AUXILIUM PHARMACEUTICALS INC - 10-Q Quarterly Report

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

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

As of May 2, 2005, the number of shares outstanding of the issuer’s common stock, $0.01 par value, was 20,681,255.

Auxilium Pharmaceuticals, Inc. and subsidiaries (the Company) is a specialty pharmaceutical company dedicated to developing and commercializing pharmaceutical products that target urologic and sexual health disorders. The Company was incorporated in Delaware in 1999 and in the fourth quarter of 2002, the Company received approval from the U.S. Food and Drug Administration to market Testim^®. Testim is a proprietary, topical 1% testosterone gel indicated for the treatment of hypogonadism. The Company launched Testim in the first quarter of 2003. The Company markets Testim in the United States through its own sales force. In April 2005, the Company signed a co-promotion agreement with Oscient Pharmaceuticals Corp. (Oscient) under which Oscient and the Company will jointly promote Testim to primary care physicians (see Note7c).

In the second quarter of 2003, the Company received regulatory approval to market Testim in the United Kingdom. In June 2004, the Company received scientific approval for Testim in 14 additional European countries. Through April 2005, the Company received marketing approvals in 11 of these countries. We anticipate that marketing approvals in the remaining countries will be received once local administrative procedures to finalize the packaging text have been completed. Testim was launched by Ipsen Farmaceutica, B.V. (Ipsen) in Germany in January 2005 and in the United Kingdom in April 2005. In 2004, the Company filed for regulatory approval to market Testim in Canada. Upon receipt of regulatory approvals, the Company will rely on third parties to market, sell and distribute Testim outside of the United States.

The Company commenced operations in the fourth quarter of 1999. Since inception, it has incurred losses and negative cash flows from operations. The Company has been dependent upon external financing, including primarily private and public sales of securities, to fund operations. As of March 31, 2005, the Company had an accumulated deficit of $110,809,000, and expects to incur additional operating losses. Management believes that its existing cash, cash equivalents and short-term investments as of March 31, 2005, together with cash generated from operations, will be sufficient to fund operations for the next 16 months.

The Company may require additional financing in the future to execute its intended business strategy. There can be no assurances that the Company will be able to obtain additional debt or equity financing on terms acceptable to the Company, when and if needed. Failure to raise needed funds on satisfactory terms could have a material impact on the Company’s business, operating results or financial condition.

The accompanying unaudited consolidated financial statements include the accounts of Auxilium Pharmaceuticals, Inc. and its wholly owned subsidiaries and have been prepared in accordance with U.S. generally accepted accounting principles for interim financial information and pursuant to the rules and regulations of the Securities and Exchange Commission (SEC) pertaining to Form 10-Q. Certain disclosures required for complete annual financial statements are not included herein. All significant intercompany accounts and transactions have been eliminated in consolidation. The information at March 31, 2005 and for the periods ended March 31, 2005 and 2004 is unaudited but includes all adjustments (consisting only of normal recurring adjustments) which, in the opinion of management, are necessary to state fairly the financial information set forth herein. The interim results are not necessarily indicative of results to be expected for the full fiscal year. These unaudited consolidated financial statements should be read in conjunction with the audited consolidated financial statements for the year ended December 31, 2004 included in the Company’s Form 10-K filed with the SEC.

The preparation of the financial statements in conformity with U.S. generally accepted accounting principles requires management to make estimates and assumptions that affect the amounts of assets, liabilities, and the disclosure of contingencies at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from these estimates.

The Company sells Testim to wholesalers and chain drug stores, who have the right to return purchased product. In accordance with Statement of Financial Accounting Standards (SFAS) No. 48, Revenue Recognition When Right of Return Exists, the Company defers recognition of revenue on product shipments of Testim to its customers until Testim units are dispensed through patient prescriptions. Under SFAS No. 48, the Company cannot recognize revenue on product shipments until it can reasonably estimate returns relating to these shipments. The Company estimates prescription units dispensed based on distribution channel data provided by external, independent sources. Testim dispensed to patients through prescription is not subject to return. The gross sales price of product shipments in the U.S. was $8,603,000 and $5,078,000 for the three months ended March 31, 2005 and 2004, respectively. Gross revenue for prescription units dispensed was $9,918,000 and $6,146,000 for the three months ended March 31, 2005 and 2004, respectively, while product revenue net of cash discounts, rebates and patient coupons was $8,797,000 and $5,634,000 for the three months ended March 31, 2005 and 2004, respectively. Product shipments in the U.S. not recognized as revenue, net of anticipated cash discounts, were $2,149,000 and $3,723,000 at March 31, 2005 and December 31, 2004, respectively and are reflected in deferred revenue, current portion. The cost of Testim units shipped to customers that has not been recognized as revenue in accordance with the Company’s policy is reflected as inventory subject to return (see Note 4). The Company will continue to recognize revenue upon prescription units dispensed until it can reasonably estimate product returns based on its product returns experience. At that time, the Company will record a one-time increase in net revenue related to the recognition of revenue previously deferred.

For revenues associated with licensing agreements, the Company uses revenue recognition criteria outlined in Staff Accounting Bulletin (SAB) No. 104 and Emerging Issues Task Force (EITF) Issue No. 00-21, Revenue Arrangements with Multiple Deliverables. Accordingly, revenues from licensing

agreements are recognized based on the performance requirements of the agreement. The Company entered into two license and distribution agreements to market and distribute Testim worldwide, excluding the U.S., Mexico and Japan (see Note 8). Under these agreements, the distributor and the sublicensee are each required to purchase Testim from the Company and make up-front, milestone and royalty payments. Under these agreements, the distributor and the sublicensee may each cancel the agreements if there is a breach of contract or if any party files for bankruptcy. Only milestone payments for product supply price decreases are refundable if the Company subsequently increases the supply price; otherwise, no up-front or milestone payments are refundable in any instance. Product shipments are subject to return and refund only if the product does not comply with technical specifications or if any of the agreements are terminated due to the Company’s nonperformance. The Company is obligated under the agreements to provide multiple deliverables; the license/product distribution rights, regulatory filing services and commercial product supply. Under EITF No. 00-21 the deliverables under each of these agreements are treated as single units of accounting as the Company does not have evidence to support that the consideration for the undelivered item, Testim units to be shipped, is at fair value. Revenue for Testim units shipped will be recognized upon product shipment, subject to the Company’s ability to reasonably estimate product returns. The Company will defer revenue recognition for non-refundable up-front and milestone payments until at least the first product shipment under each agreement. Non-refundable up-front and milestone revenue will be recognized as revenue as a percentage of Testim units shipped in the period over total Testim units expected to be shipped over the distribution term. No revenue for non-refundable up-front and milestone consideration will be recognized if a reasonable estimate of total future Testim unit shipments cannot be made. Refundable milestone payments will be deferred and only included in the revenue recognition equation with non-refundable milestone consideration when the refund right lapses. In December 2004, the Company shipped its first product totaling $311,000 to Ipsen for ultimate sale in the United Kingdom and Germany. The Company recorded the revenue associated with these shipments during the three months ended March 31, 2005 when the right of return lapsed. Through March 31, 2005 the Company collected $8,200,000 of license payments under these agreements. As of March 31, 2005, no portion of up-front and milestone amounts received has been recognized as revenue and the entire balance of deferred revenue from licensing agreements of $9,000,000 was classified as long-term as the Company is not in a position to reasonably estimate total product demand under these agreements. The remaining milestone payments due at March 31, 2005 under these agreements of $800,000 is included in accounts receivable, other on the accompanying consolidated balance sheet.

Cash, cash equivalents and short-term investments are stated at market value. Cash equivalents include only securities having a maturity of three months or less at the time of purchase. The Company limits its credit risk associated with cash, cash equivalents and short-term investments by placing its investments with banks it believes are highly creditworthy and with highly rated money market funds, U.S. government securities, or short-term commercial paper. The Company considers its investments, including securities with maturities in excess of one year, as “available for sale” under SFAS No. 115, Accounting for Certain Investments in Debt and Equity Securities, and accordingly classifies them as current, as management can sell these investments at any time at their option. Related unrealized gains and losses are recorded as a component of accumulated other comprehensive income in the equity section on the accompanying consolidated balance sheet.

Accounts receivable, trade consist of amounts due from wholesalers and chain drug stores for the purchase of Testim. Ongoing credit evaluations of customers are performed and collateral is generally not required.

Accounts receivable, trade are net of allowances for cash discounts, actual returns and bad debts of $537,000 at March 31, 2005 and $578,000 at December 31, 2004.

Inventories are stated at the lower of cost or market, as determined using the first-in, first-out method.

Research and development costs include salaries and related expenses for development personnel as well as fees and costs paid to external service providers. Costs of external service providers include both clinical trial costs and the costs associated with non-clinical support activities such as toxicology testing, manufacturing process development and regulatory affairs. External service providers include contract research organizations, contract manufacturers, toxicology laboratories, physician investigators and academic collaborators. Research and development costs, including the cost of product licenses prior to regulatory approval, are charged to expense as incurred.

Income taxes are accounted for under the asset-and-liability method. Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases and operating loss and tax credit carryforwards. Valuation allowances are established when necessary to reduce deferred tax assets to the amount expected to be realized. Deferred tax assets and liabilities are measured at the balance sheet date using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in the period such tax rate changes are enacted.

In December 2002, the Financial Accounting Standards Board (FASB) issued SFAS No. 148, Accounting for Stock-Based Compensation-Transition and Disclosure. This standard amends the transition and disclosure requirements of SFAS No. 123, Accounting for Stock-Based Compensation. As permitted by SFAS No. 148, the Company follows Accounting Principles Board (APB) Opinion No. 25, Accounting for Stock Issued to Employees, and related interpretations in accounting for equity-based awards issued to employees and directors for director services. Under APB Opinion No. 25, if the exercise price of the award equals or exceeds the fair value of the underlying stock on the measurement date, no compensation expense is recognized. The measurement date is the date on which the final number of shares and exercise price are known and is generally the grant date for awards to employees and directors. If the exercise price of the award is below the fair value of the underlying stock on the measurement date, then compensation cost is recorded, using the intrinsic-value method, and is recognized in the consolidated statements of operations over the vesting period of the award. In addition, the Company’s 2004 Employee Stock Purchase Plan is considered noncompensatory under APB Opinion No. 25 as it is a qualified plan under the Internal Revenue Code.

Had compensation cost for employee and director service option grants and purchase rights under the Company’s 2004 Employee Stock Purchase Plan been determined based on the fair value at the grant dates for those options and rights or the minimum-value method as discussed below, consistent with SFAS No. 123, net loss and net loss per common share would have increased to the pro forma amounts indicated below (in thousands, except per share amounts):

Prior to the initial public offering (“IPO”), the value of option grants under SFAS No. 123 was determined using the minimum-value method. The minimum-value method considers the expected life of an option, the risk-free interest rate prevalent at the date of grant and the expected dividend yield. Upon completion of the IPO, the Company is required to include a volatility factor in its estimation of fair value. The Company has elected to utilize the Black-Scholes option-pricing model to estimate fair value of option grants under SFAS No. 123. Information with respect to the value of option grants under the minimum-value method and the Black-Scholes option pricing model for the periods presented is summarized as follows:

Because the determination of the value of all options granted before the Company became a publicly traded entity do not include an expected volatility factor in addition to the factors described above and because additional option grants are expected in the future, the pro forma disclosures above are not representative of the pro forma effects of stock-based compensation on reported net operating results in future years (also see Note 2k). The Company utilized an expected volatility rate of 80% to value all option grants after the IPO. The weighted average disclosed in the table above assumes a volatility of zero for all option grants prior to the IPO.

Included in the pro forma net loss applicable to common stockholders for the three months ended March 31, 2005 above is $87,000 of compensation under SFAS No. 123 related to the 2004 Employee Stock Purchase Plan. The fair value of employee purchase rights was estimated utilizing the Black-Scholes option pricing model with the following weighted average assumptions: expected life of 1.3 years, risk-free interest rate of 2.25%, expected volatility of 80.63% and no expected dividend yield. The weighed average fair value of purchase rights granted in 2004 was $3.41 per share. There are no new purchase rights granted in 2005.

The Company accounts for stock-based compensation to non-employees using the fair-value method in accordance with SFAS No. 123 and 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. For the three months ended March 31, 2005 and 2004, the Company granted a total of 1,500 and no stock options, respectively, to consultants. The options and stock granted generally vested immediately. For the three months ended March 31, 2005 and 2004, the Company recorded stock-based compensation expense of $7,000 and $33,000, respectively, related to stock and stock option grants to non-employees. The Company valued the stock option grants using the Black-Scholes option-pricing model utilizing the same assumptions above except that the expected life for each grant was the contractual term.

Net loss per common share is calculated in accordance with SFAS No. 128, Earnings Per Share and SAB No. 98. Under the provisions of SFAS No. 128 and SAB No. 98, basic net loss per common share is computed by dividing the net loss applicable to common stockholders for the period by the weighted average number of common shares outstanding during the period reduced, where applicable, for unvested outstanding restricted shares.

The following table sets forth the computation of basic and diluted net loss per common share (in thousands, except share and per share amounts):

Diluted net loss per common share is computed giving effect to all dilutive potential common stock, including options, warrants and redeemable convertible preferred stock. Diluted net loss per common share for all periods presented is the same as basic net loss per common share because the potential common stock is anti-dilutive. Anti-dilutive common shares not included in diluted net loss per common share are summarized as follows:

In December 2004, the Financial Accounting Standards Board, or FASB, issued SFAS No. 123R, Share-Based Payment. SFAS No. 123R revises SFAS No. 123 and supersedes APB Opinion No. 25. Generally the approach in SFAS No. 123R is similar to the approach described in SFAS No. 123. SFAS No. 123R requires that all share-based payments to employees, including grants of employee stock options, be recognized in the statement of operations based on their grant-date fair values over the period during which employees are required to provide services in exchange for the award. In addition, under SFAS No. 123R, the Company’s 2004 Employee Stock Purchase Plan will be considered compensatory. Pro forma disclosure of stock-based compensation under fair values methods is no longer an alternative. SFAS No. 123R provides guidance on how to determine the grant-date fair value for awards of equity instruments as well as alternative methods of adopting its requirements. On April 14, 2005, the Securities and Exchange Commission delayed the effective date of SFAS No. 123R to the beginning of the first

fiscal year after June 15, 2005. As a result, the Company anticipates adopting SFAS No. 123R on January 1, 2006. As the Company currently accounts for employee stock-based compensation under the intrinsic value method permitted under APB Opinion No. 25, the adoption of SFAS No. 123R will result in significant additional compensation charges in the Company’s statements of operations, although it will have no impact on its overall financial position.

Cash and cash equivalents include only securities having a maturity of three months or less at the time of purchase. At March 31, 2005 and December 31, 2004 demand accounts, money market accounts and U.S. Treasury and agency obligations comprised all of the Company’s cash and cash equivalents.

