intended to supplement blood glucose testing and provide more frequent information about glucose levels. In the United States, the GlucoWatch G2 Biographer is sold as a adjunctive prescription device. Published data show that children and adolescents using the Biographer are able to significantly reduce high blood glucose and improve their overall blood glucose control, as measured by the glycosylated hemoglobin test (also referred to as the HbA1c test or GHb test). Users are also able to detect much more hypoglycemia than with conventional blood glucose monitoring, particularly while wearing the Biographer at night, when hypoglycemia often goes undetected. Our third-generation GlucoWatch Biographer and AutoSensor system, which was recently approved by the FDA, focuses on enhancing customer satisfaction and ease of use, but is not yet commercially available.

      The GlucoWatch G2 Biographer differs from other glucose measuring systems in several important ways. Our GlucoWatch G2 Biographer:

	•	is non-invasive, collecting glucose through the skin, not from blood,
	•	automatically measures and displays glucose levels,
	•	detects trends and tracks patterns in glucose levels, as opposed to a single, discrete reading,
	•	alerts a patient when glucose levels are too high, too low, or likely to be low within 20 minutes, and
	•	stores more than 8,500 glucose values in an electronic diary.

      Our devices are the only products approved by the FDA that provide frequent, automatic and non-invasive measurements of glucose levels. We believe our products represent the most significant commercial technological advancement in self-monitoring of glucose levels since the advent, approximately 20 years ago, of finger-stick blood glucose measurement. Our GlucoWatch G2 Biographer system consists of two components: a durable component known as the Biographer, and a consumable component known as the AutoSensor. The GlucoWatch G2 Biographer uses an extremely low electrical current to extract glucose molecules through the skin, using patented sampling processes. The glucose is extracted from interstitial fluid that surrounds cells, rather than from blood, eliminating the need for multiple finger or alternative-site pricks to provide glucose readings. The G2 Biographer can be worn on the forearm like a watch and functions like a computer, analyzing and responding to data received from the AutoSensor. The AutoSensor uses proprietary biosensor technology and snaps into the back of the Biographer. The AutoSensor is calibrated with a standard blood glucose measurement. After a two-hour warm-up period during which no glucose readings are displayed, the AutoSensor automatically and non-invasively extracts and measures glucose as often as every 10 minutes for a period of up to 13 hours before requiring replacement, thus the user can receive up to six glucose readings per hour. An optional Biographer accessory known as the Analyzer also has been approved by the FDA, and this device downloads data from an individual’s Biographer into a personal computer. The proprietary Analyzer software uses the data to generate statistical reports and graphs that are designed to create a

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      Current methods for measuring glucose, in which skin is lanced and a blood sample is obtained for measurement, are inconvenient and disruptive to the user. Because of this, the vast majority of people with diabetes do not perform the frequent glucose testing that is necessary to provide adequate information to manage diabetes, despite substantial clinical evidence of the benefits of more intensive diabetes management. We believe there is an unmet medical need for a device that can provide and track frequent glucose readings automatically and non-invasively.

Product Research and Development

      Our product research and development efforts have been focused on the performance, convenience and ease of use of our products. We believe that as we make our glucose monitoring systems increasingly easy and simple to use, market penetration will increase, frequency of use will grow and diabetes management will be improved. We announced the approval by the FDA of our third-generation product in December 2003 and this new Biographer and AutoSensor system focuses on enhancing customer satisfaction and ease of use, but is not yet commercially available because of the lack of a new sales, marketing and distribution partner and as our existing G2 Biographer inventory. Specifically, the FDA approved modifications to the signal processing routine and data point screening parameters of the Biographer to reduce the number of skipped readings, modifications to the DOWN alert of the Biographer to increase the specificity of the alarm, and an AutoSensor formulation change to improve Biographer calibration. On February 25, 2004, the FDA approved our PMA supplement that expanded our G2 Biographer labeling to include a description of pre-treatment products and a method to minimize effects of skin irritation without affecting the accuracy of G2 Biographer glucose measurements. These pre-treatment products are Kenalog® (Westwood-Squibb Pharmaceuticals, Inc., Buffalo NY) aerosol spray and Cortizone-10 Quick Shot® (Pfizer Inc., New York NY) spray. Given our current financial situation as well as this recent FDA approval, we are not currently conducting research and development, although areas of focus have included further reducing the warm-up time, extending the duration of use beyond 13 hours, and changing the physical profile of the product.

Clinical Trials

      Independent clinical trials are being conducted in the United States and United Kingdom to examine the clinical utility of our GlucoWatch G2 Biographer in diabetes management. These trials are being funded by the NIH in the United States and the National Health Service Health Technology Assessment Commissioning Board in the United Kingdom. Both the U.S. and U.K. trials are randomized, controlled trials that are examining important health care outcomes, including glycosylated hemoglobin levels and the frequency of hypoglycemia. The U.S. trial (being conducted by a multicenter study group called DirecNet) is focusing on adolescents, and the U.K. trial (being conducted by a multicenter study group called MITRE) is focusing on adults. We also provide products on a limited basis, usually free of charge, to independent researchers for use in their various clinical studies.

Research and Development Expenses

      Research and development expenses have included costs for scientific and product development personnel, material used in the development and validation of high capacity manufacturing processes, consultants, clinical trials, supplies, depreciation of equipment used in research and product development, and facilities allocations. Significant expenses have been incurred in our efforts to increase our manufacturing capacity of both the disposable AutoSensors and durable Biographer and to maintain our quality system. We have also devoted internal resources and conducted clinical trials to expand the indications of our products. Research and development expenditures totaled $5.1 million, $13.9 million, and $27.4 million in the fiscal years 2003, 2002 and 2001, respectively. Due to the significant uncertainties with respect to the timing and outcome of our efforts to obtain a sales, marketing and distribution partner or other strategic alliance, as well as the FDA review process, we are unable to estimate the future level of research and development activities.

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Our Business Strategy

      We are currently seeking a new sales, marketing and distribution partner or other strategic alliance, and we are exploring the possibility of selling the company to a third party. We have retained First Albany Capital Inc. to act as our exclusive financial advisor in connection with a possible merger, consolidation, reorganization, business combination, sale of a substantial portion of our assets or sale of more than 50% of our stock, or acquisition of the company. First Albany will receive fees that are customary for this type of transaction, including a market-rate contingent fee in the event that such a transaction is consummated. Our Biographer products have not yet been widely accepted by the market due, we believe, to a combination of factors, including adoption barriers for new technology, the need for a paradigm shift in the management of diabetes, lack of widespread medical reimbursement, and the pricing and performance characteristics of the device. We do not have the resources or infrastructure to perform the full range of functions necessary to successfully market and sell our products. Our products require a sizeable sales force to create product awareness and provide education to health care professionals and end user customers, a managed care sales force to work with national and regional health plans to secure medical reimbursement, significant advertising and promotional resources, a variety of customer support and education programs, a technical support group, logistics and distribution expertise and personnel, and marketing management resources and personnel. Thus, we must obtain a sales, marketing and distribution partner or other strategic alliance, including but not limited to a merger or an acquisition by a third party, if we are to continue to sell our products. In the event that we are unsuccessful in our efforts and our product sales do not significantly increase, we may need to liquidate the company or sell some or all of its assets.

Sales and Marketing

      Under our Global Resolution, Sankyo Pharma is required to provide certain transition services related to distribution and customer services until the earlier of June 30, 2004 or when we notify Sankyo Pharma that they may discontinue such services; thereafter, we are solely responsible for the sales, marketing and distribution of our products in the United States. We do not anticipate having the ability to effectively perform this function ourselves in our current financial condition, and are seeking a sales, marketing and distribution partner or other strategic alliance.

Reimbursement

      In the United States, as well as in foreign countries, government-funded or private insurance programs, commonly known as third-party payors, pay a significant portion of the cost of a patient’s medical expenses. A consistent approach to reimbursement does not exist among all these payors. Therefore, reimbursement can be quite different from payor to payor. We believe that reimbursement is an important factor in the success of medical devices. Currently, our products do not have widespread reimbursement, although three national managed care plans have established a reimbursement approach for our products on a case-by-case basis upon a showing of medical necessity. We do not believe our products will receive widespread reimbursement in the near future, due to the lack of a current sales, marketing and distribution partner and our lack of expertise and resources in this area.

