ARADIGM CORPORATION
INDEX

PART I. FINANCIAL INFORMATION

Item 1. Condensed Financial Statements

ARADIGM CORPORATION
CONDENSED BALANCE SHEETS

See accompanying notes.

ARADIGM CORPORATION
CONDENSED STATEMENTS OF OPERATIONS

See accompanying notes.

ARADIGM CORPORATION
CONDENSED STATEMENTS OF CASH FLOWS

See accompanying notes.

ARADIGM CORPORATION
NOTES TO THE UNAUDITED CONDENSED FINANCIAL STATEMENTS
March 31, 2004

1.

Organization and Basis of Presentation

     Organization

     Aradigm Corporation (the “Company”) is a California corporation engaged in the development and commercialization of non-invasive drug delivery systems. Principal activities to date have included obtaining financing, recruiting management and technical personnel, securing operating facilities, conducting research and development, and expanding commercial production capabilities. The Company does not anticipate receiving any revenue from the sale of products in the upcoming year. These factors indicate that the Company’s ability to continue its research, development and commercialization activities is dependent upon the ability of management to obtain additional financing as required. The Company operates as a sole operating segment.

     Basis of Presentation

     The accompanying unaudited condensed financial statements have been prepared in accordance with generally accepted accounting principles for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Certain information and footnote disclosures normally included in financial statements prepared in accordance with generally accepted accounting principles have been condensed or omitted pursuant to the Securities and Exchange Commission’s rules and regulations. In the opinion of management, the financial statements reflect all adjustments, which are of a normal recurring nature, necessary for a fair presentation. The accompanying condensed financial statements should be read in conjunction with the financial statements and notes thereto included with the Company’s 2003 Annual Report on Form 10-K as filed with the Securities and Exchange Commission. The results of the Company’s operations for the interim periods presented are not necessarily indicative of operating results for the full fiscal year or any future interim period.

     The Balance Sheet at December 31, 2003 has been derived from the audited 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.

2.

Summary of Significant Accounting Policies

     Stock Based Compensation

     The Company has elected to follow Accounting Principles Board Opinion No. (APB) 25, “Accounting for Stock Issued to Employees,” and related interpretations in accounting for its employee stock options. Compensation expense is based on the difference, if any, between the fair value of the Company’s common stock and the exercise price of the option or share right on the measurement date, which is typically the date of grant. This amount is recorded as “Deferred Stock Compensation” in the Balance Sheet and amortized as a charge over the vesting period of the applicable options or share rights. In accordance with Statement of Financial Accounting Standards (SFAS) 123, “Accounting for Stock-Based Compensation,” as amended by SFAS 148, “Accounting for Stock-Based Compensation — Transition and Disclosure,” the Company has provided below, the pro forma disclosures of the effect on net loss and loss per share as if SFAS 123 had been applied in measuring compensation expense for all periods presented (in thousands, except per share data).

     The Company accounts for options and warrants issued to non-employees under SFAS 123 and Emerging Issues Task Force (EITF) Issue No. 96-18, “Accounting for Equity Instruments that are Issued to Other than Employees for Acquiring, or in Conjunction with Selling Goods or Services,” using the Black-Scholes option pricing model. The value of options and warrants are periodically remeasured over their vesting terms.

     Computation of Net Loss Per Share

     Basic net loss per share has been computed using the weighted average number of shares of common stock outstanding less the weighted average number of shares subject to repurchase during the period. No diluted loss per share information has been presented in the accompanying statements of operations since potential common shares from stock options, warrants and redeemable convertible preferred stocks are antidilutive.

3.

Shareholders’ Equity

     In January 2004, holders of warrants to purchase 284,808 shares of common stock elected to exercise the warrants. The Company issued an aggregate of 285,214 shares of common stock in connection with the exercise of options and warrants during the three months ending March 31, 2004.