Short-term investments consist of corporate auction-rate securities with original maturities of greater than three months. As of March 31, 2005 and December 31, 2004, all the auction-rate securities held have maturities in excess of 25 years. The Company’s investment policy permits investments in auction-rate securities that have interest reset dates of three months or less at the time of purchase. The reset date is the date in which the underlying interest rate is revised based on a Dutch auction and the underlying security may be readily sold. Although the securities held have extended maturities, the Company classifies these securities as current as they are available for sale under SFAS No. 115.

The following summarizes cash, cash equivalents and short-term investments (in thousands):

Inventory subject to return represents the amount of Testim shipped to wholesalers and chain drug stores that had not been recognized as revenue (see Note 2c).

Included in work-in-process inventory at March 31, 2005 is $992,000 of Testim validation batches manufactured by a back-up supplier. The Company intends to sell this inventory after it receives approval of the manufacturing facility and process from the U.S. Food and Drug Administration. Although additional required testing of this inventory remains to be completed, the Company capitalized this inventory based on favorable preliminary results from analytical testing, past product experience and Management’s belief that it is probable that the inventory will be saleable.

In March 2004, the Company entered into a replacement line of credit with another commercial bank, Comerica Bank. The replacement line of credit was for $5,000,000 and expired in March 2005. The line bore interest at the bank’s prime rate plus 0.5% and was secured by all the Company’s tangible assets. If the amount of the Company’s cash balance at the bank fell below $10.0 million and the Company had borrowings outstanding on the line, the bank would have restricted cash on deposit based on a formula of accounts receivable. The maximum restricted cash amount would have been the full amount of the line. In addition, if the Company’s cash balance fell below $10.0 million, the Company would have been subject to financial covenants. The Company drew under this line in early 2004. There are no amounts outstanding under this facility as of December 31, 2004.

On December 31, 2004, the Company entered into a 90-month lease agreement to move its headquarters facility to Malvern, Pennsylvania. The Company anticipates moving into the new office space in the summer of 2005, before its existing office space lease expires. The Company paid a $400,000 security deposit under this new lease in January 2005 that is reflected in other assets on the accompanying balance sheet at March 31, 2005. The Company will receive an allowance to improve the new facility of up to $808,000. The Company will record the cost of the improvements as a fixed asset and the allowance as a deferred rent credit. The Company will amortize the leasehold improvement asset over the shorter of the life of the improvements or the life of the lease. The Company will amortize the deferred rent credit as a reduction of rent expense on a straight-line basis over the life of the lease. The new lease will include a period of free rent and escalating minimum rent payments. The Company will record rent expense for the minimum lease payments on a straight-line basis starting with the lease commencement date. In addition, the Company anticipates recording a charge to general and administrative expenses when it ceases to use its existing office facility. This charge will represent the rent to be paid for unutilized office space under the existing noncancelable lease less estimated sublease income that can reasonably expected to be received for the property. As of March 31, 2005, the Company has $298,000 of lease payments remaining on its existing office facility.

In June 2004, the Company entered into a development and license agreement with BioSpecifics Technologies Corp. (BioSpecifics Technologies). Under the agreement, the Company has agreed to develop products containing the licensor’s product (AA4500) for the treatment of Peyronie’s and Dupuytren’s Diseases. The Company has been granted the exclusive world-wide license to any products developed under the agreement other than dermal formulations labeled for topical administration. The Company also has the option to develop and license the technology for use in other indications other than dermal formulations labeled for topical administration. The agreement extends, on a country-by-country and product-by-product basis, for the longer of the patent life, the expiration of any regulatory exclusivity period or 12 years. The Company may terminate the agreement with 90 days written notice. The Company is obligated to pay all clinical and regulatory development costs on an on-going basis, to purchase commercial inventory from BioSpecifics Technologies and to pay royalties based on product sales. In addition, the Company is obligated to make contingent milestone payments for contract initiation, receipt of technical data, manufacturing process development, the one-year anniversary of the agreement, filing of regulatory applications and receipt of regulatory approval. Through December 31, 2004, the Company paid up-front and milestone payments under this agreement of $5,000,000. The Company recorded two payments of $2,500,000 each as an in-process research and development expense in each of the second and third quarters of 2004 because AA4500 is in the early stages of Phase II clinical trials and there is no alternative future use for AA4500 prior to FDA approval. In March 2005, the Company accrued the one-year contract anniversary payment of $3,000,000 due in June 2005 as the Company became firmly obligated to make the payment. The Company recorded this accrual as an additional in-process research and development expense in the first quarter of 2005 because AA4500 is in the early stages of Phase II clinical trials and there is no alternative future use for AA4500 prior to FDA approval. The Company could make an additional $7,500,000 of contingent milestone payments under this agreement if all existing conditions are met. Additional milestone obligations may be due if the Company exercises an option to develop and license AA4500 for additional medical indications.

In February 2005, the Company entered into an agreement with PharmaForm in which the Company agreed to develop and license eight separate pain products under its transmucosal film technology. In 2005, the Company paid an up-front payment of $0.5 million and could make up to an additional $21.2 million of contingent milestone payments if all underlying events occur. In addition to these new licenses, the Company agreed to engage PharmaForm to provide research and development services related to these pain products for four years.

In addition, the Company has entered into various other licensing agreements. Through March 31, 2005, the Company has made aggregate milestone payments under all agreements of $6,125,000 and has accrued an additional $3,000,000 of milestone payments. The Company could make an additional $29,725,000 of contingent milestone payments under all agreements if all existing conditions are met.

On April 11, 2005, the Company entered into a co-promotion agreement (the Agreement) with Oscient Pharmaceuticals Corp. (Oscient) under which the Company and Oscient will co-promote Testim in the U.S. Oscient will have the exclusive right to promote Testim jointly with the Company to primary care physicians by using its 250-person sales force. Oscient is obligated to commence co-promotion of Testim by May 9, 2005. The initial term of the Agreement ends on April 30, 2007. Oscient may extend the Agreement for two consecutive two-year periods provided that certain milestones for each extension have been met by Oscient. If these milestones are met and Oscient does not elect to terminate the Agreement, the first extension period will commence on January 1, 2007 and end on December 31, 2008 and the second extension period will commence effective January 1, 2009 and end on April 30, 2011.

The Company and Oscient will jointly develop a promotion plan which sets forth the responsibilities of both parties with respect to the marketing and promotion of Testim in the U.S. primary care physician market. The Company is obligated to share Testim promotional expenses to this audience equally with Oscient. Each party will be responsible for the costs associated with its own sales force. In addition, Auxilium is obligated to pay Oscient a co-promotion fee based on a specified percentage of the gross profit from Testim sales attributable to primary care physicians in the U.S., that exceeds a specified sales threshold. The specific percentage is based upon Testim sales levels attributable to primary care physicians and the marketing expenses incurred by Oscient in connection with the promotion of Testim under the Agreement.

The Agreement can be terminated by either party upon the occurrence of certain termination events. The Company may be obligated to make termination payments in certain instances. Also, Oscient has been granted the exclusive option to co-promote any future product candidate of the Company that treats hypogonadism and contains testosterone as the active ingredient.

In December 2003, the Company entered into an exclusive marketing and distribution agreement with Bayer, Inc. (Bayer) in Canada. The Company filed for regulatory approval of Testim in Canada in March 2004. Under the agreement, Bayer will purchase product and pay certain royalty and milestone payments. The milestones payments are due upon contract signing, filing for regulatory approval in Canada, the first sale of Testim in Canada and upon achieving specified sales levels. The term of the agreement is for the life of the patent covering Testim in Canada.

In March 2004, the Company signed a sublicense agreement with Ipsen to use and sell Testim on a worldwide basis outside of the US, Canada, Mexico and Japan. Through April 2005, Testim is approved for marketing in the United States, the United Kingdom, Belgium, Denmark, Finland, Germany, Iceland, Ireland, the Netherlands, Norway, Portugal, Spain and Sweden. In June 2004, the Company received scientific approval for Testim in an additional three European countries. The Company anticipates that marketing approvals in the remaining countries will be received once local administrative procedures to finalize the packaging text have been completed. Ipsen is responsible for obtaining regulatory approval in non-EU countries. In addition, Ipsen is obligated to purchase product from the Company and to pay royalty and certain milestone payments. The milestone payments are due upon contract signing, regulatory approval, product launch in various countries and supply price reductions. The license is exclusive and royalty-bearing for the longer of ten years from market launch or the expiration of patent protection in any particular country.

Through March 31, 2005, the Company was due or collected $9,000,000 in up-front and milestone fees under these agreements and is due an additional $400,000 in April 2005 for another milestone event. In addition to this April 2005 milestone, the Company could collect an additional $9,800,000 in milestone fees if all underlying events occur. (See Note 2c).

The foreign currency translation amounts relate to our foreign subsidiary. Unrealized gains on available for sale securities relate to our cash equivalents (see Notes 2d and 3).

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

The following discussion is qualified in its entirety by, and should be read in conjunction with, the more detailed information set forth in the consolidated financial statements and the notes thereto appearing elsewhere in this report.

This quarterly report includes forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended and Section 21E of the Securities Exchange Act of 1934, as amended. All statements other than statements of historical facts contained in this quarterly report, including statements regarding the future financial position, business strategy and plans and objectives of management for future operations, are forward-looking statements. The words “believe,” “may,” “could,” “will,” “estimate,” “continue,” “anticipate,” “intend,” “should,” “plan,” “expect,” and similar expressions, as they relate to the Company, are intended to identify forward-looking statements. The Company has based these forward-looking statements largely on current expectations and projections about future events and financial trends that it believes may affect financial condition, results of operations, business strategy and financial needs. These forward-looking statements are subject to a number of risks, uncertainties and assumptions, including, among other things:

These risks are not exhaustive. See “Factors That May Affect Our Future Results” beginning on page 29 for a more detailed discussion of these risks. Other sections of this quarterly report may include additional factors which could adversely impact business and financial performance. Moreover, the Company operates in a very competitive and rapidly changing environment. You should not rely upon forward-looking statements as predictions of future events. The Company cannot assure you that the

events and circumstances reflected in the forward-looking statements will be achieved or occur. Although it believes that the expectations reflected in the forward-looking statements are reasonable, the Company cannot guarantee future results, levels of activity, performance or achievements.

We are a specialty pharmaceutical company dedicated to the development and commercialization of pharmaceutical products focused on urology and sexual health. Our goal is to develop and commercialize a portfolio of products that treat diseases and disorders relating to urology and sexual health. We have established our own sales and marketing organization, which includes approximately 100 sales and marketing professionals that cover the U.S. We also have assembled an experienced team responsible for additional product development and regulatory affairs for North America and Europe. We are pursuing product opportunities through collaborations and in-licensing to treat other urologic and sexual health disorders. Testim, our only marketed product, is a testosterone replacement therapy, or TRT, for the treatment of hypogonadism. We launched Testim in the first quarter of 2003 in the U.S. through our own specialty sales force. Our sales force calls on physicians who are prescribers of urologic and sexual health products. In April 2005, we entered into a co-promotion agreement with Oscient Pharmaceuticals Corp., or Oscient, under which Oscient will promote Testim to primary care physicians in the U.S. using its 250-person sales force. Testosterone gels, which include Testim, represented 61% of the total TRT prescriptions dispensed in 2003, 65% of the total TRT prescriptions in 2004 and 66% of TRT prescriptions in the first quarter of 2005. Total monthly Testim prescription units dispensed, based on data from IMS Health Incorporated, have increased from approximately 1,000 in March 2003 to over 21,500 in March 2005. Testim is manufactured for us by DPT Laboratories. We licensed the underlying technology for Testim from Bentley Pharmaceuticals.

We have never been profitable and have incurred an accumulated deficit of $110.8 million as of March 31, 2005. We expect to incur significant operating losses for the next several years. Commercialization expenses, development costs, and in-licensing milestone payments related to existing and new product candidates and to enhance our core technologies will continue to increase in the near term. In particular, we expect to incur increased costs for selling and marketing as we continue to market Testim, additional development costs for existing and new product opportunities, increased general and administration expense to support the infrastructure required to grow and operate as a public company. We will need to generate significant revenues to achieve profitability.

We expect that quarterly and annual operating results of operations will fluctuate for the foreseeable future due to several factors including the overall growth of the androgen market, the timing and extent of research and development efforts, milestone payments, and the outcome and extent of clinical trial activities. Our limited operating history makes accurate prediction of future operating results difficult or impossible.

Net revenues. Net product revenues were $8.8 million and $5.6 million for the three months ended March 31, 2005 and 2004, respectively. Prescription units dispensed increased from approximately 43,000 in the first quarter of 2004 to approximately 62,200 in the comparable period in 2005. We believe that Testim prescription growth in the 2005 period over the 2004 period was primarily driven by continued growth in sales effectiveness which resulted in growth in market share and new prescriptions and favorable formulary positions with managed care providers. The increase in net product revenues in the 2005 period over the 2004 period also are a result of price increases with a cumulative impact of 12% offset by

increases in wholesaler discounts due to increased distribution costs and product rebates as Testim becomes wider prescribed by managed care providers. Net product revenues in the first quarter of 2005 also include $311,000 of product shipped to Ipsen for ultimate sale in Germany and the United Kingdom for which there is no comparable amount in the first quarter of 2004. Net revenues for Testim product sales are reflected net of cash discounts, rebates and patient coupons. Shipments in the U.S. not recognized as revenue, net of anticipated cash discounts, were $2.1 million and $3.7 million at March 31, 2005 and December 31, 2004, respectively and are reflected in deferred revenue, current portion.

Cost of goods sold. Cost of goods sold were $2.8 million and $1.8 million for the three months ended March 31, 2005 and 2004, respectively. The increase in cost of goods sold for the three months ended March 31, 2005 over the comparable period in 2004 was directly attributable to the increase in Testim prescription revenue in the U.S. and $285,000 of costs associated with product shipped to Ipsen for ultimate sale in Germany and the United Kingdom for which there is no comparable amount in the first quarter of 2004. Cost of goods sold in the 2004 period would have been approximately $0.1 million higher had purchases of a key raw material not been charged-off in 2002. Gross margin on our net product sales was 67.9% in the 2005 period compared to 68.2% in the 2004 period. Gross margin for U.S. product revenue was 70.0% for the 2005 period and would have been 66.2% for the 2004 period had purchases of a key raw material not been charged-off in 2002. The improvement in gross margin in the 2005 period over the 2004 period resulted primarily from fixed manufacturing costs spread across an increased number of units sold. In 2002, we purchased approximately $0.9 million of this raw material prior to FDA approval of Testim and, based on our policy, charged the purchase price to research and development expense because we would have had no alternative use for the raw material if Testim were not approved. As of December 31, 2004, we did not have any of the raw material with zero book value remaining in inventory.

