UNITED STATES SECURITIES AND EXCHANGE COMMISSION

FORM 10-Q

0-18962
(Commission File Number)

CYGNUS, INC.

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

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

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

     As of May 10, 2004, there were 41,009,251 shares of the Registrant’s common stock outstanding.

CYGNUS, INC.
INDEX

PART I. FINANCIAL INFORMATION

Item 1. Financial Statements.

Cygnus, Inc.

See accompanying notes.

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Cygnus, Inc.

Note: The condensed consolidated balance sheet at December 31, 2003 has been derived from the audited consolidated financial statements at that date but does not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements.

See accompanying notes.

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Cygnus, Inc.

See accompanying notes.

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Cygnus, Inc.

1. Basis of Presentation

     The interim condensed consolidated financial statements of Cygnus, Inc. and its subsidiaries (the “Company,” “Cygnus,” “us,” “we,” “our,” etc.) included herein have been prepared by the Company, without audit, pursuant to the rules and regulations of the Securities and Exchange Commission (SEC). Certain information and footnote disclosures normally included in annual financial statements prepared in accordance with accounting principles generally accepted in the United States (GAAP) have been condensed or omitted. The interim condensed consolidated financial statements reflect, in the opinion of Cygnus management, all normal and recurring adjustments that management believes necessary for a fair presentation of the financial position as of the reported dates and the results of operations for the respective periods presented. Interim financial results are not necessarily indicative of results for a full year. Certain prior period amounts in the condensed consolidated financial statements have been reclassified to conform with the current period presentation. The condensed consolidated financial statements should be read in conjunction with the audited consolidated financial statements and related notes for the year ended December 31, 2003 included in our 2003 Annual Report on Form 10-K.

2. Financing Instruments

     Convertible Debentures

     On March 23, 2004, we entered into an Exchange Agreement with our 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 valued at $1.3 million. As of March 22, 2004, the principal and accrued interest on the Convertible Debentures totaled $18.4 million. As part of the early retirement of our Convertible Debentures and warrants to purchase our common stock that had been issued to the debenture holders, we also eliminated the remaining balances of our debt issuance costs and debt discount, which totaled $62,000 and $473,000, respectively, as of March 22, 2004. We recorded a non-cash gain of $2.9 million from the early retirement of our Convertible Debentures in the three months ended March 31, 2004. As part of the Exchange Agreement, we terminated the registration rights agreement associated with the Convertible Debentures and the security interests in our assets held by the debenture holders. The following table shows the calculation of this non-cash, net gain, in thousands.

     Equity Line

     On March 24, 2004, we notified our counterparty that we were electing to terminate our remaining equity line agreement, which had a commitment period ending December 31, 2004.

3. Global Resolution with Sankyo Pharma

     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 our pending litigation, and terminated our July 8, 2002 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 outstanding at the time of the Global Resolution to the other party, thus allowing us to write off certain liabilities and assets, resulting in a total net gain of $75.8 million in the three months ended December 31, 2003. 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

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Pharma is providing 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 during this transition period. The amount received in the three months ended March 31, 2004 was $72,000 and has been recorded as “Gain from Sankyo Pharma Settlement” in our statement of operations.

4. Significant Accounting Policies

Accounting for Stock-Based Compensation

     We issue stock options to our employees and outside directors and provide them the right to purchase our stock pursuant to stockholder-approved stock option programs. We account for our stock-based compensation plans under the intrinsic-value method of accounting as defined by Accounting Principles Board Opinion No. 25 (APB 25), “Accounting for Stock Issued to Employees,” and related interpretations. We have elected to follow APB 25 in accounting for our employee stock options because the alternative fair value accounting provided for under Financial Accounting Standards Board (FASB) Statement No. 123 (FAS 123), “Accounting for Stock Based Compensation,” requires the use of option valuation models that were not developed for use in valuing employee stock options. Under APB 25, because the exercise price of our employee and director stock options equals the market price of the underlying stock on the date of grant, no compensation expense is recognized for these grants.

