Collagenex Pharmaceuticals 10Q 2006 Q1 Quarterly report

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, DC 20549

FORM 10-Q

x QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended March 31, 2006

o TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

Commission File Number 0-28308

CollaGenex Pharmaceuticals, Inc.

(Exact Name of Registrant as Specified in Its Charter)

Delaware		52-1758016
(State or Other Jurisdiction of		(I.R.S. Employer
Incorporation or Organization)		Identification No.)

41 University Drive, Newtown, PA		18940
(Address of Principal Executive Offices)		(Zip Code)

(215) 579-7388

(Registrant’s Telephone Number,
Including Area Code)

Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

Yes: x No: o

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):

Large accelerated filer o Accelerated filer x Non-accelerated filer o

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).

Yes: o No: x

Indicate the number of shares outstanding of each of the issuer’s classes of common stock as of May 1, 2006:

Class		Number of Shares
Common Stock $.01 par value		17,478,909

COLLAGENEX PHARMACEUTICALS, INC.

TABLE OF CONTENTS

		Page
PART I.	FINANCIAL INFORMATION	1
Item 1.	Financial Statements (unaudited)	1
	Condensed Consolidated Balance Sheets as of March 31, 2006 and December 31, 2005 (unaudited)	2
	Condensed Consolidated Statements of Operations for the Three Months Ended March 31, 2006 and 2005 (unaudited)	3
	Condensed Consolidated Statements of Cash Flows for the Three Months Ended March 31, 2006 and 2005 (unaudited)	4
	Notes to Condensed Consolidated Financial Statements (unaudited)	5
Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	15
	Results of Operations	17
	Liquidity and Capital Resources	20
Item 3.	Quantitative and Qualitative Disclosures About Market Risk	24
Item 4.	Controls and Procedures	25
PART II.	OTHER INFORMATION	26
Item 1A.	Risk Factors	26
Item 6.	Exhibits	37
SIGNATURES		38

CollaGenex Pharmaceuticals, Inc. - United States trademarks:
Periostat®, Metastat®, Dermostat®, Nephrostat®, Osteostat®, Arthrostat®, Rheumastat®, Corneostat®, Gingistat®, IMPACS™, PS20®, The Whole Mouth Treatment®, Restoraderm®, Dentaplex®, Lytra™, Periostat-MR™, SansRosa™, Unorthodoxy™, Aprecin™, Zedara™ and Oracea™.
CollaGenex Pharmaceuticals, Inc. - European Community trademarks:
Periostat®, Nephrostat®, Optistat®, Xerostat®, SansRosa™, Unorthodoxy™, Aprecin™, Zedara™ and Oracea™.
CollaGenex International, Ltd. (our wholly-owned subsidiary) - United Kingdom trademarks:
Periostat®, Nephrostat®, Optistat®, Xerostat®, IMPACS®, Dentaplex®, Restoraderm®, Periocycline®, Periostatus® and Periostat-MR®.
CollaGenex International, Ltd. - European Community and United Kingdom trademarks:
CollaGenex®, PS20®, Dermastat®, Periostan®, Periostat-SR®, “C” Logo® and “The Whole Mouth Treatment” Logo®.
CollaGenex International, Ltd. - European Community Trademarks:
Periocycline™, Restoraderm™, and Periostat-MR™.

Marks listed herein may additionally be registered in jurisdictions not specified in the above list. All other trade names, trademarks or service marks appearing in this Quarterly Report are the property of their respective owners and are not property of CollaGenex Pharmaceuticals, Inc. or any of our subsidiaries.

PART I. FINANCIAL INFORMATION

Item 1. Financial Statements (unaudited).

COLLAGENEX PHARMACEUTICALS, INC.
AND SUBSIDIARIES

Condensed Consolidated Balance Sheets
March 31, 2006 and December 31, 2005
(dollars in thousands, except share data)
(unaudited)