Research and development expenses. Research and development expenses were $9.1 million and $2.4 million for the three months ended March 31, 2005 and 2004, respectively. The increase in the three months ended 2005 over the comparable period in 2004 was due primarily to $5.0 million in development expenses for AA4500, our Peyronie’s and Dupuytren’s Diseases product candidate for which there was no expenditures in the 2004 period. These expenses are comprised of the accrual of the $3.0 million milestone due to BioSpecifics Technologies on the one-year anniversary of our in-license agreement for AA4500 and $2.0 million of additional development expenses, consisting primarily of manufacturing process development work. In addition, the increase in the 2005 period over the 2004 period is a result of the $1.1 million increase in development expenses on our androgen replacement and overactive bladder transmucosal film product candidates and the $0.5 million up-front payment for the in-license of eight separate pain products under the transmucosal film technology in February 2005.

Selling, general and administrative expenses. Selling, general and administrative expenses were $8.7 million and $7.4 million for the three months ended March 31, 2005 and 2004, respectively. The increase for the three months ended March 31, 2005 over the comparable period in 2004 was due primarily to general and administrative expenses increasing by $0.9 million resulting from the previously disclosed investigation initiated by the Audit Committee of our Board of Directors into certain transactions and the effectiveness of our internal disclosure controls and procedures, severance accruals related to the termination of our President and Chief Operating Officer and incremental costs associated with operating as a publicly traded company. Selling and marketing expenses increased by $0.4 million associated with an increase in our sales force compared to the 2004 period offset by lower promotion expense in anticipation of a concerted promotional campaign to be instituted in conjunction with the co-promote agreement signed with Oscient. We anticipate significant increases in selling and marketing expenses due to the co-promote agreement signed with Oscient.

Interest income (expense),net. Interest income (expense), net was $0.2 and $(0.5) million for the three months ended March 31, 2005 and 2004, respectively. Net interest income in the 2005 period relates primarily to interest earned on the invested proceeds from our initial public offering in July of 2004. The expense in the 2004 period relates primarily to non-cash amortization of deferred debt issuance costs related to a line of credit and to interest paid on the line of credit. The line of credit was repaid and terminated in March 2004.

Accretion of redeemable convertible preferred stock. Accretion of redeemable convertible preferred stock was $0 and $0.1 million for the three months ended March 31, 2005 and 2004, respectively. In the 2004 period, we were accreting the carrying value of redeemable convertible preferred stock to its redemption value. There is no corresponding accretion in the 2005 period as all previously outstanding shares of this stock were converted into our common stock in connection with our initial public offering.

Since inception through March 31, 2005, we have financed our product development, operations and capital expenditures primarily from private and public sales of equity securities. Since inception through March 31, 2005, we received approximately $134.0 million from the IPO, private sales of equity securities and the exercise of stock options. Since launching Testim in 2003, net revenue from the sales of Testim has become a source of cash, a trend that we believe will continue. We had approximately $28.0 million and $32.7 million in cash and cash equivalents as of March 31, 2005 and December 31, 2004, respectively. As of March 31, 2005 and December 31, 2004, we also had $12.1 million and $14.1 million, respectively, in short-term investments.

We believe that our current financial resources and sources of liquidity will be adequate to fund our operations for the next 16 months from March 31, 2005. We may, however, need to raise additional funds prior to this time in order to enhance our sales and marketing efforts for additional products or potentially as part of a co-promotional plan for Testim, fund our product development, including clinical trials, commercialize any product candidates that receive regulatory approval, and acquire or in-license approved products or product candidates or technologies for development. Insufficient funds may cause us to delay, reduce the scope of, or eliminate one or more of our planned development, commercialization or expansion activities. Our future capital needs and the adequacy of our available funds will depend on many factors, including the effectiveness of our sales and marketing activities, the cost of clinical studies and other actions needed to obtain regulatory approval of our products in development, and the timing and cost of any acquisitions. If additional funds are required, we may raise such funds from time to time through public or private sales of equity or debt securities or from bank or other loans. Financing may not be available on acceptable terms, or at all, and our failure to raise capital when needed could materially adversely impact our growth plans and our financial condition or results of operations. Additional equity financing, if available, may be dilutive to the holders of our common stock and may involve significant cash payment obligations and covenants that restrict our ability to operate our business.

In March 2004, we terminated our existing bank line of credit and entered into a replacement $5.0 million line of credit with Comerica that expired in March 2005. This facility bore interest at an annual rate of prime plus 0.5%. We are evaluating whether to pursue a new line of credit. In addition, we have two equipment loans with General Electric Capital Corporation totaling $0.7 million outstanding at March 31, 2005. The equipment facilities bear interest at a weighted-average rate of 9.3% per annum.

Cash used in operations was $6.5 million and $7.2 million for the three months ended March 31, 2005 and 2004, respectively. Testim product sales and up-front and milestone payments generated approximately $10.0 million and $5.5 million in cash receipts for the three months ended March 31, 2005 and 2004, respectively. Cash used in operations in the 2005 period results primarily from operating losses offset by the $3.0 million accrual of a milestone payment. Cash used in operations in the 2004 period results primarily from operating losses.

Cash provided by investing activities was $1.8 million for the three months ended March 31, 2005 compared to cash used in investing activities of $0.2 million for the three months ended March 31, 2004. Cash provided by investing activities in the 2005 period relates primarily to the redemption of short-term investments to fund operations. Cash used in investing activities for the 2004 period relates primarily to the purchase of manufacturing equipment, office furniture and computer equipment.

Cash provided by financing activities was essentially zero and $4.8 million for the three months ended March 31, 2005 and 2004, respectively. Cash provided by financing activity in the 2005 period results from the $0.1 million in cash receipts from stock option exercises being offset by $0.1 million in debt payments. Cash provided by financing activities for the 2004 period is related primarily to the redemption of a restricted bank certificate of deposit to pay off a bank line of credit offset by borrowings under a new line of credit.

In June 2004, we entered into an agreement with BioSpecifics Technologies in which we were granted an exclusive license to develop, manufacture and market an enzyme (AA4500) for the treatment of Peyronie’s Disease and Dupuytren’s Disease. Under the terms of the agreement, BioSpecifics Technologies is responsible for supplying clinical and commercial product supplies; we however, have the right to qualify a back-up supplier. We are in the process of qualifying a back-up supplier and negotiating the terms of agreement with this back-up supplier for the production of our clinical supply of AA4500. Upon completion of the qualification process, we expect to rely on this back-up supplier, rather than BioSpecifics Technologies, for our clinical supply of AA4500. Upon completion of the qualification process, we expect to rely on this back-up supplier, rather than BioSpecifics Technologies, for our clinical supply of AA4500. As a result, we do not anticipate paying BioSpecifics Technologies the manufacturing process development milestones under our agreement. Under this agreement we paid up-front and milestone payments totaling $5.0 million through December 31, 2004 and accrued $3.0 million of additional milestone payments as of March 31, 2005 that we anticipate paying in the second quarter of 2005. Additional milestone obligations may be due if we exercise an option to license and develop this enzyme for additional medical indications.

In February 2005, we entered into an agreement with PharmaForm in which we were granted an exclusive sub-license to develop, manufacture and market eight separate pain products under the licensed transmucosal film technology. In 2005 we paid an up-front payment of $0.5 million and could make up to an additional $21.2 million of contingent milestone payments if all underlying events occur. In addition to these new licenses, we engaged PharmaForm to provide research and development services related to these pain products for four years. We expect to incur at least $700,000 under the services agreement through December 31, 2005, but do not anticipate making any additional milestone payments over the same time period.

In April 2005, we entered into a co-promotion agreement with Oscient under which Oscient will promote Testim to primary care physicians in the U.S. using its 250-person sales force. We are obligated to share Testim promotional expenses with Oscient and to pay Oscient a co-promotion fee based on a specified percentage of the gross profit from Testim sales attributable to primary care physicians in the

U.S., that exceeds a specified sales threshold. The specific percentage is based upon Testim sales levels attributable to primary care physicians and the marketing expenses incurred by Oscient in connection with the promotion of Testim under the Agreement. During the initial two-year term of the agreement, we anticipate no negative impact on liquidity, but if any Testim revenues from the co-promotional efforts lag behind the fees and expenses due Oscient, there will be a negative impact on our operating cash flows.

The following table summarizes our future payment obligations and commitments as of March 31, 2005 (in thousands):

The contractual commitments reflected in this table exclude $29.7 million of contingent milestone payments that we may be obligated to pay in the future. Except for the $3.0 million milestone payment reflected in the table above, we do not expect to pay any of these contingent milestone payments through March 31, 2006. These remaining milestones relate primarily to manufacturing process development, filing of regulatory applications and receipt of regulatory approval. Of the $29.7 million of contingent milestone payments, we do not anticipate paying BioSpecifics Technologies an additional $3.0 million for manufacturing process development milestones. The above table also excludes future royalty payments and wholesaler distribution fees because they are contingent on product sales. In addition, the above table excludes any co-promotional expenses and fees that may be due Oscient because they are contingent upon combined promotional expenditures and future product sales to primary care physicians, respectively.

We do not have any off-balance sheet arrangements as defined in Item 303(a)(4) of Regulation S-K.

Our management’s discussion and analysis of our financial condition and results of operations, which are based on our consolidated financial statements, have been prepared in accordance with U.S. generally accepted accounting principles. The preparation of these financial statements requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements as well as the reported revenues and expenses during the reporting periods. We base our estimates on historical experience and on various other factors that we believe are reasonable under the circumstances, the results of which form the basis for making judgments about the carrying value of assets and liabilities that are not readily apparent from other sources. We are subject to uncertainties that may cause actual results to differ from these estimates, such as changes in the healthcare environment, competition, legislation and regulation. We believe the following accounting policies, which have been discussed with our audit committee, are

the most critical because they involve the most significant judgments and estimates used in the preparation of our consolidated financial statements:

Revenue Recognition. We sell Testim to pharmaceutical wholesalers and chain drug stores. These companies have the right to return Testim for any reason up to one-year after product expiration. As a result of Testim’s launch in the first quarter of 2003, we do not have sufficient sales history to estimate product returns. In accordance with Statement of Financial Accounting Standards (SFAS) No. 48, we defer recognition of revenue on product shipments of Testim to our U.S. customers until such time as Testim units are dispensed through patient prescriptions, since they are not subject to return. Under SFAS No. 48, we cannot recognize revenue on product shipments until we can reasonably estimate returns relating to these shipments. We estimate the volume of prescription units dispensed at pharmacies based on data provided by external, independent sources. These sources poll pharmacies, hospitals, mail order and other retail outlets for Testim prescriptions and project this sample on a national level. We will continue to recognize revenue based on prescription units until we have sufficient history to estimate product returns. When we are able to reasonably estimate our product returns, we will recognize a one-time increase in net revenue related to the recognition of revenue previously deferred, net of appropriate allowances for cash discounts, rebates, patient coupons and product returns. We continue to gather experience with our returns and believe that we will be in a position to reasonably estimate returns during 2005. In addition, we must make estimates for rebates provided to third-party payers and coupons provided to patients. Testim is covered by Medicaid and numerous independent insurance and pharmacy benefit managers, or PBMs. Some of these programs have negotiated rebates. We obtain estimates of prescription units dispensed under the various rebate programs from the same external sources discussed above. We make estimates of the rebates based on the external-source reports of volumes and actual contract terms. In addition, we provide coupons to physicians for use with prescriptions as promotional incentives. We utilize a contract service provider to process and pay claims to patients for actual coupon usage. The timing of processing coupon invoices from this service provider is delayed. We make estimates of actual coupon usage based on previous experience. As Testim becomes more widely used and as we continue to add managed care and PBM contracts, our estimates may result in differences to actual results. To date, our estimates have not resulted in any material adjustments to our operating results.

We have licensed out to Ipsen the right to market and distribute Testim worldwide, excluding the U.S., Canada, Mexico and Japan. We have entered into a distribution agreement with Bayer for Canada. Under these agreements, Bayer and Ipsen are each required to purchase Testim from us and make up-front, milestone and royalty payments. We are obligated under the agreements to provide multiple deliverables; the license/product distribution rights, regulatory filing services and commercial product supply. Under Emerging Issues Task Force (EITF) No. 00-21, Revenue Arrangements with Multiple Deliverables, the deliverables under each of these agreements are treated as single units of accounting as we do not have evidence to support that the consideration for the undelivered item, Testim units to be shipped, is at fair value. Revenue for Testim units shipped will be recognized upon product shipment, subject to our ability to reasonably estimate product returns. We will defer revenue recognition for up-front and milestone payments until at least the first product shipment under each agreement. Up-front and milestone revenue will be recognized over the distribution term based on Testim units shipped. We will need to estimate the total Testim units to be shipped under the agreements. As a result, we plan on

utilizing independent appraisers to help us determine the useful life of Testim in markets where we anticipate Testim units shipped to be material. We will use this information along with market penetration data from independent sources to estimate the total Testim units to be shipped. Periodically, we will reevaluate these estimates and adjust on a prospective basis the amortization of the up-front and milestone payments. We will disclose the reasons for any significant changes in our future estimates. If we are unable to reasonably estimate the total units to be shipped, the amortization of the deferred revenue will not be recognized as revenue until we are able to make a reasonable estimate.

Inventory Valuation. We rely on a single source supplier for one of the key ingredients in Testim. As a result, we have purchased a substantial safety stock of this ingredient on which we have limited shelf-life data. We continue to perform stability testing on the ingredient to determine its maximum shelf-life. In addition, our finished goods inventory has a definitive shelf-life. We estimate that the demand for Testim will be such that the raw materials and finished goods on hand will ultimately be used in future production and sold to our customers. As a result, we have not recorded a material valuation allowance for potential excess inventory as of March 31, 2005. We will continually evaluate the demand for Testim and the data from the stability testing to determine whether an allowance for excess inventory is warranted. In addition, at March 31, 2005 we have capitalized as work-in-process inventory $992,000 of Testim manufactured by a back-up supplier. We intend to sell this inventory after we receive approval of the manufacturing facility and process from the U.S. Food and Drug Administration, or FDA. Although additional required testing of this inventory remains to be completed, we capitalized this inventory based on favorable preliminary results from analytical testing, past product experience and our belief that it is probable that the inventory will be saleable. If the ultimate testing results prove unfavorable or the FDA does not approve the manufacturing facility or process, we will have to write-off this inventory.