     For purposes of disclosure pursuant to FAS 123, as amended by FASB Statement No. 148 (FAS 148), “Accounting for Stock-Based Compensation — Transition and Disclosure,” the estimated fair value of employee and director stock options is amortized to expense over the vesting periods of the options.

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

     For the three months ended March 31, 2004 and 2003, the estimated grant date fair value for stock options granted was $22,000 and $621,000, respectively. The fair value for the options was estimated at the date of grant using the Black-Scholes option valuation model with the following weighted-average assumptions:

     Effective January 8, 2003, our Board of Directors suspended the Amended 1991 Employee Stock Purchase Plan, as last amended and restated February 12, 2002, because our stock had been delisted from trading on the Nasdaq National Market. Thus, no shares were purchased pursuant to the Employee Stock Purchase Plan during 2004 and 2003.

     The Black-Scholes option valuation model was developed for use in estimating the fair value of traded options that have no vesting restrictions and are fully transferable. In addition, option valuation models require the input of highly subjective assumptions, including the expected stock-price volatility. Because our employee stock

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options have characteristics significantly different from those of traded options, and because changes in the subjective input assumptions can materially affect the fair value estimate, in management’s opinion the existing models do not necessarily provide a reliable single measure of the fair value of our employee stock options.

Use of Estimates

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

     Due to the current uncertainty surrounding our business situation, the realization of values for our long-lived assets is based on significant estimates.

Revenue Recognition

     Product revenues are generated upon the sale of our GlucoWatch G2 Biographer 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. In fiscal year 2003, 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. Product revenues recorded by us for the first three calendar quarters of 2003 were 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. Revenues generated from our shipments of sample and practice Biographers to Sankyo Pharma were recognized when all the above conditions were met, typically upon delivery of these products to Sankyo Pharma, as the sales of such products were not subject to future pricing adjustments. Product revenues for the three months ended March 31, 2004 have primarily been generated from the sale of our products in the United Kingdom.

     With regard to product sales that are made directly by us to third parties, from time to time we have allowed customers to return product for credit. In such instances, we deferred revenue until the return period expired. We offer a one-year warranty on our Biographer from the date of sale to the end-user customer. We accrue for estimated warranty costs and other allowances when the revenues from product sales are recognized. The warranty costs recorded to date have not been significant and are within historical estimates. We periodically assess the adequacy of our recorded warranty liability and adjust the amount as necessary.

     Our contract revenues relate to payments received pursuant to research grants and contracts. Revenues were recognized based on the performance requirements of the grant or contract and as reimbursable expenses were incurred.

Accounting for Impairment of Long-Lived Assets

     We review equipment and improvements and other long-lived assets for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Recoverability is measured by comparison of 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 the first three months of 2004. 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 were to 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

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recognized any impairment against these assets at March 31, 2004. We will continue to evaluate the realizable value of these assets, which may result in future adjustments.

Net Loss Per Share

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

5. Inventory

     Inventory is stated at standard cost, adjusted to approximate the lower of actual cost (first-in, first-out method) or market, after appropriate consideration has been given to obsolescence and inventory in excess of anticipated future demand. Our inventory of $41,000 and $62,000 at March 31, 2004 and December 31, 2003, respectively, consists of finished goods for sale in the United Kingdom.

6. Arbitration Obligation

     As of March 31, 2004, we had $11.5 million in remaining arbitration obligation payments resulting from our 1997 arbitration with Sanofi, S.A., now Sanofi-Synthelabo. Of this $11.5 million, $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 have 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.