Manufacturing

      Under the terms of our Global Resolution with Sankyo Pharma, Sankyo Pharma transferred title to us of more than 20,000 GlucoWatch G2 Biographers and more than 1.0 million AutoSensors that we had previously sold and shipped to them. These supplies are more than adequate to meet foreseeable demand in the near term, and we do not have any plans to manufacture our G2 Biographer or third-generation product in the immediate future. Prior to our suspension of manufacturing, other companies manufactured for us the materials for the durable portion of our glucose monitoring system, the G2 Biographer, and we performed the final assembly and testing of the G2 Biographer at our facility in Redwood City, California, which complies with all applicable regulatory requirements. Other companies manufactured the materials for the disposable portion of our system, the AutoSensor, which was assembled in a third-party facility in Michigan, using equipment we own. This facility has been inspected by the FDA and was determined to be in compliance with

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Intellectual Property

      It is our policy to aggressively protect our investments in technology and marketing by filing patent and trademark applications in the United States and key foreign countries. As of December 31, 2003, we had 35 issued U.S. patents and 192 issued foreign patents, with approximately 46 additional patent applications pending worldwide. These patents and applications cover our algorithms and data processing, biosensors, and reverse iontophoresis methodologies for glucose and other analytes and represent more than 30 patent families. As of December 31, 2003, we had 16 U.S. trademark registrations, with 6 U.S. trademark applications pending or published, and 65 foreign trademark registrations, with approximately 19 additional foreign trademark applications pending. Our “GlucoWatch” trademark is registered in the United States, the European Community, Japan, and other countries.

      Additionally, we have a license from The Regents of the University of California relating to their U.S. and foreign patents covering technology for transdermal extraction of glucose and other analytes.

Customers

      Our 2003 revenues consisted of product and contract revenues. Of our product revenues, 93% related to sales of our products to Sankyo Pharma in the United States. Prior to termination of our agreements with Sankyo Pharma, we sold our products to Sankyo Pharma at specified prices. The majority of the remainder of our product revenues resulted from product sales to end-user customers in the United Kingdom. In light of our Global Resolution with Sankyo Pharma, we will not be selling any additional products to Sankyo Pharma.

      Of our contract revenues in 2003, 100% related to a Small Business Innovation Research (SBIR) grant from the NIH. We currently are not performing work under any SBIR grants or contracts, and thus do not expect any contract revenues in the near future.

Competition

      The self-monitoring of blood glucose is a large and growing market. The market is dominated by conventional finger-stick blood measurement technologies, with LifeScan, Inc. (a Johnson & Johnson company), Roche Diagnostics Corporation, Bayer AG and Abbott Laboratories having the largest market shares. Conventional finger-stick technology requires the individual to draw blood from the fingertip through the use of a lancet and then place the blood on a test strip that is inserted into a meter. Although this has been the standard of care for more than 20 years, many customers find the procedure to be painful and inconvenient. New products known as alternative-site technologies have been introduced to reduce the pain of the lancing procedure. These products use multiple sites, not just the fingertip, to extract blood samples.

      A number of companies are developing invasive methods to monitor glucose concentrations in interstitial fluid to provide frequent and automatic readings. For example, Medtronic, Inc., through its subsidiary Medtronic MiniMed, currently markets a device that must be inserted subcutaneously by a physician into the patient’s abdominal region. Glucose readings taken over a period of up to three days can only be retrieved by a physician, who must extract the device and download the data. A patient version of this device has recently been approved by the FDA, although the user only receives alarms and not glucose readings. Additionally, TheraSense, Inc. (whose purchase by Abbott Laboratories was recently announced) has a subcutaneous continuous glucose monitoring device under FDA review. Companies are also developing technologies that provide non-invasive extraction for episodic readings.

Government Regulation

      On March 22, 2001, the FDA granted approval for us to market and commercially distribute our first-generation GlucoWatch Biographer. Then, on March 21, 2002, the FDA approved our second-generation product, the GlucoWatch G2 Biographer. On August 28, 2002, we received approval from the FDA of our

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      In 1999, we received a CE Certificate for our GlucoWatch Biographer, indicating that the product met the essential requirements and other criteria of the European Community Directive 93/42/ ECC. The CE Certificate is required for selling products in the European Community. In the European Community, the GlucoWatch Biographer does not require a prescription.

      Our manufacturing facility is subject to periodic inspection by federal, state and foreign regulatory authorities and has been registered by the FDA and licensed by the California Department of Health Services, Food and Drug Branch. Our quality assurance system is also subject to regulation by both the FDA and the State of California. We also comply with ISO 9001, EN 46001 and ISO 13485 standards. ISO standards were developed to signify that companies have a quality manufacturing system with products that meet international quality standards. Our AutoSensors were commercially manufactured at a third-party facility that also complies with applicable regulatory requirements.

Employees

      As of December 31, 2003, we had a total of 24 full-time employees, all in the United States. Of this total number of employees, 13 were in technical functions and 11 were in general administration. None of our employees is represented by a labor union. We have not experienced any labor-related work stoppages and we believe we have good relations with our employees. In October 2003, we reduced our workforce by approximately 60%, primarily in the areas of research and development and operations.

Executive Officers

      The executive officers of the Company, who serve at the discretion of the Board of Directors, are as follows, in alphabetical order:

      Neil R. Ackerman, Ph.D. was appointed Chief Technical Officer in December 2000 and has served as Senior Vice President, Research & Development and Scientific Affairs since September 1998. Dr. Ackerman joined Cygnus in May 1994 as Vice President, Research & Development and, from January 1997 to September 1998, he served as Senior Vice President, Research & Development. From 1990 to May 1994, Dr. Ackerman served as Vice President of Research and Development for Glycomed, leading its discovery efforts on cardiovascular and inflammatory diseases. From 1982 to 1990, he was Research Director, Cancer and Inflammatory Diseases with DuPont Pharmaceuticals. Prior to that time, he held research and management positions at Syntex Corporation and Pfizer, Inc. Dr. Ackerman received B.S. and Ph.D. degrees from the University of Maryland and completed a post-doctoral fellowship in immunology at Stanford University.

      Craig W. Carlson was appointed Chief Operating Officer in December 2000 and has served as Chief Financial Officer since 1998. He joined Cygnus in July 1993 as Vice President, Corporate Communications, became Vice President, Strategic Planning and Corporate Marketing, then assumed responsibility for finance and information technology in 1997 as Senior Vice President, Finance. From 1988 to 1993, he was Vice President and Group Director at Young & Rubicam Advertising in San Francisco. Prior to that, Mr. Carlson

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      John C Hodgman was appointed Chairman of the Board in 1999 and has served as a director, President and Chief Executive Officer since August 1998. He was President, Cygnus Diagnostics from May 1995 to August 1998, and was also Chief Financial Officer of Cygnus, Inc. Mr. Hodgman joined Cygnus in August 1994 as Vice President, Finance and Chief Financial Officer. Prior to joining Cygnus, Mr. Hodgman served as Vice President of Operations and Finance and as Chief Financial Officer for Central Point Software, a personal computer and networking software company. Prior to that, he was Vice President of Finance and Administration and Chief Financial Officer of Ateq Corporation. Mr. Hodgman holds a B.S. degree from Brigham Young University and an M.B.A. from the University of Utah. Mr. Hodgman is also a director of Immersion Corporation and AVI BioPharma, Inc.

      Barbara G. McClung was appointed General Counsel, Senior Vice President and Corporate Secretary in December 1998. Ms. McClung joined Cygnus in January 1998 as Vice President, Intellectual Property. In August 1998, Ms. McClung was promoted to Vice President and General Counsel. Prior to joining Cygnus, from August 1990 to January 1998, she was Corporate Patent Counsel at Chiron Corporation, a biotechnology company. Prior to that she was Patent Counsel at E.I. du Pont de Nemours & Co. She is a member of the California, Delaware and Pennsylvania bars, as well as being a registered patent attorney before the United States Patent and Trademark Office. Ms. McClung received a J.D. from the University of Pennsylvania Law School, as well as a B.A. from the University of California, San Diego, and an M.A. from the University of Pennsylvania.

Available Information

      Our corporate website is www.cygn.com and our product website is www.glucowatch.com. We make available free of charge, on or through our website, our annual, quarterly and current reports, and any amendments to those reports, as soon as reasonably practicable after we electronically file such reports with the Securities and Exchange Commission. Information contained on our website is not part of this Report.

      In the United States, we lease approximately 38,000 square feet in a building located in Redwood City, California, and our lease runs through April 2009. This building houses our administrative offices, laboratories, and final assembly lines for the Biographer. On October 15, 2003, we terminated our second building lease that would have run through December 2003, which we had previously subleased to Maxygen, Inc. We received full payment from Maxygen, Inc. for this early termination, and in turn paid the remaining lease amount to the property owner.