Assets	March 31, 2006			December 31, 2005

Current assets:
Cash and cash equivalents	$	22,883		$	26,219
Short-term investments	21,370			18,206
Accounts receivable, net of allowances of $115 and $104 at March 31, 2006 and December 31, 2005, respectively	1,538			1,428
Inventories	759			630
Prepaid expenses and other current assets	1,924			1,564
Total current assets	48,474			48,047
Equipment and leasehold improvements, net	633			539
Acquired product rights, net	469			536
Other assets	43			43
Total assets	$	49,619		$	49,165
Liabilities and Stockholders’ Equity
Current liabilities:
Accounts payable	$	3,715		$	5,411
Accrued expenses	5,097			6,024
Accrued financing costs	—			1,069
Preferred dividends payable	—			900
Total current liabilities	8,812			13,404
Deferred revenue	36			93
Commitments and Contingencies (Notes: 5 and 7)
Stockholders’ equity:
Preferred stock, $0.01 par value, 5,000,000 shares authorized, 200,000 shares of Series D-1 Cumulative Convertible Preferred Stock issued and outstanding at March 31, 2006 and December 31, 2005 (liquidation value of $20,000 at March 31, 2006 and $20,900 at December 31, 2005); 150,000 shares of Series A Participating Preferred Stock $0.01 par value, designated and no shares issued and outstanding at March 31, 2006 and December 31, 2005	2			2
Common stock, $0.01 par value; 25,000,000 shares authorized, 17,465,369 and 16,054,797 shares issued and outstanding at March 31, 2006 and December 31, 2005, respectively	175			161
Additional paid-in capital	138,614			124,647
Accumulated other comprehensive loss	(30		)	(4		)
Accumulated deficit	(97,990		)	(89,138		)
Total stockholders’ equity	40,771			35,668
Total liabilities and stockholders’ equity	$	49,619		$	49,165

See accompanying notes to unaudited condensed consolidated financial statements.

COLLAGENEX PHARMACEUTICALS, INC.
AND SUBSIDIARIES

Condensed Consolidated Statements of Operations
For the Three Months Ended March 31, 2006 and 2005
(amounts in thousands, except share and per share data)
(unaudited)

	Three Months Ended March 31,
	2006			2005
Revenues:
Net product sales	$	3,341		$	11,836
Contract revenues	252			39
License revenues	23			160
Grant revenues	105			—
Total revenues	3,721			12,035
Operating expenses:
Cost of product sales	895			2,465
Research and development	3,713			4,094
Selling, general and administrative	8,511			7,746
Total operating expenses	13,119			14,305
Operating loss	(9,398		)	(2,270		)
Other income:
Interest income	546			212
Net loss	(8,852		)	(2,058		)
Preferred stock dividend	464			400
Net loss allocable to common stockholders	$	(9,316	)	$	(2,458	)
Net loss per basic and diluted share allocable to common stockholders	$	(0.54	)	$	(0.17	)
Weighted average shares used in computing net loss per basic and diluted share allocable to common stockholders	17,348,984			14,404,677

See accompanying notes to unaudited condensed consolidated financial statements.

COLLAGENEX PHARMACEUTICALS, INC.
AND SUBSIDIARIES

Condensed Consolidated Statements of Cash Flows
For the Three Months Ended March 31, 2006 and 2005
(dollars in thousands)
(unaudited)

	Three Months Ended March 31,
	2006			2005
Cash flows from operating activities:
Net loss	$	(8,852	)	$	(2,058	)
Adjustments to reconcile net loss to net cash used in operating activities:
Share-based compensation	793			—
Write-down of inventory	—			844
Depreciation and amortization expense	124			212
Accounts receivable provisions	11			(5		)
Charge for in-process research and development	200			—
Changes in operating assets and liabilities:
Accounts receivable	(121		)	(542		)
Inventories	(129		)	273
Prepaid expenses and other assets	(360		)	(306		)
Accounts payable	(1,696		)	555
Accrued expenses	(927		)	(194		)
Deferred revenue	(57		)	(91		)
Net cash used in operating activities	(11,014		)	(1,312		)
Cash flows from investing activities:
Capital expenditures	(151		)	(157		)
Purchase of in-process research and development	(200		)	(150		)
Purchase of short-term investments	(12,240		)	(6,168		)
Maturities of short-term investments	9,050			12,623
Net cash (used in) provided by investing activities	(3,541		)	6,148
Cash flows from financing activities:
Net proceeds from issuance of common stock	11,594			—
Net proceeds from common stock under share-based compensation plans	525			26
Payment of preferred dividends	(900		)	(800		)
Net cash provided by (used in) financing activities	11,219			(774		)
Net (decrease) increase in cash and cash equivalents	(3,336		)	4,062
Cash and cash equivalents at beginning of period	26,219			11,889
Cash and cash equivalents at end of period	$	22,883		$	15,951

See accompanying notes to unaudited condensed consolidated financial statements.