     In January 2004, we amended the operating lease for one of our facilities. Effective January 1, 2004, the new agreement reduces the aggregate annual lease payments by $1.1 million through 2006 and increases the aggregate annual payments by $1.1 million from 2007 through 2010. In consideration for the amended lease agreement, we replaced warrants to purchase 135,000 shares of common stock at prices ranging from $10.16 to $21.72 per share with new warrants to purchase 135,000 shares of common stock at $1.71 per share. The repricing resulted in additional expense of $88,000 that we will amortize on a straight-line basis over the remaining life of the lease.

4.

Related Party

     Novo Nordisk and its affiliate, Novo Nordisk Pharmaceuticals, Inc., are considered related parties, and in addition to being the Company’s primary revenue source, own approximately 11.4% of the Company’s total outstanding common stock (on an as-converted basis) at March 31, 2004.

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

     The discussion below contains forward-looking statements that are based on the beliefs of management, as well as assumptions made by, and information currently available to, management. Our future results, performance or achievements could differ materially from those expressed in, or implied by, any such forward-looking statements as a result of certain factors, including, but not limited to, those discussed in this section as well as in the section entitled “Risk Factors” and elsewhere in the Company’s most recent Form 10-K and Form 10-Q filed with the Securities and Exchange Commission.

     The business is subject to significant risks including, but not limited to, the success of research and development efforts, dependence on corporate partners for marketing, distribution and other resources,

obtaining and enforcing patents important to the business, clearing the lengthy and expensive regulatory process and possible competition from other products. Even if the products appear promising at various stages of development, they may not reach the market or may not be commercially successful for a number of reasons. Such reasons include, but are not limited to, the possibilities that the potential products may be found to be ineffective during clinical trials, fail to receive necessary regulatory approvals, are difficult to manufacture on a large scale, are uneconomical to market, are precluded from commercialization by proprietary rights of third parties or may not gain acceptance from health care professionals and patients. Readers are cautioned not to place undue reliance on the forward-looking statements contained herein. We undertake no obligation to publicly release the results of any revision to these forward-looking statements which may be made to reflect events or circumstances occurring after the date hereof or to reflect the occurrence of unanticipated events.

Overview

     Since our inception in 1991, we have been engaged in the development of innovative drug delivery systems. Beginning with our AERx pulmonary delivery system and more recently with the Intraject subcutaneous delivery technology acquired in May 2003 from Weston Medical, we are building a solid platform in needle-free drug delivery. As of March 31, 2004, we had an accumulated deficit of $223 million. We have never been profitable since inception and expect to incur additional operating losses over the next several years as research and development efforts, preclinical and clinical testing activities and manufacturing scale-up efforts expand and as we plan and build our late-stage clinical and early commercial production capabilities. To date, we have not had any material product sales and do not anticipate receiving any revenue from the sale of products in the upcoming year. Our sources of working capital have been equity financings, equipment lease financings, contract revenues and interest earned on investments.

     We have performed initial feasibility work on a number of compounds with the AERx system and have been compensated for expenses incurred while performing this work in several cases pursuant to feasibility study agreements with third parties. Once feasibility is demonstrated with respect to a potential product, we seek to enter into development contracts with pharmaceutical corporate partners. We currently have an agreement pursuant to which we are developing pulmonary delivery systems with Novo Nordisk A/S, to manage diabetes using insulin.

     We expect to perform various studies evaluating our Intraject subcutaneous delivery platform following the completion of clinical performance verification trials scheduled for later this year. While Aradigm will be actively engaging partners for discussions on Intraject, we believe that it is unlikely that a new commercial deal for Intraject will be signed until the clinical verification trial is completed and presented to potential partners later this year. In some cases, a partnership may not be disclosed until a long-term development agreement has been established.

     Our lead development program is developing pulmonary delivery systems to manage diabetes using insulin with our partner Novo Nordisk. Since Novo Nordisk and we successfully initiated Phase 3 clinical trials in September 2002, we have been focused on supporting our partner in the existing and planned additional Phase 3 clinical trials that will be needed for their regulatory submission and commercial scale-up activities. In April 2004, we and Novo Nordisk announced results from a planned interim analysis of the initial phase 3 trial. Although the results showed that the trial met its primary safety and efficacy endpoints, the analysis showed delayed post-meal plasma glucose suppression in type 1 diabetics using the AERx system. Because of the unexpected nature of these observations, Novo Nordisk has decided to amend the current trial protocol to conclude the study in advance of the planned 24 months of patient exposure. Novo Nordisk will make decisions concerning the structure and timing of additional clinical trials after these observations have been fully assessed.