      The applicable Cygnus manufacturing facility complies with ISO 9001, EN 46001, ISO 13485 and United States Quality System Regulations standards. We hold a Medical Device Manufacturing License from the California Department of Health Services, Food and Drug Branch and a Device Establishment Registration Number from the Center for Devices and Radiological Health branch of the FDA.

      On October 6, 2003, we filed a complaint in the Superior Court of the State of California for the County of San Mateo against Sankyo Pharma and Sankyo Japan for breach of contract and intentional interference with contract, respectively, relating to the sales, marketing and distribution of our GlucoWatch Biographer products. On November 6, 2003, Sankyo Pharma filed an answer and cross-claims against us for declaratory relief, breach of contract, and defamation. On December 15, 2003 we filed a response to these claims, and Sankyo Japan filed its answer.

      On December 23, 2003, we entered into the Global Resolution with Sankyo Pharma that resolved and dismissed the pending litigation, and terminated our Sales, Marketing and Distribution Agreement and all other contractual arrangements. The Global Resolution provided for Sankyo Pharma to pay us $30.0 million

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      On February 23, 2004, using outside counsel, we invoked the mediation provisions set forth in our Asset Purchase Agreement with Ortho-McNeil Pharmaceutical, Inc. (“Ortho-McNeil”), a Johnson & Johnson company, relating to $34.6 million in potential milestone payments, which are under dispute between the parties.

      None.

PART II

      On January 6, 2003, we received the determination of the Nasdaq Listing Qualifications Panel to transfer our common stock to the OTC Bulletin Board, effective at the open of business on January 8, 2003. Our common stock previously had been trading on the Nasdaq National Market under the symbol “CYGN” since 1991. Our common stock is currently trading on the OTC Bulletin Board under the symbol “CYGN.” The following table sets forth, for the periods indicated, the high and low sale prices per share of our common stock as quoted on the Nasdaq National Market through January 7, 2003, and as quoted on the OTC Bulletin Board commencing January 8, 2003.

      On March 24, 2004, the last reported sale of our common stock on the OTC Bulletin Board was $0.46 per share and there were 969 record holders of our common stock. We have never paid any cash dividends on our capital stock. We anticipate that we will retain our earnings, if any, to support operations and to finance the growth and development of our business. Therefore, we do not expect to pay cash dividends in the foreseeable future.

Recent Sales of Unregistered Securities

      None.

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      The selected consolidated financial data presented below are derived from the audited consolidated financial statements of Cygnus, Inc. The following data should be read in conjunction with the consolidated financial statements and related notes, the information set forth under “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations” and other financial information included herein.

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      Some of the statements in this report, including in the documents incorporated by reference, are forward-looking statements that involve risks and uncertainties. These forward-looking statements include statements about our plans, objectives, expectations, intentions and assumptions and other statements contained in this report, including in the documents incorporated by reference, that are not statements of historical fact. Forward-looking statements include but are not limited to statements about our ability to find a new sales, marketing and distribution partner or other strategic alliance, including but not limited to a merger or an acquisition by a third party; the capabilities and potential of the GlucoWatch G2 Biographer business; our ability to achieve market acceptance of the GlucoWatch G2 Biographer; our ability to manufacture the GlucoWatch G2 Biographer; our plans for other commercialization alliances; and the speed and potential results of the regulatory process. In some cases, you can identify these statements by words such as “may,” “will,” “should,” “estimates,” “predicts,” “potential,” “continues,” “strategy,” “believes,” “anticipates,” “plans,” “expects,” “intends” and similar expressions. We cannot guarantee future results, levels of activity, performance or achievements. Our actual results and the timing of certain events may differ significantly from the results and timing discussed in this report, including those under “Risk Factors” herein, as well as in the documents incorporated by reference. All forward-looking statements included in this report are based on information available to us on the date hereof, and we assume no obligation to update any such forward-looking statements.

      This information should be read in conjunction with our consolidated financial statements and accompanying notes thereto in the F- pages of this report.

Overview

      We have developed and manufactured frequent, automatic and non-invasive glucose monitoring devices. Our devices are designed to provide more data to individuals and their physicians and enable them to make better-informed decisions on how to manage diabetes. We began the U.S. market launch of our first-generation GlucoWatch® Biographer on April 15, 2002. On March 21, 2002, the U.S. Food and Drug Administration (FDA) approved our second-generation product, the GlucoWatch G2® Biographer. On August 28, 2002, we received approval from the FDA of our supplemental pre-market approval (PMA) application for use of the GlucoWatch G2 Biographer by children and adolescents (ages 7 to 17). On December 4, 2003, we announced that the FDA approved our third-generation product. Compared with our second-generation product, this improved Biographer and AutoSensor system focuses on enhancing customer satisfaction and ease of use; however, it is not yet commercially available.

      On December 23, 2003, we entered into the Global Resolution with Sankyo Pharma that resolved and dismissed the pending litigation filed on October 6, 2003, and terminated our Sales, Marketing and Distribution Agreement and all other contractual arrangements with Sankyo Pharma. The Global Resolution provided for Sankyo Pharma to pay us $30.0 million and also specified that neither party owed any payments to the other party, thus allowing us to write off certain liabilities and assets, resulting in a total net gain of $75.8 million. Furthermore, Sankyo Pharma transferred title to us of more than 20,000 GlucoWatch G2 Biographers and more than 1.0 million AutoSensors that we had previously sold and shipped to them. Sankyo Pharma is to provide certain transition services related to distribution and customer services until the earlier of June 30, 2004 or when we notify Sankyo Pharma that they may discontinue such services, and we are entitled to receive 30% of all monies received from product sales by Sankyo Pharma during this transition period. In light of these developments, we are not likely to manufacture our G2 Biographer or third-generation product or develop new products in the near future. We are currently seeking a new sales, marketing and distribution partner or other strategic alliance, and we are exploring the possibility of selling the company to a third party. We have retained a financial advisor to lead this process.

      On March 23, 2004, we entered into an Exchange Agreement with the debenture holders and retired all of our outstanding Convertible Debentures in exchange for an aggregate of $13.8 million in cash and 2.5 million shares of our common stock. As a result of this exchange, $18.8 million in principal and interest that was to be paid under the Convertible Debentures will not have to be paid. Although this exchange

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      On March 24, 2004, we notified our counterparty that we have elected to terminate our remaining equity line agreement, which had a commitment period ending December 31, 2004, in light of the fact that we do not believe we would have been able to draw on this facility anytime in the foreseeable future. We have not utilized any portion of this equity line. Because we did not expect to be able to draw on this facility, as a practical matter, we do not expect our termination of this equity line to have any impact on our liquidity.

Critical Accounting Policies

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

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

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

      Revenues in the United States generated from our shipments of product to Sankyo Pharma for resale under our now-terminated Sales, Marketing and Distribution Agreement were deferred until the product was sold by Sankyo Pharma to its third-party customers, because the net price of our product sales to Sankyo Pharma was subject to certain contractual pricing adjustments, such as rebates, discounts and certain fees offered or paid by Sankyo Pharma to its third-party customers. Product revenues recorded by us for the first three calendar quarters of 2003 are net of these adjustments; however, product revenues recorded for the fourth quarter ended December 31, 2003 were not subject to such adjustments because our Sales, Marketing and Distribution Agreement with Sankyo Pharma had been terminated pursuant to the Global Resolution. As a result of the Global Resolution, the remaining $9.3 million balance in “Deferred revenues from Sankyo Pharma net of deferred costs of products shipments” previously deferred in our balance sheet at the date of the Global Resolution was included as a component of “Gain from Sankyo Pharma settlement” in our statement of operations during the fourth quarter of 2003. We do not expect any significant product revenues in 2004 unless we obtain a sales, marketing and distribution partner or other strategic alliance.

      Our contract revenues may include up-front and interim milestone payments from co-promotion; sales, marketing and distribution; and development agreements. Milestone payments are recorded as revenue based on the provisions of the underlying agreement and the estimated period of continuing obligations, generally the contract term. We received $25.0 million in milestones from Sankyo Pharma under our now-terminated Sales, Marketing and Distribution Agreement and prior Co-Promotion Agreement, and these milestone payments

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      Our contract revenues also included payments received pursuant to research grants. Revenues were recognized based on the performance requirements of the grant contract and as reimbursable expenses are incurred. We currently are not performing work under any SBIR grants or contracts, and thus do not expect any contract revenues in the near future.