Valuation of Equity Instruments used in Stock-Based Compensation. We account for employee stock options using the intrinsic-value method in accordance with Accounting Principles Board (APB) Opinion No. 25, Accounting for Stock Issued to Employees, and related interpretations and have adopted the disclosure-only provisions of SFAS No. 148, Accounting for Stock-Based Compensation-Transition and Disclosure, an amendment of SFAS No. 123, Accounting of Stock-Based Compensation. The disclosure-only provisions of SFAS No. 148 require us to disclose pro forma net loss applicable to common stockholders and net loss per common share as if we accounted for employee stock options at fair value. SFAS No. 123 also requires us to estimate the value of purchase rights granted to employees under our 2004 Employee Stock Purchase Plan for inclusion in the SFAS 148 pro forma disclosure. In addition, we account for stock-based compensation to non-employees using the fair-value method in accordance with SFAS No. 123 and 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. Our disclosure under SFAS No. 148 and our accounting under EITF Issue No. 96-18 require us to estimate the value of equity instruments issued. We utilize the Black-Scholes option-pricing model to value stock options issued to employees and non-employees and purchase rights granted to employees under our 2004 Employee Stock Purchase Plan. The Black-Scholes option-pricing model requires us to make assumptions of the estimated life of the underlying options, the anticipated volatility of the price of our common stock, the risk-free interest rate and the expected dividend yield of our common stock.

options, be recognized in the statement of operations based on their grant-date fair values over the period during which employees are required to provide services in exchange for the award. In addition, under SFAS No. 123R our 2004 Employee Stock Purchase Plan will be considered compensatory. Pro forma disclosure of stock-based compensation under fair values methods is no longer an alternative. SFAS No. 123R provides guidance on how to determine the grant-date fair value for awards of equity instruments as well as alternative methods of adopting its requirements. On April 14, 2005, the Securities and Exchange Commission delayed the effective date of SFAS No. 123R to the beginning of the first fiscal year after June 15, 2005. As a result, we anticipate adopting SFAS No. 123R on January 1, 2006. As we currently account for employee stock-based compensation under the intrinsic value method permitted under APB Opinion No. 25, the adoption of SFAS No. 123R will result in significant additional compensation charges in our statements of operations, although it will have no impact on our overall financial position.

In addition to the other information included in this Report, the following factors should be considered in evaluating our business and future prospects. Any of the following risks, either alone or taken together, could materially and adversely affect our business, financial position or results of operations. If one or more of these or other risks or uncertainties materialize, or if our underlying assumptions prove to be incorrect, our actual results may vary materially from what we projected. There may be additional risks that we do not presently know or that we currently believe are immaterial which could also impair our business or financial position.

We have incurred significant losses since our inception and may not achieve profitability in the foreseeable future.

We have incurred significant losses since our inception, including net losses of $11.6 million for the three months ended March 31, 2005. As of March 31, 2005, we had an accumulated deficit of $110.8 million. Our only approved product is Testim. We expect to continue to make substantial expenditures related to the marketing and selling of Testim. As we launched Testim in the first quarter of 2003, we cannot be certain how effective our marketing and selling programs will be in the future. We continue to expand and enhance the marketing and selling of Testim. In April 2005, we entered into an agreement with Oscient for the co-promotion of Testim to primary care physicians in the U.S. As a result, marketing and selling expenses may increase substantially in the future. In addition, we expect to continue to incur substantial expenses, including milestone payments, as we:

Accordingly, we expect to continue to incur substantial additional losses for the foreseeable future. In order to achieve and maintain profitability, we will need to generate significantly greater revenues from Testim and any other product candidate for which we receive marketing approval. As a result, we are unsure when we will become profitable, if at all. If we fail to achieve profitability within the time frame expected by investors, the value of our common stock may decline substantially.

Because we have a limited operating history, our future results are unpredictable, and therefore, our common stock is a highly speculative investment.

We commenced operations in the fourth quarter of 1999 and have a very limited operating history for you to evaluate our business. Accordingly, you must consider our prospects in light of the risks and difficulties encountered by companies in their early stages. In order to address these risks, we must:

In addition, due to our limited operating history, we have minimal experience with product returns. If returns are higher than expected, our operating results could be materially harmed.

All of our revenues to date have been generated from the sale of Testim, and, if sales of Testim do not grow, we will not become profitable.

Our only product with marketing approval is Testim and our product revenues to date have been generated solely from the sale of Testim. Until such time as we develop, acquire or in-license additional products that are approved for marketing, we will continue to rely on Testim for all of our revenues. Accordingly, our success depends significantly on our ability to increase sales of Testim. Our sales and marketing efforts or those of our co-promotion partner may not be successful in increasing prescriptions for Testim. Sales of Testim are subject to the following risks, among others:

For the foreseeable future, if we are unable to grow Testim sales, we will be unable to increase our revenues or achieve profitability and we may be forced to delay or change our current plans to develop other product candidates.

If we fail to raise additional funds in the future, we may be required to limit, scale back or cease our operations.

Our operations to date have generated substantial and increasing needs for cash. Our negative cash flows from operations are expected to continue for at least the foreseeable future. Our strategy contains elements that we will not be able to execute without outside funding. Specifically, we may need to raise additional capital to:

We believe that our existing cash resources and interest on these funds will be sufficient to meet our projected operating requirements for the next 16 months. Our future funding requirements will depend on many factors, including:

These factors could result in variations from our currently projected operating and liquidity requirements. If our existing resources are insufficient to satisfy our liquidity requirements, we may need to borrow money or sell additional equity or debt securities. We may not be able to borrow money on commercially reasonable terms. Moreover, the terms of the sale of any equity or debt securities may not be acceptable to us and could result in substantial dilution of your investment. If we are unable to obtain this additional financing, we may be required to:

Our revenues, operating results and cash flows may fluctuate in future periods and we may fail to meet investor expectations, which may cause the price of our common stock to decline.

Variations in our quarterly operating results are difficult to predict and may fluctuate significantly from period to period. We are a relatively new company and our sales prospects are uncertain. We have been selling Testim, our only approved product, since the first quarter of 2003 and cannot predict with certainty the timing or level of sales of Testim in the future. If our quarterly sales or operating results fall

below the expectations of investors or securities analysts, the price of our common stock could decline substantially. In addition to the other factors discussed under these “Factors That May Affect Our Future Results,” specific factors that may cause fluctuations in our operating results include:

Forecasting our revenues is further complicated by difficulties in estimating inventory levels at our wholesaler and chain drug store customers, prescription levels, the timing of purchases by wholesalers and retailers to replenish inventory and the occurrence and amount of product returns. As a result of these factors, we believe that period-to-period comparisons of our operating results are not a good indication of our future performance.

We may not be able to develop product candidates into viable commercial products, which would impair our ability to grow and could cause a decline in the price of our stock.

The process of developing product candidates involves a high degree of risk and may take several years. Product candidates that appear promising in the early phases of development may fail to reach the market for several reasons, including:

Success in preclinical and early clinical trials does not ensure that large-scale clinical trials will be successful. Clinical results are frequently susceptible to varying interpretations that may delay, limit or prevent regulatory approvals. The length of time necessary to complete clinical trials and to submit an application for marketing approval for a final decision by a regulatory authority varies significantly and may be difficult to predict. Currently, there is substantial congressional and administrative review of the regulatory approval process for drug candidates in the U.S. Any changes to the U.S. regulatory approval process could significantly increase the timing or cost of regulatory approval for our product candidates making further development uneconomical or impossible.

In addition, developing product candidates is very expensive and will have a significant impact on our ability to generate profits. Factors affecting our product development expenses include:

Our product development efforts also could result in large and immediate write-offs, significant milestone payments, incurrence of debt and contingent liabilities or amortization of expenses related to intangible assets, any of which could negatively impact our financial results. Additionally, if we are unable to develop our product candidates into viable commercial products, we may remain reliant solely on Testim sales for our revenues, potentially limiting our growth opportunities.

If clinical trials for our product candidates are delayed, we would be unable to commercialize our product candidates on a timely basis, which would materially harm our business.

Clinical trials that we may conduct may not begin on time or may need to be restructured after they have begun. Clinical trials can be delayed or may need to be restructured for a variety of reasons, including delays or restructuring related to:

Prior to commencing clinical trials in the U.S., we must have an effective IND for each of our product candidates. An IND has been filed by BioSpecifics Technologies for our Peyronie’s Disease product candidate. An IND has been filed and is effective for our androgen replacement transmucosal film product candidate; however, INDs have not been filed for our overactive bladder transmucosal film or pain transmucosal film product candidates. We will not be able to commence clinical trials in the U.S. for these product candidates until we file, and the FDA fails to object to, an IND for each candidate.

Our primary product candidates that are in development are our AA4500 product for the treatment of Peyronie’s and Dupuytren’s Diseases, our androgen replacement transmucosal film, overactive bladder transmucosal film and pain transmucosal film product candidates. We believe that these product candidates have significant milestones to reach, including the successful filing of INDs for our overactive bladder transmucosal film and our pain transmucosal film, and completion of clinical trials for each product candidate, before commercialization. If we experience delays in or termination of clinical trials or if the cost or timing of the regulatory approval process in the U.S. increases, our financial results and the commercial prospects for our product candidates will be adversely impacted. In addition, our product development costs would increase and our ability to generate additional revenue from new products could be impaired.

Adverse events in our clinical trials may force us to stop development of our product candidates or prevent regulatory approval of our product candidates, which could materially harm our business.

Patients participating in the clinical trials of our product candidates may experience serious adverse health events. A serious adverse health event includes death, a life-threatening condition, hospitalization, disability, congenital anomaly, or a condition requiring intervention to prevent permanent impairment or damage. The occurrence of any of these events could interrupt, delay or halt clinical trials of our product candidates and could result in the FDA, or other regulatory authorities, denying approval of our product candidates for any or all targeted indications. An institutional review board or independent data safety monitoring board, the FDA, other regulatory authorities or we may suspend or terminate clinical trials at any time. Our product candidates may prove not to be safe for human use. Any delay in the regulatory approval of our product candidates could increase our product development costs and allow our competitors additional time to develop or market competing products. If our product candidates do not receive the necessary regulatory approval, we may remain reliant on sales of Testim as our sole source of revenue.

Our failure to successfully in-license or acquire additional technologies, product candidates or approved products would impair our ability to grow.

We intend to in-license, acquire, develop and market additional products and product candidates so that we are not solely reliant on Testim sales for our revenues. Because we have limited internal research capabilities, we are dependent upon pharmaceutical and biotechnology companies and other researchers to sell or license products or technologies to us. The success of this strategy depends upon our ability to identify, select and acquire the right pharmaceutical product candidates, products and technologies. To date, we have in-licensed the formulation technology underlying Testim from Bentley, the transmucosal film technology underlying our androgen replacement transmucosal film, overactive bladder transmucosal film and pain transmucosal film product candidates from PharmaForm and the enzyme underlying AA4500 from BioSpecifics Technologies.

We may not be able to successfully identify any other commercial products or product candidates to in-license, acquire or internally develop. Moreover, negotiating and implementing an economically viable in-licensing arrangement or acquisition is a lengthy and complex process. Other companies, including those with substantially greater financial, marketing and sales resources, may compete with us for the in-licensing or acquisition of product candidates and approved products. We may not be able to acquire or in-license the rights to additional product candidates and approved products on terms that we find acceptable, or at all. If we are unable to in-license or acquire additional commercial products or product candidates we may be reliant solely on Testim sales for revenues. As a result, our ability to grow our business or increase our profits could be severely limited.

If we engage in any acquisition, we will incur a variety of costs, and we may never realize the anticipated benefits of the acquisition.

Since our inception, we have acquired the underlying technology for Testim and all of our product candidates through in-licensing arrangements. The underlying technology for Testim has been licensed from Bentley. The underlying technology for our androgen replacement, overactive bladder and pain therapy transmucosal film product candidates has been licensed from PharmaForm. AA4500, our product candidate for Peyronie’s and Dupuytren’s Diseases, has been licensed from BioSpecifics Technologies. One of our strategies for business expansion is the acquisition of additional products and product candidates. We may attempt to acquire these product candidates, or other potentially beneficial technologies, through in-licensing or the acquisition of businesses, services or products that we believe are a strategic fit with our business. If we undertake an acquisition, the process of integrating any newly acquired business, technology, service or product into our existing operations could be expensive and time consuming and may result in unforeseen operating difficulties and expenditures and may divert significant management attention from our ongoing business operations. Moreover, we may fail to realize the anticipated benefits of any acquisition for a variety of reasons, such as an acquired product candidate proving to not be safe or effective in later clinical trials. We may fund any future acquisition by issuing equity or debt securities, which could dilute your ownership percentage or limit our financial or operating flexibility as a result of restrictive covenants related to new debt. Acquisition efforts can consume significant management attention and require substantial expenditures, which could detract from our other programs. In addition, we may devote resources to potential acquisitions that are never completed. If we are unable to acquire and successfully integrate product candidates through in-licensing or the acquisition of businesses, services or products, we may remain reliant solely on Testim sales for revenue. In pursuing our acquisition strategy, we have expended significant management time, consulting costs and legal expenses without consummating a transaction.

We are subject to numerous complex regulatory requirements and failure to comply with these regulations, or the cost of compliance with these regulations, may harm our business.

The testing, development and manufacturing and distribution of our products are subject to regulation by numerous governmental authorities in the U.S., Europe and elsewhere. These regulations govern or affect the testing, manufacture, safety, labeling, storage, record-keeping, approval, distribution, advertising and promotion of Testim and our product candidates, as well as safe working conditions and the experimental use of animals. Noncompliance with any applicable regulatory requirements can result in refusal of the government to approve products for marketing, criminal prosecution and fines, recall or seizure of products, total or partial suspension of production, prohibitions or limitations on the commercial sale of products or refusal to allow the entering into of federal and state supply contracts. FDA and comparable governmental authorities have the authority to withdraw product approvals that have been previously granted. Currently, there is a substantial amount of congressional and administrative review of the FDA and the regulatory approval process for drug candidates in the U.S. As a result, there may be significant changes made to the regulatory approval process in the U.S. In addition, the regulatory requirements relating to the manufacturing, testing, and promotion, marketing and distribution of our products may change in the U.S. or the other jurisdictions in which we may have obtained or be seeing regulatory approval for our products or product candidates. Such changes may increase our costs and adversely effect our operations.

Testosterone is listed by the U.S. Drug Enforcement Agency, or DEA, as a Schedule III substance under the Controlled Substances Act of 1970. The DEA classifies substances as Schedule I, II, III, IV or V substances, with Schedule I substances considered to present the highest risk of substance abuse and Schedule V substances the lowest risk. Our transmucosal film product candidates may also involve the use of scheduled substances. Scheduled substances are subject to DEA regulations relating to manufacturing, storage, distribution and physician prescription procedures. For example, all regular Schedule III drug prescriptions must be signed by a physician and may not be refilled. Furthermore, the amount of Schedule III substances we can obtain for clinical trials and commercial distribution is limited by the DEA and our quota may not be sufficient to complete clinical trials or meet commercial demand, if any.

Entities must be registered annually with the DEA to manufacture, distribute, dispense, import, export, and conduct research using controlled substances. State controlled substance laws also require registration for similar activities. In addition, the DEA requires entities handling controlled substances to maintain records and file reports, follow specific labeling and packaging requirements, and provide appropriate security measures to control against diversion of controlled substances. Failure to follow these requirements can lead to significant civil and/or criminal penalties and possibly even lead to a revocation of a DEA registration.