     The collaborative agreement with Novo Nordisk provides for reimbursement of research and development expenses as well as additional payments to us as we achieve certain significant milestones. We also expect to receive royalties from this development partner based on revenues from product sales and to receive revenue from the manufacturing of unit dose packets and hand-held devices. We recognize

revenues under the terms of our collaborative agreement as the research and development expenses are incurred, to the extent they are reimbursable. For the three months ended March 31, 2004, this partner-funded program has contributed approximately 99.5% of our total contract revenues. At March 31, 2004, Novo Nordisk and its affiliate, Novo Nordisk Pharmaceuticals, Inc., own approximately 11.4% of our total outstanding common stock (on an as-converted basis) and are considered a related party.

     In general, it is our policy not to disclose the partner and/or the drug until a long-term development agreement has been established; both parties agree to highlight a clinical advancement in the program or under special circumstances in which both parties agree to disclosure.

Critical Accounting Policies

     We consider certain accounting policies related to revenue recognition and the use of estimates to be critical accounting policies that require the use of significant judgments and estimates relating to matters that are inherently uncertain and may result in materially different results under different assumptions and conditions.

     Revenue Recognition

     Contract revenues consist of revenue from collaboration agreements and feasibility studies. We recognize revenue under the agreements as costs are incurred. Deferred revenue represents the portion of all refundable and nonrefundable research payments received that have not been earned. In accordance with contract terms, milestone payments from collaborative research agreements are considered reimbursements for costs incurred under the agreements and, accordingly, are generally recognized as revenue either upon the completion of the milestone effort when payments are contingent upon completion of the effort or are based on actual efforts expended over the remaining term of the agreements when payments precede the required efforts. Costs of contract revenues are approximate to or are greater than such revenue and are included in research and development expenses. Refundable development and license fee payments are deferred until the specified performance criteria are achieved. Refundable development and license fee payments are generally not refundable once the specific performance criteria are achieved and accepted and such payments are no longer refundable.

     Impairment of Long-Lived Assets

     We review for impairment whenever events or changes in circumstances indicate that the carrying amount of property and equipment may not be recoverable. Determination of recoverability is based on an estimate of undiscounted future cash flows resulting from the use of the asset and its eventual disposition. In the event that such cash flows are not expected to be sufficient to recover the carrying amount of the assets, the assets are written down to their estimated fair values and the loss is recognized on the Statements of Operations.

     Use of Estimates

     The preparation of financial statements in conformity with generally accepted accounting principles requires us to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes to the financial statements. These estimates include useful lives for property and equipment and related depreciation calculations, estimated amortization period for payments received from product development and license agreements as they relate to the revenue recognition of deferred revenue and assumptions for valuing options and warrants. Actual results could differ from these estimates.

Results of Operations

     Three Months Ended March 31, 2004 and 2003

     Contract and License Revenues: Contract revenues for the three months ended March 31, 2004 decreased to $6.6 million from $7.7 million for the same period in 2003. Revenue from Novo Nordisk was

$6.6 million for the three months ended March 31, 2004 compared to $7.6 million for the same period in 2003. The decrease in contract and license revenues was attributable to relatively higher reimbursement in 2003 from Novo Nordisk for clinical supply and product development activities for the ongoing Phase 3 clinical program and completion of other projects funded in 2003. Costs associated with collaborative agreements are included in research and development expenses. We expect that the revenue from Novo Nordisk may trend downward at a modest pace in subsequent quarter(s) due to the expected level of activity in support of the ongoing Phase 3 clinical program, offset by increases in other development efforts.