7. Sale of Drug Delivery Business

     On December 15, 1999, we completed the sale of substantially all of our drug delivery business segment assets to Ortho-McNeil Pharmaceutical, Inc. (“Ortho-McNeil”). Under the terms of our agreement, Ortho-McNeil was subject to paying up to an additional $55.0 million in cash, contingent on the achievement of certain milestones. Of this $55.0 million, $20.0 million was not paid to us because certain Ortho-McNeil technical and regulatory accomplishments relating to the Ortho Evra® (Johnson & Johnson, New Brunswick, New Jersey) contraceptive patch were not met, and $34.6 million is under dispute. Both parties have retained outside legal counsel and, on February 23, 2004, we invoked the mediation provisions set forth in our Asset Purchase Agreement. Thereafter, the parties agreed to waive the mediation provisions and to enter into binding arbitration as set forth in our Asset Purchase Agreement and, on April 15, 2004, we provided notice of arbitration to Ortho-McNeil.

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

     Some of the statements in this report, including in the documents incorporated by reference, are forward-looking statements that involve risks and uncertainties. These forward-looking statements include statements about our plans, objectives, expectations, intentions and assumptions and other statements contained in this report, including in the documents incorporated by reference, that are not statements of historical fact. Forward-looking statements include but are not limited to statements about our ability to find a new sales, marketing and distribution partner or other strategic alliance, including but not limited to a merger with or 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.

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 and, on September 16, 2002, this product was launched in the United States under our now-terminated Sales, Marketing and Distribution Agreement with Sankyo Pharma. 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.

     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. 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 with or acquisition by a third party, if we are to continue to sell our products. We are not currently manufacturing our G2 Biographer or our third-generation product and are not conducting research and development on new products at this time. 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.

     On February 23, 2004, we invoked the mediation provisions set forth in our Asset Purchase Agreement with Ortho-McNeil Pharmaceutical, Inc., a Johnson & Johnson company, regarding $34.6 million in disputed milestone payments relating to the 1999 sale of substantially all our drug delivery business to Ortho-McNeil. Thereafter, the parties agreed to waive the mediation provisions and to enter into binding arbitration as set forth in our Asset Purchase Agreement and, on April 15, 2004, we provided notice of arbitration to Ortho-McNeil.

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     On March 23, 2004, we entered into an Exchange Agreement with our 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 valued at $1.3 million. As of March 22, 2004, the principal and accrued interest on the Convertible Debentures totaled $18.4 million. As a result of this exchange, we recorded a non-cash gain of $2.9 million from the early retirement of our Convertible Debentures in the three months ended March 31, 2004. Although this exchange significantly reduced our liquidity in the near term, we will benefit over the course of the repayment period because we were able to retire the debentures at less than face value. 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 were electing 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 had 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.

     On April 1, 2004, as a result of our Exchange Agreement and retirement of all of our Convertible Debentures and related warrants, we filed a post-effective amendment to our related stock registration statement to remove from registration all of the shares of common stock issuable upon conversion of our Convertible Debentures or upon exercise of the warrants that remained unsold under the registration statement.

Critical Accounting Policies

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

     Revenue Recognition

     Product revenues are generated upon the sale of our GlucoWatch G2 Biographer 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. We do not expect any significant product revenues in 2004 unless we obtain a sales, marketing and distribution partner or other strategic alliance.

     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. In fiscal year 2003, 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. Product revenues recorded by us for the first three calendar quarters of 2003 were 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. Revenues generated from our shipments of sample and practice Biographers to Sankyo Pharma were recognized when all the above conditions were met, typically upon delivery of these products to Sankyo Pharma, as the sales of such products were not subject to future pricing adjustments. Product revenues for the three months ended March 31, 2004 have primarily been generated from the sale of our products in the United Kingdom.

     With regard to product sales that are made directly by us to third parties, from time to time we have 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.

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

     Inventory Valuation

     Inventory is stated at standard cost, adjusted to approximate the lower of actual cost (first-in, first-out method) or market, after appropriate consideration has been given to obsolescence and inventory in excess of anticipated future demand. Our inventory of $41,000 and $62,000 at March 31, 2004 and December 31, 2003, respectively, consists of finished goods for sale in the United Kingdom.

     Impairment of Long-Lived Assets

     We review equipment and improvements and other long-lived assets for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Recoverability is measured by comparison of 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 in the three months ended March 31, 2004. 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 were to 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 March 31, 2004. We will continue to evaluate the realizable value of these assets, which may result in future adjustments.