Products containing controlled substances may generate public controversy. As a result, these products may have their marketing rights or regulatory approvals withdrawn. Political pressures and adverse publicity could lead to delays in, and increased expenses for, and limit or restrict the introduction and marketing of our product candidates. For some scheduled substances, the FDA may require us to develop a comprehensive risk management program to reduce the inappropriate use of our products and product candidates, including the manner in which they are marketed and sold, so as to reduce the risk of improper patient selection and diversion or abuse of the product. Developing such a program in consultation with the FDA may be a time-consuming process and could delay approval of any of our product candidates. Such a program or delays of any approval from the FDA could increase our product development costs and may allow our competitors additional time to develop or market competing products.

Additionally, failure to comply with or changes to the regulatory requirements that are applicable to Testim or our other product candidates may result in a variety of consequences, including the following:

If our product candidates are not demonstrated to be sufficiently safe and effective, they will not receive regulatory approval and we will be unable to commercialize them.

Other than Testim, all of our other product candidates are in preclinical or clinical development and have not received regulatory approval from the FDA or any foreign regulatory authority. BioSpecifics Technologies has filed an IND for our Peyronie’s Disease product candidate. An IND has been filed and is effective for our androgen replacement transmucosal film product candidate; however, INDs have not been filed for our overactive bladder or pain transmucosal film product candidates. The regulatory approval process typically is extremely expensive, takes many years and the timing or likelihood of any approval cannot be accurately predicted.

As part of the regulatory approval process, we must conduct preclinical studies and clinical trials for each product candidate to demonstrate safety and efficacy. The number of preclinical studies and clinical trials that will be required varies depending on the product candidate, the indication being evaluated, the trial results and regulations applicable to any particular product candidate.

The results of preclinical studies and initial clinical trials of our product candidates do not necessarily predict the results of later-stage clinical trials. Product candidates in later stages of clinical trials may fail to show the desired safety and efficacy despite having progressed through initial clinical trials. We cannot assure you that the data collected from the preclinical studies and clinical trials of our product candidates will be sufficient to support FDA or other regulatory approval. In addition, the continuation of a particular study after review by an institutional review board or independent data safety monitoring board does not necessarily indicate that our product candidate will achieve the clinical endpoint.

The FDA and other regulatory agencies can delay, limit or deny approval for many reasons, including:

Any delay in, or failure to receive, approval for any of our product candidates or the failure to maintain regulatory approval for Testim could prevent us from growing our revenues or achieving profitability.

Our corporate compliance program cannot guarantee that we are in compliance with all potentially applicable regulations.

We are a relatively small company and we rely heavily on third parties to conduct many important functions. As a pharmaceutical company, we are subject to a large body of legal and regulatory requirements. In addition, as a publicly traded company we are subject to significant regulations, some of which have either only recently been adopted or are currently proposals subject to change. We cannot assure you that we are or will be in compliance with all potentially applicable laws and regulations. Failure to comply with all potentially applicable laws and regulations could lead to the imposition of fines, cause the value of our common stock to decline, impede our ability to raise capital or lead to the de-listing of our stock.

If medical doctors do not prescribe our products or the medical profession does not accept our products, our ability to grow our revenues will be limited.

Our business is dependent on market acceptance of our products by physicians, healthcare payors, patients and the medical community. Medical doctors’ willingness to prescribe our products depends on many factors, including:

Even though we have received regulatory approval for Testim, and even if we receive regulatory approval and satisfy the above criteria for any of our other product candidates, physicians may not prescribe our products if we do not promote our products effectively. Factors that could affect our success in marketing our products include:

If any of our products or product candidates fails to achieve market acceptance, we may not be able to market and sell the products successfully, which would limit our ability to generate revenue and could harm our business.

If testosterone replacement therapies are perceived to create or create health risks, our sales of Testim may decrease and our operations may be harmed.

Recent studies of female hormone replacement therapy products have reported an increase in health risks. As a result of such studies, some companies that sell or develop female hormone replacement products have experienced decreased sales of these products, and in some cases, a decline in the value of their stock. Publications have, from time to time, suggested potential health risks associated with testosterone replacement therapy. Potential health risks were described in various articles, including a 2002 article published in Endocrine Practice and a 1999 article published in the International Journal of Andrology. The potential health risks detailed were fluid retention, sleep apnea, breast tenderness or enlargement, increased red blood cells, development of clinical prostate disease, increased cardiovascular disease risk and the suppression of sperm production. It is possible that studies on the effects of TRT could demonstrate these or other health risks. This, as well as negative publicity about the risks of hormone replacement therapy, including TRT, could adversely affect patient or prescriber attitudes and impact Testim sales. In addition investors may become concerned about these issues and decide to sell our common stock. These factors could adversely affect our business and the price of our common stock.

Testim competes in a very competitive market, and if we are unable to compete effectively with the other companies that produce products for the treatment of urologic or sexual health disorders, our ability to generate revenues will be limited.

The primary competition for Testim is AndroGel^®, marketed by Solvay Pharmaceuticals. AndroGel^® was launched approximately three years before Testim and, according to IMS, has a much larger share of the testosterone gel market than we do and also accounted for approximately 58% of total testosterone prescriptions for the quarter ended March 31, 2005. Furthermore, Solvay is a much larger company than we are with greater resources and greater ability to promote its product through a larger sales force. Testim also competes with other forms of testosterone replacement therapies such as oral treatments, patches, injectables and a buccal tablet. Generally, Testim is more expensive than patches and injectables. AndroDerm^® is a transdermal testosterone patch marketed by Watson Pharmaceuticals. AndroDerm^® is the leading patch product and accounted for approximately 12% of total testosterone prescriptions for the quarter ended March 31, 2005. Many of our competitors, such as Solvay and Watson, have substantially greater financial, technical and human resources than we have. These resources may be used to more effectively develop, market or acquire products and technologies. Additional mergers and acquisitions in the pharmaceutical industry may result in even more resources being concentrated in our competitors. Competition may increase further as a result of advances made in the commercial applicability of technologies and greater availability of capital for investment in these fields. In addition, our competitors are developing new testosterone treatment therapies.

The pharmaceutical industry is highly competitive. Our success will depend on our ability to acquire, develop and commercialize products and our ability to establish and maintain markets for Testim or any products for which we receive marketing approval. Potential competitors in North America, Europe and elsewhere include major pharmaceutical companies, specialty pharmaceutical companies and biotechnology firms, universities and other research institutions and government agencies. Many of our competitors have substantially greater research and development capabilities and experience, and greater management, manufacturing, distribution, marketing and financial resources, than we do. Accordingly, our competitors may:

Other new treatments are being sought for TRT, including a new class of drugs called Selective Androgen Receptor Modulators, or SARMs. SARMs are in the early stages of development and their future impact on TRT is unknown.

If other pharmaceutical companies develop generic versions of any products that compete with our commercialized products or any of our products, our business may be adversely affected.

Other pharmaceutical companies may develop generic versions of any products that compete with our commercialized products or any of our products that are not subject to patent protection or other proprietary rights. For example, because the ingredients of Testim are commercially available to third parties, it is possible that competitors may design formulations, propose dosages or develop methods of administration that would be outside the scope of the claims of one or more, or of all, of the patent rights that we in-license. This would enable their products to effectively compete with Testim. Governmental and other pressures to reduce pharmaceutical costs may result in physicians writing prescriptions for these generic products. Increased competition from the sale of competing generic pharmaceutical products

could cause a material decrease in revenue from our products. Additionally, if a generic form of Testim is approved and sold in the U.S., our co-promotion partner for Testim may terminate our co-promotion agreement which could cause a material decrease in revenue from Testim.

The primary competition for Testim is AndroGel^®, marketed by Solvay Pharmaceuticals. We are aware of at least two companies, Watson and Par Pharmaceutical, that have filed abbreviated new drug applications, or ANDAs, with the FDA to be approved as generics of AndroGel^®. Solvay has filed patent infringement lawsuits against these two companies to block the approval and marketing of the generic products. On November 1, 2004, Par Pharmaceutical’s partner, Paddock Laboratories, received tentative approval of its ANDA from the FDA, but cannot market its generic of AndroGel^{^®} until the Solvay action is resolved and until final approval is received from the FDA. The final approval of either or both of these ANDAs would result in increased competition for Testim at lower prices.

If third-party payors do not reimburse customers for Testim or any of our product candidates that are approved for marketing, they might not be used or purchased, and our revenues and profits will not grow.

Our revenues and profits depend heavily upon the availability of coverage and reimbursement for the use of Testim, and any of our product candidates that are approved for marketing, from third-party healthcare and state and federal government payors, both in the U.S. and in foreign markets. Reimbursement by a third-party payor may depend upon a number of factors, including the third-party payor’s determination that use of a product is:

Since reimbursement approval for a product is required from third-party and government payors, seeking this approval, particularly when seeking approval for a preferred form of reimbursement over other competitive products, is a time-consuming and costly process. Third-party payors may require cost-benefit analysis data from us in order to demonstrate the cost-effectiveness of any product we might bring to market. For any individual third-party payor, we may not be able to provide data sufficient to gain reimbursement on a similar or preferred basis to competitive products or at all. Once reimbursement at an agreed level is approved by a third-party payor, we may lose that reimbursement entirely or we may lose the similar or better reimbursement we receive compared to competitive products. As reimbursement is often approved for a period of time, this risk is greater at the end of the time period, if any, for which the reimbursement was approved. To date, we have not experienced any problems with third-party payors. This does not mean that we will not experience any problems with third-party payors in the future.

International commercialization of Testim and our product candidates faces significant obstacles.

As with Testim, we may plan to commercialize some of our product candidates internationally through collaborative relationships with foreign partners. We have limited foreign regulatory, clinical and commercial resources. We may not be able to enter into collaboration agreements with appropriate partners for important foreign markets on acceptable terms, or at all. Future collaborations with foreign partners may not be effective or profitable for us.

If our co-promotion partnership does not increase Testim sales, our gross profit may be negatively affected, which could cause the price of our common stock to decline.

In April 2005, we entered into a co-promotion agreement with Oscient. Under the terms of the agreement, Oscient will promote Testim to primary care physicians in the U.S. using its 250-person sales force, while we will continue to promote Testim using our specialty sales force that calls on urologists, endocrinologists and select primary care physicians. We will compensate Oscient for its co-promotion services by paying Oscient a specified percentage of the gross profit from Testim sales attributable to primary care physicians in the U.S. generated by the combined sales force that exceeds a specified sales threshold. If we are unable to effectively utilize the combined sales forces or if the additional selling efforts do not increase Testim sales, our gross profit may be negatively affected, which may cause our stock price to decline.

The business and financial condition of pharmaceutical companies are affected by the efforts of governmental and third-party payors to contain or reduce the costs of healthcare. In the U.S. and in foreign jurisdictions there have been, and we expect that there will continue to be, a number of legislative and regulatory proposals aimed at changing the healthcare system. For example, in some countries other than the U.S., pricing of prescription drugs is subject to government control, and we expect proposals to implement similar controls in the U.S. to continue. The pendency or approval of such proposals could result in a decrease in our stock price or limit our ability to raise capital or to obtain strategic partnerships or licenses.

If product liability lawsuits are brought against us, we may incur substantial liabilities.

The commercialization of Testim and the clinical testing and, if approved, commercialization of our product candidates involves significant exposure to product liability claims. We have clinical trial and product liability insurance that covers Testim and the clinical trials of our other product candidates that we believe is adequate in both scope and amount and has been placed with what we believe are reputable insurers. We are self-insured for the first $1.0 million of liability under these policies. Our product liability policies have been written on a claims-made basis. If any of our product candidates are approved for marketing, we may seek additional coverage. We cannot predict all of the adverse health events that Testim or our product candidates may cause. As a result, our current and future coverages may not be adequate to protect us from all the liabilities that we may incur. If losses from product liability claims exceed our insurance coverage, we may incur substantial liabilities that exceed our financial resources. Whether or not we were ultimately successful in product liability litigation, such litigation could consume substantial amounts of our financial and managerial resources, and might result in adverse publicity, all of which would impair our business. We may not be able to maintain our clinical trial insurance or product liability insurance at an acceptable cost, if at all, and this insurance may not provide adequate coverage against potential claims or losses. If we are required to pay a product liability claim, we may not have sufficient financial resources and our business and results of operations may be harmed.

We may be exposed to liability claims associated with the use of hazardous materials and chemicals.

Our research and development activities and our commercial product, Testim, involve the use of testosterone and large amounts of alcohol which are classified as hazardous materials and chemicals. AA4500 is a biologic product. Biologic products may present a manufacturing health hazard due to risk of infection with the bacterial cell line used to produce the product or with potential viral contamination with the fermentation. Although we believe that our safety procedures for using, storing, handling and disposing of these materials comply with federal, state and local laws and regulations, we cannot

completely eliminate the risk of accidental injury or contamination from these materials. In the event of such an accident, we could be held liable for any resulting damages and any liability could materially adversely affect our business, financial condition and results of operations. In addition, the federal, state and local laws and regulations governing the use, manufacture, storage, handling and disposal of hazardous or radioactive materials and waste products may require us to incur substantial compliance costs that could materially adversely affect our business and financial condition. To our knowledge, we have not been the subject of any investigation by any agency or authority for failure to comply with any rules or regulations applicable to hazardous materials or chemicals. We do not maintain specific insurance for the handling of biological, hazardous and radioactive materials. We have contracts with third-party providers for the storage and disposal of hazardous waste and believe that any claims against us in these areas would be the responsibility of these third parties. However, we may be held responsible for these claims despite the fact that we have contracted with third parties for the storage and disposal of hazardous waste. If we are exposed to these types of claims, we could be held responsible for liabilities that exceed our financial resources, which could severely affect our operations.

Risks Related to Our Dependence on Third-Party Manufacturers and Service Providers

Since we rely on third-party manufacturers and suppliers, we may be unable to control the availability or cost of manufacturing our products, which could adversely affect our results of operations.

We do not manufacture Testim or any of our product candidates and have no current plan to develop any capacity to do so. We have contracted with DPT Laboratories to manufacture Testim through December 31, 2005. We are in the process of qualifying a back-up supplier to manufacture Testim. BioSpecifics Technologies is responsible for supplying clinical and commercial product supplies of AA4500; we however, have the right to qualify a back-up supplier. We are in the process of qualifying a back-up supplier and negotiating the terms of agreement with this back-up supplier for the production of our clinical supply of AA4500, our Peyronie’s and Dupuytren’s Diseases product candidate. Upon completion of the qualification process, we expect to rely on this back-up supplier, rather than BioSpecifics Technologies, for our clinical supply of AA4500. We plan to contract with one or more third-party manufacturers to manufacture our transmucosal film product candidates. The manufacture of pharmaceutical products requires significant expertise and capital investment. DPT Laboratories, any back-up supplier for Testim or AA4500, or any other third-party manufacturer may encounter difficulties in production. These problems may include:

DPT, any back-up supplier for Testim or AA4500, or any of our other third-party manufacturers may not perform as agreed or may terminate its agreement with us, which would adversely impact our ability to produce and sell Testim.