COLLAGENEX PHARMACEUTICALS, INC.
AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
March 31, 2006 and 2005
(dollars in thousands, except per share data)
(Unaudited)

Note 1 — Basis of Presentation

The unaudited condensed consolidated financial statements included herein have been prepared by CollaGenex Pharmaceuticals, Inc. and subsidiaries, or the Company, pursuant to the rules and regulations of the Securities and Exchange Commission and in accordance with accounting principles generally accepted in the United States of America. Certain information and footnote disclosures normally included in the annual consolidated financial statements prepared in accordance with accounting principles generally accepted in the United States of America have been condensed or omitted pursuant to such rules and the regulations of the Securities and Exchange Commission. These unaudited condensed consolidated financial statements should be read in conjunction with the Company’s 2005 audited consolidated financial statements and footnotes included in its Annual Report on Form 10-K for the year ended December 31, 2005.

The accompanying unaudited condensed consolidated financial statements include the results of the Company and its subsidiaries. All intercompany accounts and transactions have been eliminated in consolidation.

Certain amounts in the 2005 consolidated financial statements have been reclassified to conform to the 2006 presentation.

In the opinion of the Company’s management, the accompanying unaudited condensed consolidated financial statements have been prepared on a basis substantially consistent with the audited consolidated financial statements for the year ended December 31, 2005 and contain adjustments, all of which are of a normal recurring nature, necessary to present fairly the Company’s consolidated financial position at March 31, 2006, the results of operations for the three months ended March 31, 2006 and 2005, and the cash flows for the three months ended March 31, 2006 and 2005. Interim results are not necessarily indicative of results anticipated for the full fiscal year.

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

Net Product Sales

The Company historically recognized product sales revenue upon shipment to wholesale customers, net of estimated future returns and estimates for chargebacks, applicable wholesale distribution fees, rebates and current inventory levels in the distribution channel, provided that collection was probable and no significant obligations remained. Following the launch of a third party generic competitor to Periostat in May 2005 and commencing with the second quarter of

2005, the Company began recognizing Periostat® sales revenue based on sales to end-users, which are estimated using prescription dispensing data generated by a leading independent prescription tracking service, as well as on-hand inventory estimates in the distribution channel. Since the launch of generic competition to Periostat may result in increased product returns existing in the wholesale and retail channel, the Company has accrued an estimated liability of $969 for potential Periostat and other product returns in accrued expenses on the consolidated balance sheet at March 31, 2006.

Pursuant to the Company’s Promotion and Cooperation Agreement, or the Promotion Agreement, with Primus Pharmaceuticals, Inc., or Primus, contract revenues for Alcortin™, a prescription topical antifungal steroid combination, and Novacort™, a prescription topical steroid and anesthetic, are fee-based arrangements where contract revenue is earned as prescriptions are filled and recognized as a percentage of the gross profit earned by Primus. The Company does not take title to the inventory sold by Primus under the Promotion Agreement.

During the fourth quarter of 2005, the Company received notice that a grant had been approved by the National Institutes of Health, or NIH, to fund additional research by the Company and its collaborators of the potent anti-inflammatory effects of incyclinide. The Company expenses such research expenditures as they are incurred and recognizes grant revenue for the portion of the expenditures that are reimbursed by the NIH. These revenues are recorded at the time they are submitted for reimbursement. The Company recognized $105 in grant revenues during three months ended March 31, 2006.

Pre-Launch Manufacturing Costs

The Company classifies direct manufacturing costs relating to the manufacture of product inventory and samples in advance of a new product launch as research and development expense until it receives an approval letter from the Food and Drug Administration, or FDA, for a new product. Following FDA approval of a product, the Company capitalizes the inventory costs relating to that product.

Stock-Based Compensation

As part of the Company’s adoption of Statement of Financial Accounting Standards (SFAS) No. 123 (revised 2004), Share-Based Payment, or SFAS No. 123R, as of January 1, 2006, the Company recognized the fair value of share-based compensation awards in the Company’s consolidated financial statements using the modified prospective method. The Company applies the Black-Scholes option pricing model in order to determine the fair value of stock options on the date of grant, and it applies judgment in estimating key assumptions that are important elements in the model, such as the expected stock-price volatility and expected stock option life. The Company’s estimates of these important assumptions and expected forfeiture rates are based on historical data and judgment regarding market trends and factors.