Results of Operations

     Our results of operations have fluctuated from period to period and are expected to continue to fluctuate in the future based upon the progress and ultimate outcome of our attempts to secure alternative strategic options (including, but not limited to, a merger with or 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 a sales, marketing and distribution partner 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 in 2004. At March 31, 2004, our accumulated deficit and our stockholders’ equity were $247.7 million and $7.7 million, respectively.

Comparison for the Three Months Ended March 31, 2004 and 2003

     Net product revenues for the three months ended March 31, 2004 were $46,000, compared to $297,000 for the three months ended March 31, 2003. Substantially all of our net product revenues recognized for the three months ended March 31, 2004 resulted from sales of our GlucoWatch G2 Biographers in the United Kingdom; however, our net product revenues for the three months ended March 31, 2003 included revenues recognized from U.S. sales of our products to Sankyo Pharma under our now-terminated Sales, Marketing and Distribution Agreement. 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 three months ended March 31, 2004 were $0, compared to $51,000 for the three months ended March 31, 2003. Contract revenues for the three months ended March 31, 2003 included revenues related to our NIH SBIR Phase II grant, and revenues were recognized as research activities were performed. We

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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 three months ended March 31, 2004 were $116,000, compared to $1.8 million for the three months ended March 31, 2003. This decrease is a result of our reduced product revenues and suspension of our manufacturing efforts while we seek to obtain a sales, marketing and distribution partner or other strategic alliance. Costs of product revenues for the three months ended March 31, 2004 and 2003 included material, labor, and other product costs associated with manufacturing our products. Costs of product revenues for the three months ended March 31, 2004 also included a charge of $95,000 pursuant to our $150,000 minimum royalties payable to the University of California for the year 2004. This $95,000 included a $70,000 charge that we do not expect to be covered by product margins in the remaining three fiscal quarters of 2004. It is estimated that the balance of our minimum royalties for 2004 will be covered by margins generated in these quarters. Costs of product revenues for the three months ended March 31, 2003 also included underabsorbed indirect overhead associated with building up our manufacturing capacity to meet then-expected future volumes. 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 three months ended March 31, 2004 were $0, compared to $1.7 million for the three months ended March 31, 2003. We have discontinued our research and development efforts and do not foresee commencing such activities until we secure a sales, marketing and distribution partner or other strategic alliance. For the three months ended March 31, 2003, 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.

     Sales, marketing, general and administrative expenses for the three months ended March 31, 2004 were $2.9 million, compared to $2.2 million for the three months ended March 31, 2003. This increase is a result of maintaining personnel and capacity to resume manufacturing and research and development efforts in the future if we are successful in obtaining a sales, marketing and distribution partner or other strategic alliance. We do not expect any significant changes in these expenses unless we secure such a partner or alliance.

     Interest and other income/(expense), net for the three months ended March 31, 2004 was $67,000, compared to $42,000 for the three months ended March 31, 2003. Although the yields were slightly lower for the three months ended March 31, 2004, our average cash balance was higher for the current period when compared to the three months ended March 31, 2003.

     Interest expense for the three months ended March 31, 2004 was $427,000, compared to $555,000 for the three months ended March 31, 2003. Included in interest expense for the three months ended March 31, 2004 and 2003 was the interest accrued on our Convertible Debentures and the amortization of the value of the warrants issued in connection with financing agreements. Interest expense decreased for the three months ended March 31, 2004 as a result of the lower principal balance on our Convertible Debentures during the period and the retirement of this debt on March 23, 2004.

     Gain from Sankyo Pharma settlement for the three months ended March 31, 2004 was $72,000. 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 are 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.

     Gain on early retirement of Convertible Debentures for the three months ended March 31, 2004 was $2.9 million. The following table shows the calculation of this non-cash, net gain, in thousands:

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Liquidity and Capital Resources

     As of March 31, 2004, our cash, cash equivalents and investments totaled $16.8 million.