     Research and Development Expenses: Research and development expenses for the three months ended March 31, 2004 decreased to $11.9 million from $13.0 million for the same period in 2003. The decrease in research and development expenses was primarily associated with cost savings efforts, reduction of non-funded projects, a decrease in depreciation expense, and reduction of research and development efforts on non-Novo projects.

     These expenses represent proprietary research expenses as well as costs related to contract revenues. Such costs primarily include salaries and benefits of scientific and development personnel, laboratory supplies, consulting services and expenses associated with the development of manufacturing processes. We expect research and development spending to increase over the next few years as we continue to expand our development activities to support current and potential future collaborations, initiate commercial manufacturing of the AERx systems, and increase ongoing development efforts of the Intraject system. The increase in research and development expenditures cannot be predicted accurately as it depends in part upon the future success of, and funding levels supported by, our existing development collaborations, as well as obtaining new collaborative agreements.

     General and Administrative Expenses: General and administrative expenses were $2.5 million for the three months ended March 31, 2004 and $2.7 million for the same period in 2003. The decrease was primarily due to lower building maintenance and utilities expenses.

     Interest Income: Interest income for the three months ended March 31, 2004 decreased to $66,000 from $108,000 for the same period in 2003. The decrease is due to lower average investment portfolio balances and lower yields.

     Interest Expense and Other: Interest expense for the three months ended March 31, 2004 decreased to $10,000 from $56,000 for the same period in 2003. The decrease is primarily due to a reduction in outstanding capital lease and equipment loan balances under various equipment leases.

     Net Loss: Net loss for the three months ended March 31, 2004 of $7.7 million was lower compared to the $7.9 million net loss for the same period in 2003 due to lower outside services expenses and cost savings made in other operating expenses.

     Earnings per Share: Net loss per share for the three months ended March 31, 2004 of $0.12 per share was substantially lower compared to the $0.22 net loss per share for the same period in 2003 due to the increase in the weighted average number of shares of common stock outstanding from 35.6 million for the three months ended March 31, 2003 compared to 62.9 million for the same period in 2004 resulting from equity financing activities in 2003, conversion of redeemable convertible preferred stock in 2003 and exercises of warrants in 2003 and 2004.

Liquidity and Capital Resources

     We have financed our operations since inception primarily through private placements and public offerings of capital stock, proceeds from equipment lease financing, contract revenues and interest earned on investments. As of March 31, 2004, we had cash, cash equivalents and short-term investments of approximately $25.4 million.

     In January 2004, we received net proceeds of approximately $305,000 and issued an aggregate of 284,808 shares of common stock in connection with the exercise of warrants by certain investors.

     Net cash used in operating activities for the three months ended March 31, 2004 decreased to $4.3 million from $7.4 million for the same period in 2003. As the net loss for the two periods was similar, the significant decline in net cash used in operating activities was primarily the result of the timing of cash payment activity. Specifically, reduced prepayments made on lease obligations significantly reduced the prepaid component of other current assets and higher accounts payable for prototype materials and legal costs increased the accounts payable balance at the end of the first quarter of 2004. Additionally, the amortization of deferred revenue decreased due to an extension in the estimated life of the milestone payments and the timing of cash provided by Novo Nordisk for future program activities.

     Investing activities for the three months ended March 31, 2004 provided cash of $4.1 million in contrast to the use of cash of $1.0 million for the same period in 2003. The net increase in cash provided by investing activities is primarily due to lower capital expenditures and cash provided of $4.4 million due to net proceeds received from the sales of investments and short-term securities. Capital expenditures for the three months ended March 31, 2004 were $264,000 compared to $1.3 million for the same period in 2003. Higher capital expenditures in 2003 related to the acquisition of manufacturing production equipment for commercial production.

     Net cash provided by financing activities for the three months ended March 31, 2004 was $107,000 compared to net cash provided of $13.5 million for the same period in 2003. Cash provided by financing activities for the same period in 2003 was higher primarily due to the completion of a private placement financing in March 2003.