      Inventory is stated at standard cost adjusted to approximate the lower of actual cost (first-in, first-out method) or market, after appropriate consideration is given to obsolescence and inventory in excess of anticipated future demand. However, due to the early stage of our product commercialization activities, the estimates required in inventory valuation, including production yields and normal capacity, labor costs incurred in the production of each unit and overhead costs applicable to manufacturing operations, are inherently uncertain. Thus, actual results may differ from those estimates.

      For the quarter ended September 30, 2003, in light of our then-ongoing litigation with Sankyo Pharma, our subsequent reduction in force, and the excess product inventory held by Sankyo Pharma, we concluded that it was unlikely that we would continue to manufacture any products in the near future. Thus, we determined that we would not be able to realize the value of our remaining raw materials and work-in-process inventories and wrote off a total of approximately $4.9 million of these inventories at that time.

      Under the terms of our Global Resolution, Sankyo Pharma transferred title to us of more than 20,000 GlucoWatch G2 Biographers and more than 1.0 million AutoSensors that we had previously sold and shipped to them. Because we do not have a new sales, marketing and distribution partner or other strategic alliance to sell our products, we anticipate minimal demand for our products in the foreseeable near term. Therefore, we assessed that the Sankyo Pharma finished goods inventory received as part of the Global Resolution in December 2003 had no realizable value at the time. Additionally, in December 2003, we wrote off substantially all of our remaining finished goods inventory, approximately $630,000, that had not been shipped or sold to Sankyo Pharma. Our remaining inventory of $62,000 at December 31, 2003 consisted of finished goods for sale in the United Kingdom.

      Prior to the approval by the FDA of our product and our commercial processes, material was generally charged to research and development expenses upon receipt and was not carried as inventory in our financial statements. Accordingly, for the year ended December 31, 2003, costs of product revenues do not include previously expensed material.

      We review equipment and improvements and other long-lived assets for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Recoverability is measured by comparison of the carrying amount of the assets to the future net cash flows that the assets are expected to generate. If such assets are considered to be impaired, the impairment is recognized and is measured as the amount by which the carrying amount of the assets exceeds the fair value of the assets, evaluated by considering the present value of future net cash flows. No impairment charges were recorded during 2003 and 2001. In the fourth calendar quarter of 2002, we recorded an impairment charge of $1.5 million, primarily related to our semi-automated back-up AutoSensor-manufacturing equipment, which became obsolete in the fourth quarter of 2002 as a result of the deployment of our fully automated manufacturing equipment. This charge was included in sales, marketing, general and administrative expenses. As of December 31, 2003, we do not anticipate using our production equipment in the near term. We have concluded that its current carrying amounts would be recoverable if we enter into a new sales, marketing and distribution agreement or other strategic alliance. We may also use this equipment in research and development efforts, if any. As a result, we have not recognized any impairment against these assets at

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Results of Operations

      Our results of operations have fluctuated from period to period and are expected to continue to fluctuate in the future based upon the progress and ultimate outcome of our attempts to secure alternative strategic options (including, but not limited to, a merger or an acquisition by a third party), the demand for our products, product revenues and our costs of product revenues, as well as the level of our expenses during any given period. Historical results should not be viewed as indicative of future operating results. We are also subject to risks common to companies in our industry and in our current position, including risks inherent in our need to find alternative approaches or other strategic alliance for the sales, marketing and distribution of our products in the United States; enforcement of our patents and proprietary rights; need for future capital, particularly in light of our stock currently being listed on the OTC Bulletin Board; potential competition; and uncertainty of future regulatory approvals. We have experienced operating losses since our inception, and we expect to continue to incur operating losses at least until we have significant product sales, if we ever do. Because of the terms of the Global Resolution, however, we recorded a non-operating gain of approximately $75.8 million (“Gain from Sankyo Pharma settlement” in our statement of operations) for the quarter ended December 31, 2003, which resulted in net income of $49.4 million for the year ended December 31, 2003. We expect to continue our previous experience of incurring operating losses in 2004. At December 31, 2003, our accumulated deficit and our stockholders’ equity were $247.3 million and $6.8 million, respectively.

Comparison for the Years Ended December 31, 2003 and 2002

      Net product revenues for the year ended December 31, 2003 were $2.7 million, compared to $3.5 million for the year ended December 31, 2002. Ninety four percent (94%) of net product revenues recognized for the year ended December 31, 2003 resulted from sales of our GlucoWatch G2 Biographers in the United States. Approximately $1.2 million of our net product revenues recognized in 2003 related to sample and practice G2 Biographers and related products shipped to Sankyo Pharma for use by their sales force. Sample and practice G2 Biographers and related products were sold to Sankyo Pharma at a fixed price that was not subject to adjustment and therefore the revenues from these sales were recognized upon Sankyo Pharma’s receipt of the product.

      Unit shipments from us to Sankyo Pharma of the GlucoWatch G2 Biographers for the year ended December 31, 2003 were approximately 10,000 Biographers, approximately 2,600 of which were for resale to Sankyo Pharma’s customers and the remaining amount were sample and practice units. During the year ended December 31, 2003, we shipped approximately 1.1 million AutoSensors, substantially all of which were to Sankyo Pharma. Because the net price of some of our product sales to Sankyo Pharma was subject to certain pricing adjustments, we deferred product revenues related to product shipments during 2003 of approximately $8.1 million and this was a component of “Deferred revenues from Sankyo Pharma net of deferred costs of product shipments” in our balance sheet prior to the Global Resolution. The “Deferred revenues from Sankyo Pharma net of deferred costs of product shipments” reflected in our balance sheet prior to the Global Resolution approximated $9.3 million, and this was included as a component of “Gain from Sankyo Pharma settlement” in our statement of operations during the fourth quarter of 2003. We do not expect any significant product revenues in 2004 unless we secure a sales, marketing and distribution partner or other strategic alliance.

      Contract revenues for the year ended December 31, 2003 were $234,000, compared to $401,000 for the year ended December 31, 2002. Contract revenues for the years ended December 31, 2003 and 2002 included revenues related to our NIH SBIR Phase I and II grants, and revenues were recognized as research activities are performed. We currently are not performing work under any SBIR grants or contracts, and thus do not expect any contract revenues in the near future.

      Costs of product revenues for the year ended December 31, 2003 were $15.4 million, compared to $6.4 million for the year ended December 31, 2002. Costs of product revenues for the year ended December 31, 2003 consisted of $3.7 million in material and other production costs associated with the

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      Pursuant to our now-terminated Sales, Marketing and Distribution Agreement with Sankyo Pharma, the sales price to Sankyo Pharma of practice, sample and accessory products approximated our costs. For the year ended December 31, 2003, approximately 46% of the revenues we recognized derived from the sale of practice, sample and accessory products to Sankyo Pharma, and this had a negative impact on our margins. In addition, due to the fact that Sankyo Pharma was entitled to receive a specified margin on product sales, our margins were negatively impacted in periods when the allowed deductions were high relative to Sankyo Pharma’s sales to its third-party customers, such as occurred in 2003. Also, average manufacturing costs are greater at low unit volumes, such as the volumes experienced during our initial commercialization in the United States. As a partial offset to these negative impacts on our product margins, however, costs of product revenues did not include certain material and other product costs previously expensed. Prior to commercialization, materials that we purchased were expensed to research and development. We have been able to use some of this material in our products sold. If we were to include the costs that were previously expensed to research and development but then used in our products sold, our costs of product revenues would have been $390,000 greater than the reported amounts for the year ended December 31, 2003. Overall, we expect our product margins to vary from period to period due to the mix of products sold (i.e., Biographers, AutoSensors and accessories), actual utilization of our manufacturing facilities, and financial terms of any future sales, marketing and distribution arrangement or other strategic alliance.

      For the year ended December 31, 2003, we deferred costs of approximately $5.2 million related to deferred product revenues, and these costs were recorded as a component of “Deferred revenues from Sankyo Pharma net of deferred costs of product shipments” in our balance sheet. The “Deferred revenues from Sankyo Pharma net of deferred costs of product shipments” reflected in our balance sheet prior to the Global Resolution with Sankyo Pharma approximated $9.3 million, and this was included as a component of “Gain from Sankyo Pharma settlement” in our statement of operations. We expect our costs of product revenues to be minimal in 2004 unless we secure a sales, marketing and distribution partner or other strategic alliance.