Cash, Cash Equivalents and Short-Term Investments

The Company considers all highly liquid investments with an original maturity of three months or less at the date of acquisition to be cash equivalents. Cash equivalent investments are held at amortized cost, which approximates fair value. All short-term investments have original maturity dates of between three months and one year. The Company’s short-term investments are primarily composed of commercial paper and government notes. At March 31, 2006, all of the Company’s short-term investments, carried at fair value, were classified as available-for-sale with unrealized gains and losses included as a separate component of equity. The accumulated net unrealized loss on short-term investments was $30 and $4 at March 31, 2006 and December 31, 2005, respectively.

Recently Issued Accounting Pronouncements

In November 2005, the FASB issued FASB Staff Position SFAS 123(R)-3, Transition Election Related to Accounting for the Tax Effects of Share-based Payment Awards, that provides an elective alternative transition method of calculating the pool of excess tax benefits available to absorb tax deficiencies recognized subsequent to the adoption of SFAS No. 123R to the method otherwise required by paragraph 81 of SFAS No. 123R. We may take up to one year from the effective date of the FSP to evaluate our available alternatives and make our one-time election. We are currently evaluating the alternative methods in connection with our adoption of SFAS No. 123R.

Note 2 — Concentration of Credit and Other Risks

The Company invests its excess cash in money market funds with major U.S. financial institutions, commercial paper and government notes. The Company has established investment guidelines focused on protecting the safety and liquidity of this invested cash.

The Company currently contracts with a single source for the domestic manufacturing of Periostat tablets and has an agreement with a single company to supply the active ingredient in Periostat. A single company also provides all warehousing and distribution services to the Company.

A majority of the Company’s revenue has historically been derived from a small number of wholesale drug distributors and United Research Laboratories, Inc./Mutual Pharmaceutical Company, Inc., or Mutual. For the three months ended March 31, 2006, sales to Cardinal Health, Inc., McKesson Corporation, and Amerisource Bergen, represented approximately 53%, 26% and 14%, respectively, of the Company’s aggregate net product sales. Such customers also represented 58%, 29% and 8% of the Company’s total accounts receivable balance at March 31, 2006. For the three months ended March 31, 2005, sales to Cardinal Health, Inc., McKesson Corporation, Amerisource Bergen Corporation and Mutual represented approximately 30%, 29%, 12% and 25%, respectively, of the Company’s aggregate net product sales. Such customers also represented 19%, 14%, 8% and 55%, respectively, of the Company’s total accounts receivable balance at March 31, 2005.

During the three months ended March 31, 2006, Periostat accounted for approximately 42% of the Company’s total net revenues. During the three months ended March 31, 2005, Periostat and Mutual’s branded version of Periostat accounted for approximately 87% of the Company’s total net revenues.

Note 3 — Share-Based Compensation

At March 31, 2006, the Company had one active share-based employee compensation plan. Stock option awards granted from this plan and historical plans are granted with an exercise price per share equal to the fair market value of a share of the Company’s common stock on the date of grant. The option awards vest over a period determined at the time the options are granted, ranging from two to five years, and generally have a maximum term of ten years. Certain options provide for accelerated vesting if there is a change in control (as defined in the plans). Prior to January 1, 2006, the Company accounted for share-based employee compensation, including stock options, using the method prescribed in

Accounting Principles Board (APB) Opinion No. 25, “Accounting for Stock Issued to Employees” and related Interpretations. Under APB Opinion No. 25, for stock options granted with an exercise price per share equal to the fair market value of a share of the Company’s common stock, no compensation cost was recognized, and a disclosure was made regarding the pro forma effect on net earnings assuming compensation cost had been recognized in accordance with SFAS No. 123, “Accounting for Stock-Based Compensation”. On December 16, 2004, the Financial Accounting Standards Board issued SFAS No. 123R, Share-Based Payment, which requires companies to measure and recognize compensation expense for all share-based payments at fair value. SFAS No. 123R eliminates the ability to account for share-based compensation transactions using APB Opinion No. 25, and generally requires that such transactions be accounted for using prescribed fair-value-based methods. SFAS No. 123R permits public companies to adopt its requirements using one of two methods: (a) a “modified prospective” method in which compensation costs are recognized beginning with the effective date based on the requirements of SFAS No. 123R for all share-based payments granted or modified after the effective date, and based on the requirements of SFAS No. 123 for all awards granted to employees prior to the effective date of SFAS No. 123R that remain unvested on the effective date, or (b) a “modified retrospective” method which includes the requirements of the modified prospective method described above, but also permits companies to restate based on the amounts previously recognized under SFAS No. 123 for purposes of pro forma disclosures either for all periods presented, or prior interim periods of the year of adoption.