Our contract with DPT Laboratories to manufacture Testim expires on December 31, 2005. Although we are in the process of qualifying a back-up supplier to manufacture Testim, we do not have an alternate manufacturer of Testim at this time. We have capitalized as work-in-process inventory $992,000 of Testim manufactured by a back-up supplier. We intend to sell this inventory after we receive approval of the manufacturing facility and process from the U.S. Food and Drug Administration, or FDA.

Although additional required testing of this inventory remains to be completed, we capitalized this inventory based on favorable preliminary results from analytical testing, past product experience and our belief that it is probable that the inventory will be saleable. If the ultimate testing results prove unfavorable or the FDA does not approve the manufacturing facility or process, we will have to write-off this inventory. If there is an interruption in the supply of Testim, our co-promotion partner for Testim may terminate our co-promotion agreement and in that event, we would be obligated to make a payment to Oscient the amount of which depends on when the supply interruption occurs. The number of third-party manufacturers with the expertise, required regulatory approvals and facilities to manufacture bulk drug substance on a commercial scale is extremely limited, and it would take a significant amount of time to arrange and receive regulatory approval for alternative arrangements. We may not be able to contract for the manufacturing of Testim on acceptable terms, if at all, which would materially impair our business.

Any of these factors could increase our costs and result in us being unable to effectively commercialize our products. Furthermore, if DPT or any other third-party manufacturer fails to deliver the required commercial quantities of finished product on a timely basis and at commercially reasonable prices, we may be unable to meet the demand for our products and we may lose potential revenues.

We rely on a single source supplier and a limited number of suppliers for two of the primary ingredients for Testim and the loss of any of these suppliers could prevent us from selling Testim, which would materially harm our business.

We rely on third-party suppliers for our supply of testosterone and pentadecalactone, or CPD, two key ingredients of Testim. Testosterone is available to us from only two sources. We rely exclusively on one outside source for our supply of CPD. We do not have any agreements with these suppliers regarding these key ingredients. If either of the two sources that produce testosterone stops manufacturing it, or if we are unable to procure testosterone on commercially favorable terms, we may be unable to continue to produce or sell Testim on commercially viable terms, if at all. In addition, if our third-party source of CPD stops manufacturing pharmaceutical grade CPD, or does not make CPD available to us on commercially favorable terms, we may be unable to continue to produce or sell Testim on commercially viable terms, if at all. Furthermore, the limited number of suppliers of testosterone and CPD may provide such companies with greater opportunity to raise their prices. Any increase in price for testosterone or CPD may reduce our gross margins.

Due to our reliance on contract research organizations or other third parties to assist us in conducting clinical trials, we are unable to directly control all aspects of our clinical trials.

Currently, we rely in part on three third parties to conduct our clinical trials for the expansion of Testim and the development of our product candidates. As a result, we have had and will continue to have less control over the conduct of the clinical trials, the timing and completion of the trials and the management of data developed through the trial than would be the case if we were relying entirely upon our own staff. Communicating with outside parties can also be challenging, potentially leading to mistakes as well as difficulties in coordinating activities. Outside parties may:

These factors may adversely affect their willingness or ability to conduct our trials. We may experience unexpected cost increases that are beyond our control. Problems with the timeliness or quality of the work of a contract research organization may lead us to seek to terminate the relationship and use

an alternative service provider. However, making this change may be costly and may delay our trials, and contractual restrictions may make such a change difficult or impossible. Our contracts with the contract research organizations on which we currently rely are each terminable upon 30-days prior written notice. If we must replace any of these contract research organizations or any other contract research organization we may use in the future to conduct our clinical trials, our trials may have to be suspended until we find another contract research organization that offers comparable services. The time that it takes us to find alternative organizations may cause a delay in the commercialization of our product candidates or may cause us to incur significant expenses to replicate data that may be lost. Although we do not believe that the contract research organizations on which we rely offer services that are not available elsewhere, it may be difficult to find a replacement organization that can conduct our trials in an acceptable manner and at an acceptable cost. Any delay in or inability to complete our clinical trials could significantly compromise our ability to secure regulatory approval of the relevant product candidate and preclude our ability to commercialize the product, thereby limiting our ability to generate revenue from the sales of products other than Testim, which may result in a decrease in our stock price.

Our third-party manufacturers are subject to regulatory oversight, which may delay or disrupt our development and commercialization efforts.

Third-party manufacturers of our products or product candidates must ensure that all of the processes, methods and equipment are compliant with the current Good Manufacturing Practices, or cGMP, and conduct extensive audits of vendors, contract laboratories and suppliers. The cGMP requirements govern quality control of the manufacturing process and documentation policies and procedures. Compliance by third-party manufacturers with cGMP requires record keeping and quality control to assure that the product meets applicable specifications and other requirements. Manufacturing facilities are subject to inspection by regulatory agencies at any time. If an inspection by regulatory authorities indicates that there are deficiencies, third-party manufacturers could be required to take remedial actions, stop production or close the facility, which would disrupt the manufacturing processes and limit the supplies of Testim or our product candidates. If they fail to comply with these requirements, we also may be required to curtail the clinical trials of our product candidates, which are also supplied by these manufacturers, and may not be permitted to sell our products or may be limited in the jurisdictions in which we are permitted to sell them.

Approximately 87% of our product shipments are to only four customers; if any of these customers refuse to distribute Testim on commercially favorable terms, or at all, our business will be adversely affected.

We sell Testim to wholesale drug distributors and chain drug stores who generally sell products to retail pharmacies, hospitals and other institutional customers. We do not promote Testim to these customers, and they do not determine Testim prescription demand. However, approximately 87% of our product shipments are to only four customers: Cardinal Health, Inc., McKesson Corporation, AmerisourceBergen Corporation and Walgreen Co. Our business would be harmed if any of these customers refused to distribute Testim or refuse to purchase Testim on commercially favorable terms to us.

It is possible that wholesalers could decide to change their policies or fees, or both, at some time in the future. This could result in their refusal to distribute smaller volume products, or cause higher product distribution costs, lower margins or the need to find alternative methods of distributing products. Such alternative methods may not exist or may not be economically viable.

If we are unable to grow our sales, marketing or distribution capabilities or enter into agreements with third parties to perform some of these functions, we will not be able to grow our business.

As an organization, we have a limited history in sales, marketing and distribution. To directly market and distribute Testim or any of our product candidates which receive regulatory approval, we must continue to enhance our sales and marketing efforts. For our direct sales efforts, we will need to hire additional salespeople in order to grow and to manage any turnover that occurs in our sales force. For some market opportunities, we may need to enter into co-promotion or other licensing arrangements with pharmaceutical or biotechnology firms in order to increase the commercial success of our products. We may not be able to grow our direct sales, marketing and distribution capabilities or enter into co-promotion or similar licensing arrangements with third parties in a timely manner, or on acceptable terms. To the extent that we enter into co-promotion or other licensing arrangements, our product revenues are likely to be lower than if we directly marketed and sold our products, and some or all of the revenues we receive will depend upon the efforts of third parties, and these efforts may not be successful. Additionally, building marketing and distribution capabilities may be more expensive than we anticipate, requiring us to divert capital from other intended purposes or preventing us from building our marketing and distribution capabilities to the desired levels.

If we breach any of the agreements under which we license commercialization rights to products or technology from others, we could lose license rights that are critical to our business.

We are a party to a number of license agreements by which we have rights to use the intellectual property of third parties that are necessary for us to operate our business. In particular, we have obtained the exclusive right to develop and commercialize Testim pursuant to a license agreement with Bentley. Bentley may unilaterally terminate the agreement if we fail to make payments under this agreement and this failure continues for a period of 30 days following written notice to us by Bentley. If the agreement is properly terminated by Bentley, we may not be able to manufacture or sell Testim.

Additionally, we have obtained exclusive rights to make and sell products that are used for hormone replacement, to treat any type of urologic disorder or as a pain therapy incorporating PharmaForm’s oral transmucosal film technology. This agreement continues for the life of the licensed patent rights. Either party may terminate this agreement under certain events of bankruptcy or insolvency by the other party. PharmaForm may unilaterally terminate this agreement if:

If our agreement with PharmaForm is properly terminated by PharmaForm, we may not be able to execute our strategy to develop, manufacture or sell transmucosal film products. To the extent that unpatented PharmaForm trade secrets are necessary for the manufacture of the oral transmucosal product candidates, our license to such trade secrets would expire with the expiration of the licensed patents in 2020 or later and potentially impair our continued commercialization of our oral transmucosal product candidates thereafter.

We have also obtained exclusive worldwide rights from BioSpecifics Technologies to develop, market and sell products other than dermal formulations labeled for topical administration, where the

products contain BioSpecifics Technologies’ enzyme for the treatment of Peyronie’s Disease and Dupuytren’s Disease. We may expand the agreement, at our option, to license products which contain BioSpecifics Technologies’ enzyme for other indications, excluding dermal formulations labeled for topical administration, as they are developed by BioSpecifics Technologies or by us. This agreement continues on a product by product and country by country basis until the later of:

Upon expiration of the agreement pursuant to the preceding sentence, we will have a fully paid-up license to the products developed under the agreement. Either party may terminate this agreement in the event of bankruptcy or insolvency by the other party. Additionally, either party may terminate this agreement if the other party is in material breach of its obligations under the agreement which continues for a period of 90 days following receipt of written notice of such material breach. We may terminate this agreement in its entirety, or on a country by country basis, on an indication by indication basis, or on a product by product basis, at any time upon 90 days prior written notice to BioSpecifics Technologies. If this agreement is properly terminated by BioSpecifics Technologies, we may not be able to execute our strategy to develop and commercialize our Peyronie’s and Dupuytren’s Diseases product candidate or to develop and commercialize future product candidates utilizing BioSpecifics Technologies’ enzyme.

We expect to enter into additional licenses in the future. These licenses may impose various development, commercialization, funding, royalty, diligence or other obligations on us. If we breach any of these obligations, the licensor may have the right to terminate the license or render the license non-exclusive, which could make it impossible for us to develop, manufacture or sell the products covered by the license.

Disputes may arise with respect to our licensing agreements regarding manufacturing, development and commercialization of any products relating to our in-licensed intellectual property, including Testim. These disputes could lead to delays in or termination of the development, manufacture and commercialization of Testim or our product candidates or to litigation.

We have only limited patent protection for Testim and our product candidates, and we may not be able to obtain, maintain and protect proprietary rights necessary for the development and commercialization of Testim or our product candidates.

Our business and competitive positions are dependent upon our ability to obtain and protect our proprietary position for Testim and our product candidates in the U.S., Europe and elsewhere. Because of the substantial length of time and expense associated with development of new products, we, along with the rest of the biopharmaceutical industry, place considerable importance on obtaining and maintaining patent protection for new technologies, products and processes. The patent positions of pharmaceutical, biopharmaceutical and biotechnology companies, including ours, are generally uncertain and involve complex legal and factual questions. Our and our licensors’ patents and patent applications may not protect our technologies and products because, among other things:

We attempt to protect our intellectual property position by filing or obtaining licenses to patent applications and, where appropriate, patent applications in other countries related to our proprietary technology, inventions and improvements that are important to the development of our business. Currently, neither Testim nor our product candidates are covered by composition of matter patents. Our BioSpecifics Technologies product candidate is covered by a method of use patent. Our PharmaForm transmucosal film product candidates are covered by a formulation patent in the U.S. only. This patent expires in 2020. Testosterone, the active ingredient in Testim, is off-patent and is included in competing TRT products. The U.S. patent that we license from Bentley covers the formulation of Testim and expires in June 2008. The European patents that we license from Bentley for Testim expire in 2006. Bentley has filed a new patent application in the U.S., Europe and Japan which, if issued, could provide additional patent protection for Testim. AA4500 licensed from BioSpecifics Technologies is covered by two method of use patents in the U.S., one for the treatment of Peyronie’s Disease and one for the treatment of Dupuytren’s Disease. The Peyronie’s patent expires in 2019 and the Dupuytren’s patent expires in 2014. Both patents are limited to the use of AA4500 for the treatment of Peyronie’s Disease and Dupuytren’s Disease with certain dose ranges and/or concentration ranges. Currently there is not enough data to establish whether any ultimate approved product for Peyronie’s Disease or Dupuytren’s Disease will be covered by these patents. Foreign patents and pending applications may also cover these products in certain countries depending upon the concentration and dosage ranges of such products. Some countries will not grant patents on patent applications that are filed after the public sale or disclosure of the material claimed in the patent application. The U.S., by contrast, allows a one year grace period after public disclosure in which to file a patent application. Because the European patent application was filed after Testim went on the market in the U.S., our ability to obtain additional patent protection outside of the U.S. may be limited.

The standards that the U.S. Patent and Trademark Office, or USPTO, and its foreign counterparts use to grant patents are not always applied predictably or uniformly and can change. Limitations on patent protection in some countries outside the U.S., and the differences in what constitutes patentable subject matter in these countries, may limit the protection we seek outside of the U.S. For example, methods of treating humans are not patentable subject matter in many countries outside of the U.S. In addition, laws of foreign countries may not protect our intellectual property to the same extent as would laws of the U.S. In determining whether or not to seek a patent or to license any patent in a particular foreign country, we weigh the relevant costs and benefits, and consider, among other things, the market potential of our product candidates in the jurisdiction, and the scope and enforceability of patent protection afforded by the law of the jurisdiction. Failure to obtain adequate patent protection for our proprietary product candidates and technology would impair our ability to be commercially competitive in these markets. Accordingly, we do not know the degree of future protection for our proprietary rights or the breadth of claims allowed in any patents issued to us or others.

We intend to seek patent protection whenever it is available for any products or product candidates we acquire in the future. However, any patent applications for future products may not issue as patents, and any patent issued on such products may be challenged, invalidated, held unenforceable or circumvented. Furthermore, the claims in patents which have been issued on products we may acquire in the future may not be sufficiently broad to prevent third parties from commercializing competing products. If we fail to obtain adequate patent protection for our products, our ability to compete could be impaired.

Technology in-licensed by us is important to our business. We may not control the patent prosecution, maintenance or enforcement of some of our in-licensed technology. Accordingly, we may be unable to exercise the same degree of control over this intellectual property as we would over our internally developed intellectual property. For example, in-licensed patents for which our rights are limited to a particular field of use could be or become licensed in other fields to other licensees and, therefore, become subject to enforcement by such other licensees without our participation. Consequently, such licensed patents could be held invalid or unenforceable or could have claims construed in a manner adverse to our interests in litigation, which we would not control or to which we would not be a party. If any of the intellectual property rights of our licensors is found to be invalid, this could have a material adverse impact on our operations.