      Research and development expenses for the year ended December 31, 2003 were $5.1 million, compared to $13.9 million for the year ended December 31, 2002. Research and development expenses continued to decrease significantly as we moved products into commercialization. Research and development expenses included costs for scientific and product development personnel, material used in the development and validation of high capacity manufacturing processes, consultants, clinical trials, supplies, maintenance of our quality system, and depreciation of equipment used in research and product development. In 2002, significant expenses were incurred in our efforts to increase our manufacturing capacity of both the disposable AutoSensors and durable Biographer; however, these efforts decreased in 2003. We have devoted internal resources and conducted clinical trials to expand the indications of our products, specifically to the pediatric segment, and to enhance features and the usability of our products. Because we do not have systems in place to capture the expenses incurred in each of the above areas, we are unable to report the expenses incurred to date in each of the above categories. We do not expect our research and development expenses to increase during 2004 unless we secure a new sales, marketing and distribution partner or other strategic alliance.

      Sales, marketing, general and administrative expenses for the year ended December 31, 2003 were $6.4 million, compared to $22.5 million for the year ended December 31, 2002. These amounts included $849,000 and $14.2 million of sales and marketing expenses in the years ended December 31, 2003 and 2002, respectively. Included in the $14.2 million for 2002 is $10.0 million of advertising and promotion expenses that were required under our agreements with Sankyo Pharma. In 2003, we were not required to incur any advertising and promotion expenses under these agreements. The overall decrease of $16.1 million in sales, marketing, general and administrative expenses compared to 2002 is primarily attributed to a decrease of $13.4 million in sales and marketing expenses. Furthermore, sales, marketing, general and administrative

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      Interest and other income/(expense), net for the year ended December 31, 2003 was $114,000 compared to $417,000 for the year ended December 31, 2002. This decrease was primarily due to the lower yields on lower average cash and investment balances.

      Interest expense for the year ended December 31, 2003 was $2.2 million, compared to $3.2 million for the year ended December 31, 2002. Included in interest expense for the years ended December 31, 2003 and 2002 was the interest accrued on our convertible debentures and the amortization of the value of the warrants issued in connection with our financing agreements. The interest rate on our convertible debenture notes decreased from 8.5% to 3.5% in the fourth quarter of 2002. In addition, the principal balance due was reduced by a payment of $2.0 million in June 2003. These two factors accounted for the majority of the change in interest expense in 2003, compared to 2002.

      Gain from Sankyo Pharma settlement for the year ended December 31, 2003 was $75.8 million. The Global Resolution provided for Sankyo Pharma to pay us $30.0 million and also specified that neither party owed any payments to the other party, thus allowing us to write off certain liabilities and assets, resulting in a total net gain of $75.8 million.

      During the transition period in which Sankyo Pharma provides certain distribution and customer services, we are entitled to 30% of all monies received for products sold by Sankyo Pharma. Amounts received will be recorded as additional “Gain from Sankyo Pharma settlement” in our statement of operations. This transition period ends on the earlier of June 30, 2004 or when we notify Sankyo Pharma that they may discontinue such services. Also, as part of the Global Resolution, Sankyo Pharma transferred title to us of all GlucoWatch G2 Biographer products that they currently owned, which includes more than 20,000 GlucoWatch G2 Biographers and more than 1.0 million AutoSensors.

      The following table summarizes the components of the gain from the Sankyo Pharma settlement, in thousands:

(1)	In fiscal 2002, we were required to reimburse Sankyo Pharma for their actual promotional expenses of $6.7 million and this payment, together with an amount we owed Sankyo Pharma for customer rebates, could have been deferred until second quarter 2004.
(2)	In fiscal 2002 and 2003, we were required to pay quarterly sales and marketing commissions to Sankyo Pharma; however, payment of these commissions could have been deferred to at least 2005.
(3)	Other liabilities due to Sankyo Pharma primarily included customer advances and reserves for the replacement of stale-dated AutoSensors.

      Provision for income taxes for the year ended December 31, 2003 was $199,000, substantially all of which related to alternative minimum tax due from the gain from our settlement with Sankyo Pharma. We were able to utilize net operating loss carryforwards and research and development tax credit carryforwards to offset

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Comparison for the Years Ended December 31, 2002 and 2001

      Net product revenues for the year ended December 31, 2002 were $3.5 million, compared to $489,000 for the year ended December 31, 2001. Ninety percent (90%) of net product revenues recognized for the year ended December 31, 2002 resulted from sales of our GlucoWatch Biographers in the United States. Approximately $1.6 million of our net product revenue recognized in 2002 related to sample and practice G2 Biographers shipped to Sankyo Pharma. The majority of the remaining net product revenues reflected revenues for shipments of our first-generation product. Customers who purchased our first-generation Biographer in the United States had a right to a free upgrade to the G2 Biographer if requested within a specified time period. We recognized revenue for our first-generation product only when we shipped the free upgrades or when the upgrade period expired. Net product revenues for the year ended December 31, 2001 resulted from the initial sales of our GlucoWatch Biographer in the United Kingdom.

      Unit shipments of the GlucoWatch Biographers for the year ended December 31, 2002 were approximately 36,000 Biographers, of which approximately 2,000 were first-generation products sold directly to end users and approximately 34,000 were second-generation products shipped to Sankyo Pharma, about 21,000 of which were for resale to Sankyo Pharma’s customers and the remaining amount were sample and practice units. The majority of these shipped units reflected our initial U.S. market entry of the second-generation Biographers. During the year ended December 31, 2002, we shipped approximately 527,000 AutoSensors, of which approximately 454,000 were shipped to Sankyo Pharma.

      Contract revenues for the year ended December 31, 2002 were $401,000, compared to $5.3 million for the year ended December 31, 2001. Contract revenues for the years ended December 31, 2002 and 2001 included revenues related to our NIH SBIR Phase I and II grants and our two NIH Phase I SBIR contracts, respectively. Revenues related to our NIH grants and contracts were recognized as research activities are performed. Also included in contract revenues for the year ended December 31, 2001 was a milestone of $5.0 million pursuant to our now-terminated Product Supply and Distribution Agreement with Yamanouchi Pharmaceutical Co., Ltd. related to FDA approval of our first-generation Biographer.

      Costs of product revenues for the year ended December 31, 2002 were $6.4 million, compared to $271,000 for the year ended December 31, 2001. Costs of product revenues for the year ended December 31, 2002 consisted of $5.0 million in material and other production costs associated with the manufacturing of our products and underabsorbed indirect overhead representing excess manufacturing capacity put in place to accommodate our previously anticipated future requirements. In addition, costs of product revenues for the year ended December 31, 2002 included approximately $1.1 million in expenses from the quarter ended June 30, 2002 related to the write-off of obsolete first-generation Biographer inventory, caused by the earlier-than-anticipated FDA approval of our second-generation Biographer and its anticipated launch in the third quarter of 2002. In the quarter ended December 31, 2002, we also wrote off $290,000 of material in excess of projected requirements and for outdated literature and expired product. Subsequent to the write-off of $1.1 million in the second quarter 2002, we were able to utilize approximately $480,000 of this inventory, primarily due to our redesign of the practice G2 Biographer to allow for the use of some of this material. Our costs of product revenues for the second half of the year ended December 31, 2002 would have been $480,000 higher if we had not previously expensed the written-off material.

      Pursuant to our now-terminated Sales, Marketing and Distribution Agreement with Sankyo Pharma, the sales price to Sankyo Pharma of practice and sample products approximated our costs. For the year ended December 31, 2002, approximately half of the revenues we recognized derived from the sale of practice and sample products to Sankyo Pharma, which had a negative impact on our margins. Another factor negatively affecting our margin for 2002 was the cost of the G2 Biographers shipped as free upgrades to our customers who purchased our first-generation products. Customers who purchased our first-generation product were eligible for a free upgrade if they responded to our upgrade offer within a certain period of time. We had initially deferred product revenues and costs of product revenues for such first-generation products sold to

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      For the year ended December 31, 2002, we deferred costs of approximately $5.0 million related to deferred product revenues, and these costs were recorded as a component of “Deferred revenues from Sankyo Pharma net of deferred costs of product shipments” in our balance sheet as of December 31, 2002.

      Research and development expenses for the year ended December 31, 2002 were $13.9 million, compared to $27.4 million for the year ended December 31, 2001. Research and development expenses decreased significantly as a result of a reduction in material costs charged to research and development expenses for commercial manufacturing scale-up.