Effective January 1, 2006, the Company adopted SFAS No. 123R using the modified prospective method. No compensation expense related to stock option grants has been recorded in the consolidated statement of operations for the three months ended March 31, 2005, as all of the options granted had an exercise price per share equal to the market value of a share of the Company’s common stock on the date of grant. Results for prior periods have not been restated. The Company is using the straight-line method to recognize stock-based compensation expense. The amount of stock-based compensation recognized during a period is based on the value of the portion of the awards that are ultimately expected to vest. SFAS No. 123R requires forfeitures to be estimated at the time of grant and revised, if necessary, in subsequent periods if actual forfeitures differ from those estimates. The term “forfeitures” is distinct from “cancellations” or “expirations” and represents only the unvested portion of the surrendered option. The Company has applied an annual forfeiture rate of 2.8% to all unvested options as of the date of adoption and during the quarter ended March 31, 2006. This analysis will be re-evaluated quarterly and the forfeiture rate will be adjusted as necessary. Ultimately, the actual expense recognized over the vesting period will only be for those shares that vest. During the three months ended March 31, 2006, the Company recorded $793 of stock compensation expense. This amount is composed of $99 related to research and development expenses and $694 related to selling, general and administrative expenses. No amounts of share-based compensation cost have been capitalized into inventory or other assets during the quarter ended March 31, 2006.

The following table illustrates the effect on net loss and net loss per common share if the Company had applied the fair value recognition provisions of SFAS No. 123 to stock-based employee compensation during the first quarter of 2005 (option forfeitures are accounted for as they occurred and no amounts of compensation expense have been capitalized into inventory or other assets, but instead are considered period expenses in the pro forma amounts):

	Three Months Ended March 31, 2005
Net loss allocable to common stockholders - as reported	$	(2,458	)
Add: Stock based compensation included in the determination of net income as reported	—
Deduct: Total stock based compensation expense determined under the fair value method for all grants	(811		)(1)
Net loss allocable to common stockholders - pro forma	$	(3,269	)
Basic and diluted net loss per share
As reported	$	(0.17	)
Pro forma	$	(0.23	)

(1) Amounts have not been tax-effected as a result of the Company’s significant net operating loss carry-forwards.

As a result of adopting SFAS No. 123R, the Company’s loss allocable to common stockholders for the three months ended March 31, 2006 was $800 larger than if it had continued to account for share-based compensation under APB No. 25. Basic and diluted loss per share allocable to common stockholders for the three months ended March 31, 2006 would have been $0.58 per share if the Company had not adopted SFAS No. 123R, compared to reported basic and diluted loss per share allocable to common stockholders of $0.54 per share.

Since inception, the Company has had four stock-based compensation plans. The Company issues new shares of common stock upon the exercise of stock options. The only active plan at March 31, 2006 is the 2005 Equity Incentive Plan, or the 2005 Plan.

The 1992 Stock Option Plan, as amended, or the 1992 Plan, provided for the granting of incentive and nonqualified options to directors, employees and consultants to purchase up to 291,000 shares of the Company’s common stock at a price, for the incentive options, not less than the fair value on the grant date. Such options are exercisable for a period of ten years from the grant date and generally vest over a four-year period. All 291,000 options available under the 1992 Plan were granted by 1996.

The 1996 Non-Employee Director Stock Option Plan, or the Non-Employee Director Plan, provides for the issuance of stock options to new non-employee directors to purchase up to 300,000 shares of common stock at an exercise price equal to the fair value on the date of grant. Such options are exercisable for a period of ten years from the date of grant and vest 20% per year commencing one year from the grant date. The Non-Employee Director Plan expired in March 2006. No outstanding shares under the Non-Employee Director Plan were eligible to be transferred into other active Company stock-based compensation plans.

The 1996 Stock Option Plan, as amended, or the 1996 Plan, provides for the issuance of incentive and nonqualified options to employees and consultants to purchase up to 3,000,000 shares of the Company’s common stock at a price, for the incentive options, no less than the fair value of the common stock on the date of grant. Such options are exercisable for a period of ten years from the grant date and generally vest over a two-to-five-year period, although vesting for options granted to certain Company officers is subject to acceleration under certain circumstances. The 1996 Plan expired in March 2006, at which time all unissued options were rolled over to the 2005 Plan.