The Dupuytren’s patent will be the subject of a reexamination proceeding or a reissue application in the USPTO for the purpose of submitting prior art that was not previously submitted during the prosecution of the Dupuytren’s patent. As a result, the patent may not be allowed by the USPTO, and therefore, may not be valid and enforceable.

If we are not able to protect and control unpatented trade secrets, know-how and other technological innovation, we may suffer competitive harm. We also rely on trade secrets, know-how and technology, which are not protected by patents, to maintain our competitive position. However, trade secrets are difficult to protect. To maintain the confidentiality of trade secrets and proprietary information, we generally seek to enter into confidentiality agreements with our employees, consultants and collaborators upon the commencement of a relationship with us. However, we may not obtain these agreements in all circumstances. Nor can we guarantee that these agreements will provide meaningful protection, that these agreements will not be breached, or that we will have an adequate remedy for any such breach. In addition, adequate remedies may not exist in the event of unauthorized use or disclosure of this information. Others may have developed, or may develop in the future, substantially similar or superior know-how and technology. The loss or exposure of our trade secrets, know-how and other proprietary information, as well as independent development of similar or superior know-how, could harm our operating results, financial condition and future growth prospects. Many of our employees and consultants were, and many of our consultants may currently be, parties to confidentiality agreements with other companies. Although our confidentiality agreements with these employees and consultants require that they do not bring to us, or use without proper authorization, any third party’s proprietary technology, if they violate their agreements, we could suffer claims or liabilities.

We may have to engage in costly litigation to enforce or protect our proprietary technology or to defend challenges to our proprietary technology by our competitors, which may harm our business, results of operations, financial condition and cash flow.

The pharmaceutical field is characterized by a large number of patent filings involving complex legal and factual questions, and, therefore, we cannot predict with certainty whether our licensed patents will be enforceable. Competitors may have filed applications for or have been issued patents and may obtain additional patents and proprietary rights related to products or processes that compete with or are similar to ours. We may not be aware of all of the patents potentially adverse to our interests that may have been issued to others. Litigation may be necessary to protect our proprietary rights, and we cannot be certain that we will have the required resources to pursue litigation or otherwise to protect our proprietary rights.

Our ability to market our products may be impaired by the intellectual property rights of third parties.

Our commercial success will depend in part on not infringing the patents or proprietary rights of third parties. We are aware of competing intellectual property relating to the testosterone gel market. While we currently believe we have freedom to operate in the testosterone gel market, others may challenge our position in the future. We are also aware of at least one third-party patent relating to BioSpecifics Technologies’ enzyme which may impair BioSpecifics Technologies’ freedom to operate in the manufacture of AA4500. There has been, and we believe that there will continue to be, significant litigation in the pharmaceutical industry regarding patent and other intellectual property rights.

Third parties could bring legal actions against us claiming damages and seeking to enjoin clinical testing, manufacturing and marketing of the affected product or products. A third party might request a court to rule that the patents we in-license are invalid or unenforceable. In such a case, even if the validity or enforceability of those patents were upheld, a court might hold that the third party’s actions do not infringe the patent we in-license thereby, in effect, limiting the scope of our patent rights. If we become involved in any litigation, it could consume a substantial portion of our resources, regardless of the outcome of the litigation. If any of these actions are successful, in addition to any potential liability for damages, we could be required to obtain a license to continue to manufacture or market the affected product, in which case we may be required to pay substantial royalties or grant cross-licenses to our patents. However, there can be no assurance that any such license will be available on acceptable terms or at all. Ultimately, we could be prevented from commercializing a product, or forced to cease some aspect of our business operations, as a result of patent infringement claims, which could harm our business.

We may not be able to obtain or maintain orphan drug exclusivity for our product candidates for the treatment of urologic and sexual health disorders, and our competitors may obtain orphan drug exclusivity prior to us, which could significantly harm our business.

Some jurisdictions, including Europe and the U.S., may designate drugs for relatively small patient populations as orphan drugs. The FDA granted orphan drug status to our product candidate in the U.S. for the treatment of Peyronie’s Disease, and we plan on filing an application with the FDA requesting a transfer of the orphan drug designation from the current holder to us. Orphan drug designation must be requested before submitting an application for marketing authorization. Orphan drug designation does not convey any advantage in, or shorten the duration of, the regulatory review and approval process, but does make the product eligible for orphan drug exclusivity and specific tax credits in the U.S. Generally, if a product with an orphan drug designation subsequently receives the first marketing approval for the indication for which it has such designation, the product is entitled to orphan drug exclusivity. Orphan drug exclusivity means that another application to market the same drug for the same indication may not be approved, except in limited circumstances, for a period of up to 10 years in Europe and for a period of seven years in the U.S. Obtaining orphan drug designations and orphan drug exclusivity for our product candidates for the treatment of urologic and sexual health disorders, including Peyronie’s Disease, may be critical to the success of these product candidates. Our competitors may obtain orphan drug exclusivity for products competitive with our product candidates before we do, in which case we would be excluded from that market. Even if we obtain orphan drug exclusivity for any of our product candidates, we may not be able to maintain it. For example, if a competitive product is shown to be clinically superior to our product, any orphan drug exclusivity we have obtained will not block the approval of such competitive product. In addition, even if we obtain orphan drug exclusivity for any of our product candidates, a viable commercial market may never develop and we may never derive any meaningful revenues from the sales of these products.

If Testim or our future products or product candidates infringe the intellectual property of our competitors or other third parties, we may be required to pay license fees or cease these activities and pay damages, which could significantly harm our business.

Even if we have our own patents which protect our products, Testim and our product candidates may nonetheless infringe the patents or violate the proprietary rights of third parties. In these cases, we may be required to obtain-licenses to patents or proprietary rights of others in order to continue to sell and use Testim and develop and commercialize our product candidates. We may not, however, be able to obtain any licenses required under any patents or proprietary rights of third parties on acceptable terms, or at all. Even if we were able to obtain rights to a third party’s intellectual property, these rights may be non-exclusive, thereby giving our competitors potential access to the same intellectual property.

Third parties may assert patent or other intellectual property infringement claims against us, or our licensors or collaborators, with respect to technologies used in potential product candidates. Any claims that might be brought against us relating to infringement of patents may cause us to incur significant expenses and, if successfully asserted against us, may cause us to pay substantial damages. We may not have sufficient resources to effectively litigate these claims. Even if we were to prevail, any litigation could be costly and time-consuming and could divert the attention of our management and key personnel from business operations. In addition, any patent claims brought against our licensors or collaborators could affect their ability to carry out their obligations to us.

Furthermore, if a patent infringement suit were brought against us, or our licensors or collaborators, the development, manufacture or potential sale of product candidates claimed to infringe a third party’s intellectual property may have to cease or be delayed. Ultimately, we may be unable to commercialize one or more of our product candidates, our patent claims may be substantially limited or may have to cease some portion of our operations as a result of patent infringement claims, which could severely harm our business.

If we are not able to retain our current management team or attract and retain qualified scientific, technical and business personnel, our business will suffer.

We are dependent on the members of our management team, in particular, our Chief Executive Officer, Gerri Henwood, for our business success. In addition, an important element of our strategy is to leverage the development, regulatory and commercialization expertise of our current management, including Ms. Henwood, in our development activities. We currently carry a $1.0 million key-man life insurance policy on the life of Ms. Henwood. Our employment agreements with our executive officers are terminable on short notice or no notice. The loss of any one of our executive officers may result in a significant loss in the knowledge and experience that we, as an organization, possess and could cause significant delays, or outright failure, in the development and further commercialization of Testim or our product candidates. Since October 2004, three members of our senior management have left our employ. If we are unable to attract and retain qualified and talented senior management personnel, our business may suffer.

To grow we will need to hire a significant number of qualified commercial, scientific and administrative personnel. However, there is intense competition for human resources, including management in the technical fields in which we operate, and we may not be able to attract and retain qualified personnel necessary for the successful commercialization of Testim and the development and commercialization of our product candidates. As we grow, the inability to attract new employees when needed or to retain existing employees could severely limit our growth and harm our business.

Changes in the expensing of stock-based compensation will result in unfavorable accounting charges and may require us to change our compensation practices. Any change in our compensation practices may adversely effect our ability to attract and retain qualified scientific, technical and business personnel.

We rely heavily on stock options to compensate existing employees and attract new employees. We currently are not required to record stock-based compensation charges if the employee’s stock option exercise price equals or exceeds the fair value of our common stock at the date of grant. We also have an employee stock purchase plan under which employees can purchase our common stock at a discount. The Financial Accounting Standards Board has recently announced new rules for recording expense for the fair value of stock options and purchase rights under employee stock purchase plans. The Securities and Exchange Commission delayed the effective date for the new rules until the beginning of the first fiscal year after June 15, 2005. As a result, we will be required to change our accounting policy to record expense for the fair value of stock options and purchase rights under our employee stock purchase plan on January 1, 2006, thereby increasing our operating expenses and reported losses. Although we intend to continue to include various forms of equity in our compensation plans, if the extent to which we use forms of equity in our plans is reduced due to the negative effects on earnings, it may be difficult for us to attract and retain qualified scientific, technical and business personnel.

Our operations may be impaired unless we can successfully manage our growth.

As of March 31, 2005 we had 164 employees. In order to continue to expand Testim’s sales and commercialize our other product candidates, we currently anticipate that we will need to in the range of 10% to 15% additional managerial, selling, operational, financial and other employees to our existing departments over each of the next two years. Expansion may place, a significant strain on our management, operational and financial resources. Moreover, higher than expected market growth of Testim, the acquisition or in-licensing of additional products, as well as the development and commercialization of our other product candidates or marketing arrangements with third parties, could accelerate our hiring needs beyond our current expectations. To manage further growth, we will be required to continue to improve existing, and implement additional, operational and financial systems, procedures and controls, and hire, train and manage additional employees. Our current and planned personnel, systems, procedures and controls may not be adequate to support our anticipated growth and we may not be able to hire, train, retain, motivate and manage required personnel. Our failure to manage growth effectively could limit our ability to achieve our business goals. In addition, our direct sales force consists of relatively newly hired employees. Turnover in our direct sales force or marketing team could adversely affect Testim and future product sales growth.

Our stock price is likely to be volatile, and the market price of our common stock may drop below the current price.

Prior to our recent initial public offering in July 2004, there was no public market for our common stock. Since our initial public offering, our stock price has, at times, been volatile.

Market prices for securities of pharmaceutical, biotechnology and specialty pharmaceutical companies have been particularly volatile. Some of the factors that may cause the market price of our common stock to fluctuate include:

If any of these risks occurs, it could cause our stock price to fall and may expose us to class action lawsuits that, even if unsuccessful, could be costly to defend and a distraction to management.

A significant portion of our total outstanding common stock is restricted from resale but may be sold into the market. Sales of a substantial number of shares of our common stock in the public market, or the perception in the market that the holders of a large number of shares intend to sell shares, could depress the market price of our common stock and impair our ability to raise capital through the sale of additional equity securities, even if our business is doing well.

As of May 2, 2005, we have 20,681,255 shares of common stock outstanding, of which 15,079,375 shares, or 72.9%, are restricted securities under Rule 144 of the General Rules and Regulations under the Securities Act of 1933 or by the provisions of grants under our 2004 Equity Compensation Plan. On May 2, 2005, 8,756,943 shares of common stock were freely tradable under Rule 144(k) and 6,215,247 shares of common stock were eligible for resale under Rule 144, subject to volume limitations.

In addition, holders of 14,058,482 shares of our common stock have rights, subject to some conditions, to require us to file registration statements covering their shares or to include their shares in registration statements that we may file for ourselves or other stockholders. In addition, holders of outstanding warrants representing the right to purchase approximately 1,732,676 shares of our common

stock have these same rights with respect to the underlying common stock upon exercise of these warrants. Furthermore, all shares of common stock that we may issue under our 2004 Equity Compensation Plan and our 2004 Employee Stock Purchase Plan can be freely sold in the public market upon issuance, subject to lock-up agreements.

As of March 31, 2005, stock options to purchase 1,934,605 shares of common stock and warrants to purchase 1,732,676 shares of common stock were outstanding. In addition, as of March 31, 2005 a total of 673,416 stock options are available for grant under our 2004 Equity Compensation Plan. A total of 671,141 of the outstanding options and warrants are “in the money” and exercisable as of March 31, 2005. “In the money” means that the current market price of the common stock is above the exercise price of the shares subject to the warrant or option. The issuance of common stock upon the exercise of these options and warrants could adversely affect the market price of the common stock or result in substantial dilution to our existing stockholders.

Our executive officers, directors and major stockholders have the ability to control all matters submitted to stockholders for approval.

Our executive officers, directors and stockholders who beneficially own more than 5% of our outstanding common stock, and their affiliates, in the aggregate, beneficially own shares representing approximately 78% of our common stock. Beneficial ownership includes shares over which an individual or entity has investment or voting power and includes shares that could be issued upon the exercise of options and warrants within 60 days. As a result, if these stockholders were to choose to act together, they would be able to control all matters submitted to our stockholders for approval, as well as our management and affairs. For example, these individuals, if they chose to act together, will control the election of directors and approval of any merger, consolidation or sale of all or substantially all of our assets. This concentration of voting power could delay or prevent an acquisition of our company on terms that other stockholders may desire.

Provisions in our certificate of incorporation and bylaws and under Delaware law may prevent or frustrate a change in control in management that stockholders believe is desirable.

Provisions of our certificate of incorporation and bylaws may discourage, delay or prevent a merger, acquisition or other change in control that stockholders may consider favorable, including transactions in which you might otherwise receive a premium for your shares. These provisions may also prevent or frustrate attempts by our stockholders to replace or remove our management. These provisions include:

The affirmative vote of the holders of at least two-thirds of our shares of capital stock entitled to vote is necessary to amend or repeal the above provisions of our certificate of incorporation. In addition, absent approval of our board of directors, our bylaws may only be amended or repealed by the affirmative vote of the holders of at least two-thirds of our shares of capital stock entitled to vote.

In addition, Section 203 of the General Corporation Law of the State of Delaware prohibits a publicly held Delaware corporation from engaging in a business combination with an interested stockholder, generally a person which together with its affiliates owns or within the last three years has owned 15% of our voting stock, for a period of three years after the date of the transaction in which the person became an interested stockholder, unless the business combination is approved in a prescribed manner. Accordingly, Section 203 may discourage, delay or prevent a change in control of our company.

We do not use derivative financial instruments or derivative commodity instruments for trading purposes or any other purpose. Our financial instruments consist of cash, cash equivalents, short-term investments, trade accounts receivable, accounts payable and long-term obligations. We consider investments that, when purchased, have a remaining maturity of 90 days or less to be cash equivalents.