      Sales, marketing, general and administrative expenses for the year ended December 31, 2002 were $22.5 million, compared to $15.5 million for the year ended December 31, 2001. These amounts included $14.2 million and $7.4 million of sales and marketing expenses in the years ended December 31, 2002 and 2001, respectively. Included in the $14.2 million for 2002 was $10.0 million of advertising and promotion expenses as required under our now-terminated Sales, Marketing and Distribution Agreement with Sankyo Pharma. The overall increase of $7.0 million in sales, marketing, general and administrative expenses over 2001 was primarily attributed to an increase of $6.3 million in advertising and promotion expenses. Sales, marketing, general and administrative expenses in 2002 also included an asset impairment charge of $1.5 million, primarily related to semi-automated back-up equipment for the production of AutoSensors, for which we did not have foreseeable alternative uses.

      Interest and other income/(expense), net for the year ended December 31, 2002 was $417,000, compared to $2.4 million for the year ended December 31, 2001. Included in interest and other income/(expense), net for the year ended December 31, 2001 was a gain of $1.1 million resulting from the sale of certain marketable equity securities and cash proceeds of $416,000 pursuant to our 1999 Ortho-McNeil agreement related to the sale of substantially all of our drug delivery business. Excluding those gains, interest income decreased by $500,000 when compared to 2001. This decrease was primarily due to the lower yields on lower average cash and investment balances.

      Interest expense for the year ended December 31, 2002 was $3.2 million, compared to $3.7 million for the year ended December 31, 2001. The interest rate on our convertible debenture notes decreased from 8.5% to 3.5% in the fourth quarter of 2002, which accounted for the majority of the change in interest expense in 2002, compared to 2001.

      Provision for income taxes for the year ended December 31, 2002 was $23,000 and related to U.K. taxes on income. The provision for taxes for the year ended December 31, 2001 was $527,000, of which $500,000 was for foreign tax withholdings applicable to the milestone payment from Yamanouchi Pharmaceutical Co., Ltd. and the remaining $27,000 related to provisions for income taxes in the United Kingdom.

Liquidity and Capital Resources

      As of December 31, 2003, our cash, cash equivalents and investments totaled $33.5 million, primarily resulting from the $30.0 million received as part of our Global Resolution with Sankyo Pharma.

      Net cash provided by operating activities for the year ended December 31, 2003 was $11.0 million, compared to net cash used in operating activities of $12.2 million for the year ended December 31, 2002. Cash provided by operating activities during the year ended December 31, 2003 was primarily due to our net income of $49.4 million, partially offset by the non-cash portion of the gain from the Sankyo Pharma settlement

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      Net cash provided by investing activities of $3.1 million for the year ended December 31, 2003 resulted primarily from the net sales and maturities of investments of $3.2 million. Net cash provided by investing activities of $2.8 million for the year ended December 31, 2002 resulted primarily from the net sales and maturities of investments of $3.4 million, partially offset by capital expenditures of $601,000.

      Net cash used in financing activities totaled $4.1 million for the year ended December 31, 2003 and included principal payments of $4.0 million pursuant to our convertible debentures. Net cash provided by financing activities totaled $15.7 million for the year ended December 31, 2002 and included net proceeds of $14.7 million from the 2002 public offering of our common stock, net proceeds of $452,000 from sales of our common stock under our equity lines and additional cash proceeds of $554,000, primarily from sales of common stock under our employee stock purchase plan.

      As of December 31, 2003, our contractual obligations for the next seven years are as follows:

(1)	On March 23, 2004, we entered into an Exchange Agreement with the debenture holders and retired all of our outstanding Convertible Debentures and associated warrants in exchange for an aggregate of $13.8 million in cash and 2.5 million shares of our common stock. Thus, these amounts will not have to be paid.
(2)	Under our Exclusive License Agreement, effective January 31, 1995, as amended, and the minimum royalty payments terminate upon the last-to-expire patent licensed under this agreement. This expiration date is January 18, 2011.

      The level of cash used in operating activities during previous periods is not necessarily indicative of the level of future cash usage. Our long-term cash and capital expenditure requirements will depend upon numerous factors including but not limited to (i) costs associated with seeking and obtaining alternative approaches or other strategic alliance for the sales, marketing and distribution of our products in the United States, (ii) the time required to obtain any regulatory approvals, (iii) additional expenditures to support the manufacture of new products, including conversion of existing G2 Biographers into third-generation Biographers, (iv) the progress of our research and development programs, if any, and (v) possible expansion into new markets.

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      As of December 31, 2003, we had existing cash, cash equivalents and investments of $33.5 million. However, we have incurred significant net operating losses since our inception, including a loss from operations of $24.1 million for the year ended December 31, 2003. We have incurred negative cash flows from operations since our inception, although our Global Resolution with Sankyo Pharma provided us with positive cash flows from operating activities for the year ended December 31, 2003. At December 31, 2003, our stockholders’ equity was $6.8 million and our accumulated deficit was $247.3 million.

      As of December 31, 2003, based upon current expectations for operating losses and projected short-term expenditures, we believe that existing cash, cash equivalents, and investments of $33.5 million will be sufficient to meet our existing operating expenses, contractual obligations, and capital expenditure requirements, if any, at least for the next 12 months. Although there has been a substantial reduction in our headcount, suspension of manufacturing and related reduction in costs of product revenues and research and development activities, and other cost-cutting measures, we also expect to receive very little cash from future product revenues without first obtaining a sales, marketing and distribution partner or other strategic alliance. However, there can be no assurance that we will not require further financing and, if we do, that such financing will be available.

Income Taxes

      At December 31, 2003, we had federal net operating loss and research and development tax credit carryforwards of $238.3 million and $6.5 million, respectively. These carryforwards expire at various dates beginning in 2004 and ending in 2023. For state income tax purposes, at December 31, 2003 we had net operating loss carryforwards of $67.0 million that expire at various dates beginning in 2004 and ending in 2013, and state research and development tax credit carryforwards of approximately $4.7 million, which do not expire.

      Because of the change-in-ownership provisions of the Internal Revenue Code, a substantial portion of our net operating loss and tax credit carryforwards may be subject to annual limitations. The annual limitations may result in the expiration of the net operating losses and tax credits before utilization.

RISK FACTORS

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

Risks Related to Our Business

      Under our now-terminated Sales, Marketing and Distribution Agreement with Sankyo Pharma, we were totally dependent upon Sankyo Pharma for the sales, marketing and distribution of our products in the United States. Sankyo Pharma is to provide certain transition services related to distribution and customer services for us currently; however, such services will cease on the earlier of June 30, 2004 or when we notify Sankyo Pharma that they may discontinue such services. Despite such transition services, we do not believe we will be able to generate additional cash from product sales in any significant amounts in the near term since there are no current sales and marketing activities relating to our products.

      We do not have the cash resources or infrastructure to perform sales, marketing and distribution functions ourselves. Under our current situation, we must conserve and generate cash to finance our operations. Our ability to continue as a going concern beyond 2004 is dependent on our ability to generate sufficient cash flow to fund our operations and meet our debt and other obligations on a timely basis and to continue to keep our

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      We continue to evaluate alternative means of financing to meet our needs on terms that are acceptable to us. However, we may be unable to obtain necessary financing on favorable terms or at all. For example, we may need to enter into financing arrangements or modify our existing payment obligations that may include sales of our common stock at significant discounts to the market price, as well as causing significant dilution to our existing stockholders.

      If we cannot obtain a sales, marketing and distribution partner or other strategic alliance in the near future, we will need to sell some or all of our assets, including our intellectual property, in which Sanofi-Synthelabo has a security interest, to meet our debt obligations. If substantial additional resources are not available, we may need to cease our operations and seek protection under the bankruptcy laws.

      As of December 31, 2003, we had total liabilities of $30.9 million (net of unamortized debt discount of $709,000), of which $16.1 million were current liabilities and included $14.3 million related to our Convertible Debentures. We owe $11.5 million to Sanofi-Synthelabo, payable from February 2005 to February 2007; however, none of this amount is included in current liabilities. Our ability to meet our obligations and other liabilities depends upon our future performance, which will depend upon financial, business and other factors, many of which are beyond our control. We may fail to generate sufficient cash flows in the future to cover our fixed charges or to satisfy our obligations. Historically, we have experienced significant negative cash flows from operations. If we cannot generate sufficient cash flows in the future to cover our fixed charges or to permit us to satisfy our obligations, we may need to sell equity securities or sell all or a portion of our assets. We may not successfully complete any of these courses of action. In the event of insolvency, bankruptcy, liquidation, reorganization, dissolution or winding-up of our business or upon default or acceleration related to our obligations, our assets would first be available to pay the amounts due under our obligations. Holders of our common stock would only receive any assets remaining after satisfaction in full of all obligations and preferred stock liquidation preferences, if any.