     Net cash used in operating activities for the three months ended March 31, 2004 was $2.9 million, compared to net cash used in operating activities of $11.3 million for the three months ended March 31, 2003. Cash used in operating activities for the three months ended March 31, 2004 was primarily due to the net loss from operations of $414,000, which included a non-cash gain of $2.9 million from the early retirement of our Convertible Debentures. Cash used in operating activities for the three months ended March 31, 2003 was primarily due to a net loss of $5.8 million and our $3.0 million arbitration obligation payment to Sanofi-Synthelabo.

     Net cash used in investing activities for the three months ended March 31, 2004 was $0. Net cash used in investing activities of $52,000 for the three months ended March 31, 2003 resulted from capital expenditures.

     Net cash used in financing activities totaled $13.8 million for the three months ended March 31, 2004, substantially all of which resulted from the retirement of our Convertible Debentures. Net cash used in financing activities totaled $18,000 for the three months ended March 31, 2003.

     As of March 31, 2004, our contractual obligations for the next seven years were as follows (in thousands, except for note (1)):

(1)These payments are due under our Exclusive License Agreement, effective January 31, 1995, as amended, and they terminate upon expiration of the last-to-expire patent licensed under this agreement. This expiration date is January 18, 2011. Of the $150,000 due in less than one year, $95,000 has been accrued as of March 31, 2004.

     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 a sales, marketing and distribution partner or other strategic alliance, (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 March 31, 2004, we had existing cash, cash equivalents and investments of $16.8 million. However, we have incurred significant net operating losses since our inception, including a loss from operations of $3.0 million for the three months ended March 31, 2004. We have incurred negative cash flows from operations since our inception. At March 31, 2004, our accumulated deficit was $247.7 million and our stockholders’ equity was $7.7 million.

     As of March 31, 2004, based upon current expectations for operating losses and projected short-term expenditures, we believe that existing cash, cash equivalents, and investments of $16.8 million will be sufficient to meet our existing operating expenses, contractual obligations, and capital expenditure requirements, if any, at least through March 31, 2005. 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. There can be no assurance that we will not require further financing and, if we do, that such financing will be available.

RISK FACTORS

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

Risks Related to Our Business

     We must obtain a U.S. sales, marketing and distribution partner or other strategic alliance in the near future.

     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 providing certain transition services related to distribution and customer services for us; 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 March 31, 2005 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 expenses as low as possible. There is no certainty, however, that we will be able to generate sufficient cash or to keep our expenses low enough.

     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.

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     We may be unable to satisfy our obligations. If we cannot pay amounts due under our obligations, we may need to sell equity securities, sell all or a portion of our assets, or cease our operations and seek protection under the bankruptcy laws.

     As of March 31, 2004, we had total liabilities of $13.0 million, of which $5.9 million were current liabilities. We owe $11.5 million to Sanofi-Synthelabo, payable from February 2005 to February 2007, and $4.5 million 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 have historically incurred substantial losses, have a history of operating losses, and have an accumulated deficit. We expect continued operating losses.

     We had a net loss of $414,000 for the three months ended March 31, 2004. At March 31, 2004, our accumulated deficit and stockholders’ equity were $247.7 million and $7.7 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.

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

     On October 9, 2003, we announced a reduction in force of approximately 60% of our workforce and, as of March 31, 2004, we had 25 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 and research and development 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 efforts to hire such employees or to regain the level of expertise that we possessed prior to our reductions in force.

     If we are to recommence manufacturing, we may not be able to do so in a timely or cost-effective manner and also may not be able to obtain the necessary Biographer and AutoSensor components from third-party suppliers.

     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, Inc. 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.

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     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.

     To date, our products have not been widely accepted by the market, and there is substantial uncertainty relating to product availability, warranty fulfillment, and the like.

     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, perhaps because 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.

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

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

     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 for our products are occurring 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

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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.