We invest in marketable securities in accordance with our investment policy. The primary objectives of our investment policy are to preserve principal, maintain proper liquidity to meet operating needs and maximize yields. Our investment policy specifies credit quality standards for our investments. The maximum allowable duration of a single issue is three months. Our investment policy permits us to invest in Auction Rate Securities (ARS) with maturities of greater than three months, provided that the interest reset date, the date in which the ARS may be readily liquidated to a market maker, for the ARS is less than three months. As the underlying maturity date of our ARS investments is greater than three months, and as we classify these investments as available for sale, we classify our ARS investments as short-term investments on our consolidated balance sheet.

Our investment portfolio is subject to interest rate risk and will fall in value in the event market interest rates increase. All our cash, cash equivalents and short-term investments at March 31, 2005, amounting to approximately $40.1 million, were maintained in bank demand accounts, money market accounts, U.S. government backed securities and ARS. We do not hedge our interest rate risks as we believe reasonably possible near-term changes in interest rates would not materially affect our results of operations, financial position or cash flows.

Transactions relating to Auxilium UK, Limited are recorded in pounds sterling. Upon consolidation of this subsidiary into our consolidated financial statements, we translate the balance sheet asset and liability accounts to the U.S. dollar based on exchange rates as of the balance sheet date; balance sheet equity accounts are translated into the U.S. dollar at historical exchange rates; and all statements of operations and cash flows amounts are translated into the U.S. dollar at the average exchange rates for the period. Exchange gains or losses resulting from the translation are included as a separate component of stockholders’ equity. In addition, we conduct clinical trials in the Netherlands, exposing us to cost increases if the U.S. dollar declines in value compared to the euro. We do not hedge our foreign exchange risks as we believe reasonably possible near-term fluctuations of exchange rates would not materially affect our results of operations, financial position or cash flows.

Our management, with the participation of our Chief Executive Officer and Chief Financial Officer, evaluated the effectiveness of our disclosure controls and procedures as of the end of the period covered by this Report. Disclosure controls and procedures are controls and procedures designed to ensure that the information required to be disclosed by us in reports filed under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms. Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed by us in reports filed under the Securities Exchange Act of 1934 is accumulated and communicated to our management, including the Chief Executive Officer and Chief Financial Officer, as appropriate to allow timely decisions regarding disclosure. Based on their evaluation, and in particular the report of our General Counsel of the results of the report of the internal investigation conducted by the Audit and Compliance Committee of our Board of Directors (the “Audit

Committee”) described below, the Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures as of the end of the period covered by this Report were ineffective and there were material weaknesses in internal control over financial reporting as a result of non-compliance by certain employees, as described below.

On March 16, 2005, members of our management alerted our Board of Directors to the fact that:

As a result of disclosures by members of our management, on March 21, 2005, the Audit Committee commenced an internal investigation regarding the Employment Agreement Amendment, the Related Party Transactions, and our internal disclosure controls and procedures to determine if there were any other transactions that we had not reported. The Audit Committee retained our outside counsel to assist it with the internal investigation. The Audit Committee’s report of the internal investigation concluded that:

The Audit Committee has discussed the results of the internal investigation with our independent registered public accounting firm. Because of certain failures, including those enumerated above, this firm determined, in connection with its audit of the Company’s consolidated financial statements as of December 31, 2004 and for the year then ended, that material weaknesses in internal control over financial reporting existed.

We have taken the following actions to improve our disclosure controls and procedures and internal controls over financial reporting:

We believe that the efforts described above have addressed the deficiencies that have affected our internal disclosure controls in the past. A controls system cannot provide absolute assurance that the objectives of the controls system are met, and no evaluation of controls can provide absolute assurance that all controls issues and instances of fraud, if any, within a company have been detected

No change in our internal control over financial reporting occurred during our fiscal quarter ended March 31, 2005 that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

To remediate the material weaknesses in our internal control over financial reporting described in “Item 4. Controls and Procedures” above, subsequent to March 31, 2005 we implemented the changes described therein.

On July 28, 2004, we sold 5,500,000 shares of our common stock in our initial public offering at a price of $7.50 per share pursuant to a Registration Statement on Form S-1 (the “Registration Statement”) (Registration No. 333-114685), which was declared effective by the Securities and Exchange Commission on July 23, 2004. After deducting expenses of the offering, we received net offering proceeds of approximately $36.5 million. During the period from the offering through March 31, 2005, we have used the net proceeds from our initial public offering as follows:

The foregoing amounts represent management’s reasonable estimate of the amount of net offering proceeds applied to such activity instead of the acual amount of net offering proceeds used. The remainder of the proceeds have been invested into short-term investment-grade securities and money market accounts. None of the net proceeds were directly or indirectly paid to: (i) any of our directors, officers or their associates; (ii) any person(s) owning 10% or more of any class of our equity securities; or (iii) any of our affiliates.

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.

AUXILIUM PHARMACEUTICALS, INC.

/s/ Gerri A. Henwood

Gerri A. Henwood

Chief Executive Officer and Interim President

(Principal Executive Officer)

AUXILIUM PHARMACEUTICALS, INC.

/s/ Cornelius H. Lansing II

Cornelius H. Lansing II

Chief Financial Officer and Executive Vice President,
Commercial Logistics

(Principal Financial and Accounting Officer)


PART I FINANCIAL INFORMATION		3

Item 1:	Consolidated Financial Statements (Unaudited)	3
	Consolidated Balance Sheets	3
	Consolidated Statements of Operations	4
	Consolidated Statements of Cash Flows	5
	Consolidated Statement of Stockholders’ Equity	6
	Notes to Consolidated Financial Statements	7
Item 2:	Management’s Discussion and Analysis of Financial Condition and Results of Operations	20
Item 3:	Quantitative And Qualitative Disclosures About Market Risk	55
Item 4:	Controls And Procedures	55

PART II OTHER INFORMATION		59

Item 1:	Legal Proceedings	59
Item 2:	Unregistered Sales of Equity Securities and Use of Proceeds	59
Item 3:	Defaults Upon Senior Securities	59
Item 4:	Submission of Matters to a Vote of Security Holders	59
Item 5:	Other Information	60
Item 6:	Exhibits	60

SIGNATURES		61


	March 31, 2005			December 31, 2004
Assets
Current assets:
Cash and cash equivalents	$	28,025		$	32,707
Short-term investments		12,100			14,100
Accounts receivable, trade		2,640			4,586
Accounts receivable, other		804			400
Inventories		3,989			4,014
Prepaid expenses and other current assets		1,608			2,194

Total current assets		49,166			58,001

Property and equipment, net		2,474			2,554

Other assets		833			485

Total assets	$	52,473		$	61,040

Liabilities and Stockholders’ Equity
Current liabilities:
Notes payable, current portion	$	442		$	427
Accounts payable		2,647			2,868
Accrued expenses		13,177			8,644
Deferred revenue, current portion		2,149			4,034

Total current liabilities		18,415			15,973

Notes payable, long-term portion		209			323

Deferred revenue, long-term portion		9,000			8,500

Commitments and contingencies (Note 7)

Stockholders’ equity:
Preferred stock, $0.01 par value per share, 5,000,000 shares authorized, no shares issued or outstanding		—			—
Common stock, $0.01 par value per share; authorized 120,000,000 shares; issued and outstanding 20,680,650 and 20,648,988 shares at March 31, 2005 and December 31, 2004, respectively		207			206
Additional paid-in capital		135,965			135,856
Accumulated deficit		(110,809	)		(99,257	)
Deferred compensation		(524	)		(565	)
Notes receivable from stockholders		(17	)		(17	)
Accumulated other comprehensive income		27			21

Total stockholders’ equity		24,849			36,244

Total liabilities and stockholders’ equity	$	52,473		$	61,040


	Three Months Ended March 31,
	2005			2004
Net revenues	$	8,797		$	5,634


Operating expenses:
Cost of goods sold		2,828			1,789
Research and development		9,077			2,370
Selling, general, and administrative		8,664			7,422

Total operating expenses		20,569			11,581

Loss from operations		(11,772	)		(5,947	)

Interest income		239			42
Interest expense		(19	)		(505	)

Net loss		(11,552	)		(6,410	)
Accretion of redeemable convertible preferred stock		—			(169	)

Net loss applicable to common stockholders	$	(11,552	)	$	(6,579	)

Basic and diluted net loss per common share	$	(0.56	)	$	(7.08	)

Weighted average common shares outstanding		20,565,499			929,906


	Three Months Ended March 31,
	2005			2004
Cash flows from operating activities:
Net loss	$	(11,552	)	$	(6,410	)
Adjustments to reconcile net loss to net cash used in operating activities:
Depreciation and amortization		324			598
Stock-based compensation		48			37
Interest income accrued on notes receivable from stockholders		—			(1	)
Unrealized gain on available for sale cash equivalents		3			—
Changes in operating assets and liabilities:
Accounts receivable		1,542			(6,103	)
Inventories		25			(14	)
Prepaid expenses, other current assets and other assets		183			(126	)
Accounts payable and accrued expenses		4,315			215
Deferred revenue		(1,385	)		4,582

Net cash used in operating activities		(6,497	)		(7,222	)

Cash flows from investing activities:
Purchases of property and equipment		(190	)		(150	)
Purchases of short-term investments		(2,250	)		—
Redemptions of short-term investments		4,250			—

Net cash provided by (used in) investing activities		1,810			(150	)

Cash flows from financing activities:

Net borrowings (repayments) under lines of credit, net of transaction costs		—			(4,534	)
Movement in restricted cash to secure borrowings		—			9,500
Payments on debt financings		(100	)		(136	)
Proceeds from exercise of common stock options		103			—

Net cash provided by financing activities		3			4,830

Effect of exchange rate changes on cash		2			4

Decrease in cash and cash equivalents		(4,682	)		(2,538	)

Cash and cash equivalents, beginning of period		32,707			28,446

Cash and cash equivalents, end of period	$	28,025		$	25,908

Non-cash items:
Accretion of preferred stock redemption value	$	—		$	169
Issuance of note payable for payment of insurance premium		—			421


	Common stock				Additional paid-in capital		Accumulated deficit			Deferred compensation			Notes receivable from stockholders			Accumulated other comprehensive income		Total Stockholders’ Equity
	Shares		Amount		Additional paid-in capital		Accumulated deficit			Deferred compensation			Notes receivable from stockholders			Accumulated other comprehensive income		Total Stockholders’ Equity
Balance, January 1, 2005	20,648,988		$	206	$	135,856	$	(99,257	)	$	(565	)	$	(17	)	$	21	$	36,244
Exercise of common stock options	31,712			1		102		—			—			—			—		103
Cancellation of restricted stock	(50	)		—		—		—			—			—			—		—
Amortization of deferred compensation	—			—		—		—			41			—			—		41
Compensation on stock option grants to nonemployees for services provided	—			—		7		—			—			—			—		7
Interest income accrued on notes receivable	—			—		—		—			—			—			—		—
Foreign currency translation adjustment	—			—		—		—			—			—			3		3
Unrealized gain on available for sale securities	—			—		—		—			—			—			3		3
Net loss	—			—		—		(11,552	)		—			—			—		(11,552	)

Balance, March 31, 2005	20,680,650		$	207	$	135,965	$	(110,809	)	$	(524	)	$	(17	)	$	27	$	24,849


	Three Months Ended March 31,
	2005			2004
Numerator:
Net loss	$	(11,552	)	$	(6,410	)
Accretion of redeemable convertible preferred stock		—			(169	)

Net loss applicable to common stockholders		(11,552	)		(6,579	)

Denominator:
Weighted-average common shares outstanding		20,653,523			935,085
Weighted-average unvested restricted common shares subject to forfeiture		(88,024	)		(5,179	)

Shares used in calculating net loss applicable to common stockholders per share		20,565,499			929,906

Basic and diluted net loss per common share	$	(0.56	)	$	(7.08	)


	March 31,
	2005	2004
Common stock options	1,934,605	1,239,658
Warrants	1,732,676	1,748,676
Restricted common stock	88,005	7,250
Redeemable convertible preferred stock	—	14,042,482

	3,755,286	17,038,066


	Cost		Gross unrealized gains		Gross unrealized losses		Fair Value
Cash and Cash Equivalents
Demand deposits	$	1,463	$	—	$	—	$	1,463
Money market accounts		11,584		—		—		11,584
Obligations of U.S. Government		14,923		55		—		14,978

March 31, 2005	$	27,970	$	55	$	—	$	28,025

Short-Term Investments
Auction-rate securities	$	12,100	$	—	$	—	$	12,100

March 31, 2005	$	12,100	$	—	$	—	$	12,100

Cash and Cash Equivalents
Demand deposits	$	1,299	$	—	$	—	$	1,299
Money market accounts		11,055		—		—		11,055
Obligations of U.S. Government		20,301		52		—		20,353

December 31, 2004	$	32,655	$	52	$	—	$	32,707

Short-Term Investments
Auction-rate securities	$	14,100	$	—	$	—	$	14,100

December 31, 2004	$	14,100	$	—	$	—	$	14,100


	March 31, 2005		December 31, 2004
Raw materials	$	2,305	$	2,737
Work-in-process		1,169		481
Finished goods		250		318
Inventory subject to return		265		478

	$	3,989	$	4,014


	March 31, 2005		December 31, 2004
Payroll and related expenses	$	2,771	$	3,030
Milestone and royalty expenses		4,799		1,882
Research and development expenses		2,096		1,285
Sales and marketing expenses		474		530
Testim coupon and rebate accrual		1,405		929
Other expenses		1,632		988

	$	13,177	$	8,644


	March 31, 2005			December 31, 2004
Equipment promissory notes	$	654		$	754
Bank lines of credit		—			—

		654			754

Less unamortized discount		(3	)		(4	)
Less current portion of notes payable		(442	)		(427	)

Notes payable, long-term portion	$	209		$	323


	Total		Less than 1 year		2-3 years		4-5 years		5+ years
Long-term debt	$	654	$	442	$	212	$	—	$	—
Operating leases		3,454		485		842		887		1,240
Purchase obligation (1)		3,190		3,190		—		—		—

	$	7,298	$	4,117	$	1,054	$	887	$	1,240


Exhibit No.		Description
10*		Co-Promotion Agreement, dated April 11, 2005, between the Registrant and Oscient Pharmaceuticals Corp.

31.1		Certification of Gerri A. Henwood, the Registrant’s Principal Executive Officer, required by Rule 13a-14(a) or Rule 15d-14(a).

31.2		Certification of Cornelius H. Lansing II, the Registrant’s Principal Financial Officer, required by Rule 13a-14(a) or Rule 15d-14(a).

32		Certification of Gerri A. Henwood, the Registrant’s Principal Executive Officer, and Cornelius H. Lansing II, the Registrant’s Principal Financial Officer, required by Rule 13a-14(b) or Rule 15d-14(b) and Section 1350 of Chapter 63 of Title 18 of the United States Code (18 U.S.C. 1350).