      We had net income of $49.4 million for the year ended December 31, 2003 due to the $75.8 million gain from the Sankyo Pharma settlement. At December 31, 2003, our accumulated deficit and stockholders’ equity were $247.3 million and $6.8 million, respectively. We have experienced operating losses since our inception, and we expect to continue to incur operating losses at least until we have significant product sales, if we ever do. We may fail in our efforts to find a sales, marketing and distribution partner or alternative strategic alliance. Our products may never gain market acceptance, and we may never generate significant revenues or achieve profitability.

      On October 9, 2003, we announced a reduction in force of approximately 60% of our workforce and, as of December 31, 2003, we had 24 employees. Because of the magnitude of the workforce reductions, these layoffs have had a material adverse impact on our ability to manufacture our products and our ability to conduct research and development and to expand our operations in the future to meet the needs of our customers. As a result of this reduction in force, we are not currently producing any products and our manufacturing operations have been suspended. Additionally, if we were to secure a sales, marketing and distribution partner or other strategic alliance, we would need to hire new employees or seek to rehire former employees to regain core competencies in manufacturing and research and development. We may fail in our

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      Prior to suspension of our manufacturing, we had very limited medical device manufacturing experience and depended on third-party suppliers for the manufacturing of our Biographer and AutoSensor components. We were responsible for manufacturing the GlucoWatch Biographer and we contracted with a third party, Corium International, to manufacture our AutoSensors. Thus, we were dependent upon Corium International for such manufacturing. Our products must be manufactured in compliance with regulatory requirements, in a timely manner and in sufficient quantities, while maintaining product performance and quality and a commercially feasible cost of manufacturing. Given the current suspension of manufacturing, it will take time and extra resources if we are to recommence such manufacturing. Furthermore, we may encounter additional problems if we commence commercial manufacturing of our third-generation product, as we have not manufactured this product in large quantities. Alternatively, we may decide to convert existing G2 Biographers into third-generation Biographers, but we may not be successful in our attempts to do so.

      Our Biographer and AutoSensor were manufactured from components purchased from outside suppliers, most of which were our single source for such components. Some of these companies are small enterprises that may encounter financial difficulties because of their size. Prior to our suspension of manufacturing, we were notified by one of our sole-source component suppliers that they were encountering financial difficulties. Although we have maintained our existing supply contracts with such third parties (e.g., Hydrogel Design Systems, Inc., Key Tronic Corporation, Sanmina Corporation and E.I. du Pont de Nemours and Company, among others), we do not have contracts with all our suppliers and, given the suspension in our manufacturing, even suppliers with contracts would perhaps need additional time and resources to produce such components were we to instruct them to recommence supply. Even after recommencing manufacturing, if we are able to do so (and there is no assurance that we will be able to do so), if we cannot, for whatever reason, obtain these components from our suppliers or if the components obtained from these suppliers do not pass quality standards, we will be required to obtain the components from alternative suppliers. Additionally, in the event a current supplier is unable to meet our component requirements, we might not be able to rapidly find another supplier of the particular component or an alternative supply of the particular component at the same price or lead time. Any interruption in the supply of Biographer or AutoSensor components or excessive pricing of these components could prevent us from manufacturing our products in the future or could adversely affect our margins.

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

      We have focused our efforts on a line of frequent, automatic and non-invasive glucose monitoring devices based on novel technologies. To date, the market has not widely accepted our continuous-type monitoring products that measure glucose from interstitial fluid, and our products are different from the established blood glucose episodic monitors commercially available and also require additional workload and training. In addition, because our products are based on novel technologies, there can be no assurance that unforeseen problems will not develop with these technologies or that we will be able to successfully address technological challenges that we may encounter.

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      Given the uncertainty of a new sales, marketing and distribution partner, physicians may be hesitant to prescribe our products for their patients. Our financial situation has already caused substantial uncertainty relating to product availability, warranty fulfillment, and the like.

      Successful commercialization of our products will depend in large part on whether patients who purchase our products will be reimbursed for the expense by third-party payors, which include private insurance plans, Medicare, Medicaid and other federal health care programs. Currently, our products do not have widespread reimbursement. Third-payor reimbursement occurs on a plan-by-plan and often case-by-case basis. There can be no assurance that such reimbursement will be available in a sufficient time frame, or at all. To obtain such reimbursement, we will need to have a partner who has substantial expertise and resources in managed care so as to work with third-party health care payor organizations to obtain broad reimbursement coverage. We do not have the resources, expertise or infrastructure to perform such functions ourselves. Third-party payors, including federal health care programs and managed care and other private insurance plans, are increasingly seeking to contain health care costs by limiting the coverage of, and the amount of reimbursement for, new diagnostic products. As a result, adequate levels of reimbursement may not be available for patients, many of whom may therefore not purchase our products. If meaningful reimbursement from third-party payors is not available, or if the process of obtaining such reimbursement takes too long, we may not be able to achieve a level of market acceptance of our products, and we may not be able to maintain price levels sufficient to realize an adequate return on our investment.

      We are exclusively focused on a line of frequent, automatic and non-invasive glucose monitoring devices. To be successful, we will need to continue to develop glucose monitoring products that address the needs of people with diabetes; however, in light of our recent reduction in force and expenses associated with product research and development, our ability to produce new products has been materially impaired. Our third-generation product has been approved by the FDA, but we have no plans for its commercialization, or for converting our G2 Biographers to third-generation products, unless we obtain a sales, marketing and distribution partner or other strategic alliance. Furthermore, without additional resources, we are not currently working on developing future glucose monitoring products.

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

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      The design, manufacturing, labeling, distribution and marketing of our products are subject to extensive and rigorous government regulation in the United States and certain other countries where the process of obtaining and maintaining required regulatory clearance or approvals is lengthy, expensive and uncertain. The FDA may not approve additional future enhancements and possible manufacturing changes, if any, to the Biographers and the AutoSensors or it may require us to file one or more new PMA applications rather than allowing us to supplement our existing PMA application. Even if the FDA grants us expedited review status on an application for approval, obtaining approval of a PMA or a PMA supplement could take a substantial period of time, and the FDA may not ultimately grant such approval. Moreover, even if regulatory approval is granted, such approval may include significant limitations on intended uses for which any such products could be marketed.

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

      Development and protection of our intellectual property are critical to our business. If we do not adequately protect our intellectual property, both in the United States and abroad, competitors may be able to use our technologies. Our success depends in part on our ability to obtain patent protection for our products and processes in both the United States and other countries, protect trade secrets, and prevent others from infringing on our proprietary rights.

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

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

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

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

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

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

      We currently sell the GlucoWatch G2 Biographer on a very limited basis in the United Kingdom, which has a National Health Service (NHS); our products are not currently reimbursed by the NHS. We have established a contract with a third-party authorized representative in the United Kingdom, and the product-ordering, logistics, and technical-support functions, although minimal, are handled by us. If we are unable to support these necessary functions or generate sufficient revenues from such sales, we may not be able to continue to sell our products in the United Kingdom. We may never be able to secure necessary

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Risks Related to Our Industry

      The medical device industry, particularly the market encompassing our GlucoWatch G2 Biographer, is intensely competitive, and we compete with other providers of personal glucose monitors. Currently, the market is dominated by blood glucose monitoring products sold by a few major companies. These companies have established products and distribution channels. In addition, several companies are marketing alternative-site devices to monitor glucose levels in a painless manner or in a manner involving less pain than that associated with finger sticking. Furthermore, companies are developing a variety of methods to extract interstitial fluid and measure the glucose concentration therein, as well as developing devices to monitor glucose on a frequent and automatic basis. At least one such product is now under review by the FDA, and an alarms-only product recently received FDA approval. Another technology that some companies are pursuing utilizes infrared spectroscopy, which uses radiation to measure glucose levels. There can be no assurance that other products will not be accepted more readily in the marketplace than the GlucoWatch Biographer or will not render our current or future devices noncompetitive or obsolete. Additionally, the GlucoWatch G2 Biographer or our third-generation product may fail to replace any currently used devices or systems.

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

      Our ability to continue as an ongoing business and to find a sales, marketing and distribution partner or other strategic alliance depends significantly upon retaining our remaining key personnel, which is difficult in light of our current business situation. In the event that we find such a partner or alliance and recommence manufacturing and possibly research and development, we will need to attract highly qualified personnel in these areas. We face competition for such personnel, and we may not be able to attract and retain these individuals. We compete with numerous pharmaceutical, health care and software companies, as well as universities and non-profit research organizations, in the northern California business area. The loss of key personnel or our inability to hire and retain additional qualified personnel in the future could prevent us from maintaining our business. There can be no assurance that we will continue to be able to attract and retain sufficient qualified personnel.