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

     We are exclusively focused on a line of frequent, automatic and non-invasive glucose monitoring devices. 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 currently cannot make 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 able to work on developing future glucose monitoring products.

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

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

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

     The design, manufacturing, labeling, distribution and marketing of our products are subject to extensive and rigorous government regulation in the United States and certain other countries where the process of obtaining and maintaining required regulatory clearance or approvals is lengthy, expensive and uncertain. 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.

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

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

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

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

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

     We have entered into agreements with 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

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incorporate the applicable technology into our products or to use such technology in the manufacture of our products, possibly impairing our ability to produce or market the GlucoWatch Biographer or other products. If any such license or other right is made non-exclusive, we may be unable to prevent others from developing, manufacturing and marketing devices based on the same or similar technologies.

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

     Our registered or unregistered trademarks or trade names, such as the marks “GlucoWatch” and “G2,” may be challenged, canceled, infringed upon, circumvented, declared generic or determined to be infringing on other marks. We may not be able to protect our rights to these trademarks and trade names, without which we may be unable to build brand loyalty. Brand recognition is critical to our short-term and long-term marketing strategies, especially 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 do business on a very limited basis in the United Kingdom and do not have any plans to enter other international markets; thus, the success of our business depends on our success in the U.S. market.

     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 commercialization agreements in countries other than the United States and the United Kingdom, despite the fact that we have CE certification in the European Community. If we are unable to secure these necessary agreements for other countries, we may not be able to sell our products or, even if such sales are possible, to broadly launch our products in other countries.

Risks Related to Our Industry

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

     The medical device industry, particularly the market encompassing our GlucoWatch 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.

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

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

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

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

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

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

     The market price for shares of our common stock has been highly volatile. Factors, such as 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.

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

     Our certificate of incorporation contains certain provisions that may delay or prevent a takeover. The Company currently has 5.0 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 of our charter documents and Delaware law may inhibit a takeover, thus limiting the price investors might be willing to pay in the future for our common stock.

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

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

     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.

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Item 3. Quantitative and Qualitative Disclosures About Market Risk.

     The Company has no material changes to the disclosure made on this matter in the Company’s Annual Report on Form 10-K for the year ended December 31, 2003.

Item 4. Controls and Procedures.

     a) Evaluation of disclosure controls and procedures. Our Chief Executive Officer and our Chief Financial Officer, after evaluating the effectiveness of 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.

     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 in the three months ended March 31, 2004 has materially affected, or is reasonably likely to materially affect, our internal controls over financial reporting.

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PART II. OTHER INFORMATION

Item 1. Legal Proceedings.

     On December 15, 1999, we completed the sale of substantially all of our drug delivery business segment assets to Ortho-McNeil Pharmaceutical, Inc. (“Ortho-McNeil”). Under the terms of our agreement, Ortho-McNeil was subject to paying up to an additional $55.0 million in cash, contingent on the achievement of certain milestones. Of this $55.0 million, $20.0 million was not paid to us because certain Ortho-McNeil technical and regulatory accomplishments relating to the Ortho Evra® (Johnson & Johnson, New Brunswick, New Jersey) contraceptive patch were not met, and $34.6 million is under dispute. Both parties have retained outside legal counsel and, on February 23, 2004, we invoked the mediation provisions set forth in our Asset Purchase Agreement. Thereafter, the parties agreed to waive the mediation provisions and to enter into binding arbitration as set forth in our Asset Purchase Agreement and, on April 15, 2004, we provided notice of arbitration to Ortho-McNeil.

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

a)

Exhibits

The following exhibits are filed herewith or incorporated by reference:

b)

Current Reports on Form 8-K

          The following Current Report on Form 8-K was filed in the three months ended March 31, 2004:

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     On March 25, 2004, we filed a Current Report on Form 8-K, reporting under Item 5 that the Company retired all of its outstanding Convertible Debentures pursuant to an Exchange Agreement with our debenture holders.

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SIGNATURES

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

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EXHIBIT INDEX

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