     The development of our technology and proposed products, including the Intraject development program, will require a commitment of substantial funds to conduct the costly and time-consuming research, preclinical studies and clinical trial activities necessary to develop and refine the technology and proposed products and bring such products to market. Our future capital requirements will depend on many factors, including continued progress and results from research and development for the technology and drug delivery systems, the ability to establish and maintain favorable collaborative arrangements with others, progress with preclinical studies and clinical trials and the results thereof, the time and costs involved in obtaining regulatory approvals, the cost of development and the rate of scale-up for the required production technologies, the costs involved in preparing, filing, prosecuting, maintaining and enforcing patent claims and the need to acquire licenses or other rights to new technology.

     We continue to review our planned operations through the end of 2004 and beyond. We particularly focus on capital spending requirements to ensure that capital outlays are not expended sooner than necessary. We expect our total annual capital outlays for 2004 not to exceed $8.0 million. In January 2004, we amended the operating lease for one of our facilities. Effective January 1, 2004, the new agreement reduces the aggregate annual lease payments by $1.1 million through 2006 and increases the aggregate annual payments by $1.1 million from 2007 through 2010. We believe that our existing cash balances at March 31, 2004, funding commitments from corporate development partners and interest earned on our investments should be sufficient to meet our needs for at least the next 12 months. There can be no assurance that our funding commitments from corporate development partners will not be amended or terminated, and if they are amended or terminated, we will need to obtain additional sources of capital sooner than would otherwise be the case.

     If our development programs, including the Intraject development program, continue to progress, we would expect our cash requirements for capital spending and operations to increase in future periods. We will need to raise additional capital to fund our capital spending and operations before we become profitable. We may seek additional funding through collaborations, borrowing arrangements or through public or private equity financings. There can be no assurance that additional financing can be obtained on acceptable terms, or at all. Dilution to shareholders may result if funds are raised by issuing additional equity securities. If adequate funds are not available, we may be required to delay, to reduce the scope of, or to eliminate one or more of our research and development programs, or to obtain funds through

arrangements with collaborative partners or other sources that may require us to relinquish rights to certain of our technologies or products that we would not otherwise relinquish.

Item 3. Quantitative and Qualitative Disclosures About Market Risk

Market Risk Disclosures

     In the normal course of business, our financial position is routinely subject to a variety of risks, including market risk associated with interest rate movement. We regularly assess these risks and have established policies and business practices to protect against these and other exposures. As a result, we do not anticipate material potential losses in these areas.

     As of March 31, 2004, we had cash, cash equivalents and short-term investments of $25.4 million consisting of cash and highly liquid short-term investments. Our short-term investments will decline by an immaterial amount if market interest rates increase, and therefore, our exposure to interest rate changes has been immaterial. Declines of interest rates over time will, however, reduce our interest income from our short-term investments. Our outstanding capital lease obligations are all at fixed interest rates and, therefore, have minimal exposure to changes in interest rates.

Item 4. Controls and Procedures

Evaluation of Disclosure Controls and Procedures

     Based on their evaluation of our disclosure controls and procedures (as defined in the rules promulgated under the Securities Exchange Act of 1934), our chief executive officer and our chief financial officer concluded that our disclosure controls and procedures were effective as of the end of the period covered by this report.

     We believe that a controls system, no matter how well designed and operated, cannot provide absolute assurance that the objectives of the controls system are met, and no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, within a company have been detected. Our disclosure controls and procedures are designed to provide reasonable assurance of achieving their objectives, and our chief executive officer and our chief financial officer have concluded that these controls and procedures are effective at the “reasonable assurance” level.

Changes in Internal Controls

     There were no significant changes in our internal control over financial reporting during the period covered by this Quarterly Report on Form 10-Q that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

PART II. OTHER INFORMATION

Item 6. Exhibits and Reports on Form 8-K

(a) Exhibits

31.1		Certification by Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
31.2		Certification by Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
32.1		Certification by Chief Executive Officer and Chief Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

(b) Reports on Form 8-K

          We filed a Current Report on Form 8-K dated February 11, 2004 to furnish a press release in which we announced our financial results for the fourth fiscal quarter and the fiscal year ended December 31, 2003.

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.

Dated: May 14, 2004

INDEX TO EXHIBITS