Risks Related to Our Common Stock

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

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

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

      The market price for shares of our common stock has been highly volatile. Factors, such as new product introductions by our competitors; our ability to obtain a sales, marketing and distribution partner or other strategic alliance; sales levels of our products; litigation outcomes; regulatory approvals or delays or recalls of our products or those of our competitors; developments relating to our patents or proprietary rights or those of our competitors; results of clinical trials for products of our competitors; and period-to-period fluctuations in financial results, may have a significant impact on the market price of our common stock. Additionally, following periods of volatility in the market price for a company’s securities, securities class action litigation may be instituted. Such litigation could result in substantial costs to us and further divert management’s attention and resources.

      Our certificate of incorporation contains certain provisions that may delay or prevent a takeover. The Company currently has 5.0 million shares of authorized and unissued preferred stock. Our Board of Directors has the authority to determine the price, rights, preferences and restrictions, including voting and conversion rights, of these shares without any further action or vote by the stockholders. The rights of the holders of common stock will be subject to, and may be adversely affected by, the rights of the holders of preferred stock that may be issued in the future. Such provisions could adversely affect the holders of common stock in a variety of ways, including by potentially discouraging, delaying or preventing a takeover of our company and by diluting stockholder ownership.

      Provisions in our Restated Certificate of Incorporation and Bylaws may have the effect of delaying or preventing an acquisition of our Company or a merger in which we are not the surviving company and may otherwise prevent or slow changes in our Board of Directors and management. In addition, because we are incorporated in Delaware, we are governed by the provisions of Section 203 of the Delaware General

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

      Our exposure to market risk for changes in interest rates relates primarily to our investment portfolio and our long-term debt obligations. We do not use derivative financial instruments in our investment portfolio. We place our investments with high credit quality issuers and, by policy, limit the amount of credit exposure to any one issuer. As stated in our policy, we are averse to principal loss and ensure the safety and preservation of our invested funds by limiting default risk, market risk and reinvestment risk.

      We mitigate default risk by investing in only the highest credit quality securities. The portfolio includes only marketable securities with active secondary or resale markets to ensure portfolio liquidity.

      We had no cash flow exposure due to interest rate changes for our $18.3 million convertible debentures, which all had fixed rates. We also have no cash flow exposure due to a rate change for our Sanofi-Synthelabo arbitration obligation, as such obligation is not interest-bearing. We primarily have entered into debt obligations to support general corporate purposes, including capital expenditures and working capital needs.

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      The table below presents principal amounts and related weighted-average interest rates by year of maturity for our investment portfolio and debt obligations.

(1)	On March 23, 2004, we entered into an Exchange Agreement with the debenture holders and retired all of our outstanding Convertible Debentures and associated warrants in exchange for an aggregate of $13.8 million in cash and 2.5 million shares of our common stock. Thus, this amount will not have to be paid.

      Effective June 28, 2000, we established Cygnus (UK) Limited, a wholly owned subsidiary of Cygnus, Inc., in the United Kingdom. On January 30, 2004, we filed an application to dissolve this subsidiary, which provided sales support and other administrative functions for us. We now handle these functions directly from the United States. This application to strike-off was filed with the Companies House and published on March 16, 2004; we expect our application to be granted in early third quarter 2004. Our exposure to gains and losses resulting from foreign currency exchange transaction fluctuations on foreign net assets was not material as of December 31, 2003 or 2002. No material foreign exchange transaction gain or loss has been recorded in our consolidated financial statements during the year ended December 31, 2003. We do not anticipate any material adverse effect on our financial position, results of operations or cash flows resulting from foreign exchange transaction fluctuations in the future.

      The consolidated financial statements and supplementary data for the years ended December 31, 2003, 2002 and 2001 are incorporated herein by reference and submitted as a separate section of this Form 10-K. (See Item 15.)

      Not applicable.

      a) Evaluation of disclosure controls and procedures. Our Chief Executive Officer and our Chief Financial Officer, after evaluating the effectiveness of the Company’s “disclosure controls and procedures,” as defined in the Securities Exchange Act of 1934, as amended (the “Exchange Act”), Rules 13a-15e or 15d-15e as of the end of the period covered by this report (the “Evaluation Date”), have concluded that, as of the Evaluation Date, our disclosure controls and procedures were adequate based on the evaluation of these controls and procedures required by paragraph (b) of the Exchange Act Rules 13a-15 or 13d-15.

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      b) Changes in internal controls. No change in our internal controls over financial reporting identified in connection with the evaluation required by paragraph (d) of Exchange Act Rules 13a-15 or 15d-15 that occurred during our fourth fiscal quarter has materially affected, or is reasonably likely to materially affect, our internal controls over financial reporting.

PART III

      We incorporate by reference the information concerning our directors set forth under the heading “Proposal One — Re-election of Directors” in our definitive Proxy Statement to be filed pursuant to Regulation 14A for our 2004 Annual Meeting of Stockholders.

      Information concerning our Executive Officers is set forth in Part I of this Form 10-K.

      We incorporate by reference the information set forth under the heading “Section 16(a) Beneficial Ownership Reporting Compliance” in our definitive Proxy Statement to be filed pursuant to Regulation 14A for our 2004 Annual Meeting of Stockholders.

      We have adopted a code of ethics that applies to all of our executive officers and directors, a copy of which is available at http://www.cygn.com/corporate overview.

      We incorporate by reference the information set forth under the heading “Executive Compensation and Other Information” in our definitive Proxy Statement to be filed pursuant to Regulation 14A for our 2004 Annual Meeting of Stockholders.

      We incorporate by reference the information set forth under the heading “Security Ownership of Directors and Executive Officers” in our definitive Proxy Statement to be filed pursuant to Regulation 14A for our 2004 Annual Meeting of Stockholders.

      We incorporate by reference the information set forth under the heading “Equity Compensation Plan Information” in our definitive Proxy Statement to be filed pursuant to Regulation 14A for our 2004 Annual Meeting of Stockholders.

      We incorporate by reference the information set forth under the heading “Executive Compensation and Other Information” in our definitive Proxy Statement to be filed pursuant to Regulation 14A for our 2004 Annual Meeting of Stockholders.

      We incorporate by reference the information concerning our auditor fees set forth under the heading “Principal Auditors’ Fees and Services” in our definitive Proxy Statement to be filed pursuant to Regulation 14A for our 2004 Annual Meeting of Stockholders.

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PART IV

a) Financial Statements and Report of Ernst & Young LLP, Independent Auditors

b) Reports on Form 8-K

      The following Current Reports on Form 8-K were filed during the fourth quarter of 2003:

      On October 7, 2003, we filed a Current Report on Form 8-K, reporting under Item 9 that we filed a lawsuit against Sankyo Pharma Inc. and Sankyo Co., Ltd. in excess of $450 million relating to the GlucoWatch Biographer business.

      On October 9, 2003, we filed a Current Report on Form 8-K, reporting under Item 9 a reduction in force of approximately 60% of our work force.

      On November 10, 2003, we filed a Current Report on Form 8-K, reporting under Item 9 the restructuring of the remaining royalty payments owed to Sanofi-Synthelabo pursuant to a 1997 Final Arbitration Award. We also reported that Sankyo Pharma filed an answer and cross-claims against Cygnus for declaratory relief, breach of contract, and defamation in response to the Company’s lawsuit filed on October 6, 2003.

      On November 13, 2003, we filed a Current Report on Form 8-K, reporting under Item 12 our earnings release and financial results for the quarter ended September 30, 2003.

      On December 5, 2003, we filed a Current Report on Form 8-K, reporting under Item 5 that the FDA approved our supplemental PMA application for our third-generation GlucoWatch Biographer.

      On December 23, 2003, we filed a Current Report on Form 8-K, reporting under Item 5 that we had settled the lawsuit between Cygnus and Sankyo Pharma regarding distribution and marketing of the GlucoWatch G2 Biographer in the United States.

c) Schedules

      All other schedules are omitted, as they are either not required or the required information is included in the financial statements or notes thereto.

d) Exhibits

      The following exhibits are filed herewith or incorporated by reference:

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*	A confidential treatment request has been applied for or granted with respect to a portion of this document.

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SIGNATURES

      Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, Registrant has duly caused this Report to be signed on its behalf by the undersigned, thereunto duly authorized, on the 26th day of March, 2004.

	CYGNUS, INC.

	By	/s/ JOHN C HODGMAN

	Chairman, President and Chief Executive Officer
	(Principal Executive Officer)