The 2005 Plan provides for the issuance of incentive and nonqualified options, restricted stock awards, restricted stock units and other stock-based awards, including the grant of stock appreciation rights to employees, officers, directors, consultants, advisors, and other service providers to purchase shares of the Company’s common stock at a price per share, for the incentive options, not less than the fair value of a share of the Company’s common stock on the grant date. The number of shares of common stock that may be issued pursuant to the 2005 Plan is 1,000,000 shares plus the roll over of 476,555 remaining shares of common stock reserved for issuance under the 1996 Plan upon its expiration in March 2006. At March 31, 2006, there were only stock options available for issuance under the 2005 Plan. Such options are exercisable for a period of ten years from the grant date and generally vest over a five-year period, although vesting for options granted to certain Company officers is subject to acceleration under certain circumstances. At March 31, 2006, 1,010,555 shares of common stock were available for issuance pursuant to awards under the 2005 Plan.

Certain options granted in 2003 are being amortized at a rate that is accelerated versus the contractual vesting period of such options as these options are performance-based and it is anticipated that the performance criteria will be met prior to straight-line vesting.

The following table summarizes activity under all stock option plans for the respective periods:

	Three Months Ended
(In thousands, except per share data)	March 31, 2006		March 31, 2005
Weighted-average fair value of options granted per share	$	7.78	$	3.91
Intrinsic value of options exercised	$	349	$	125

At March 31, 2006, the value of the unvested portion of all outstanding stock-related awards was $8,386, which the Company expects to amortize and recognize as compensation expense over the weighted average service period of approximately 3.3 years.

The amount of cash received during the three months ended March 31, 2006 from exercise of options was approximately $525. No related tax benefit from the exercise of such options was realized as a result of the Company’s significant net operating loss carryforwards and full valuation allowance.

The fair values of the options granted during the three months ended March 31, 2006 and 2005 were determined using the Black-Scholes option pricing model, which incorporates various assumptions. The risk-free rate of interest for the average contractual life of the option is based on U.S. Government Securities Treasury Constant Maturities. Expected volatility is based on the historical daily volatility of the Company’s stock. The expected life is determined using the short-cut method permitted under SAB 107. The expected dividend rate yield is zero because the Company currently does not pay or expect to pay dividends to common stockholders. The following are the weighted average assumptions used during the respective periods:

	Three Months Ended March 31,
	2006		2005
Expected life in years	6.50		6.46
Risk-free interest rate	4.54	%	4.09	%
Volatility	69.7	%	72.8	%
Expected dividend yield	0	%	0	%

Stock option activity under all plans during the three months ended March 31, 2006 is as follows:

	Number of Shares		Weighted Average Exercise Price per Share		Weighted Average Remaining Contractual Term (years)	Aggregate Intrinsic Value (1)
Balance at December 31, 2005	3,305,267		$	9.35
Options granted	387,600		$	11.45
Options exercised	(60,562	)	$	8.67
Options forfeited or cancelled	(19,550	)	$	8.69
Balance at March 31, 2006	3,612,755		$	9.58	6.40	$	18,859
Exercisable, March 31, 2006	2,133,582		$	9.99	4.77	$	10,263

(1) The aggregate intrinsic value on this table was calculated based on the positive difference between the closing sales price of the Company’s common stock on March 31, 2006 and the exercise price of the underlying options.

Note 4 — Inventories

Inventories at March 31, 2006 and December 31, 2005 consist of the following:

	2006		2005
Raw materials	$	77	$	77
Finished goods	682		553
	$	759	$	630

Note 5 — Line of Credit

On June 7, 2004, the Company entered into a Loan Modification Agreement with Silicon Valley Bank to renew and amend its revolving credit facility, which expired on March 15, 2004. The amended credit facility expires on May 31, 2006. Under the amended credit facility, the Company may borrow up to the lesser of $5,000 or 80% of eligible accounts receivable, as defined under the amended credit facility. The amount available to the Company is reduced by any outstanding letters of credit which may be issued under the amended credit facility in

amounts totaling up to $2,000. As the Company pays down amounts under any letter of credit, the amount available to it under the credit facility increases. No letter of credit was outstanding at March 31, 2006 and December 31, 2005. The Company is not obligated to draw down any amounts under the amended credit facility and any borrowings shall bear interest, payable monthly, at the current prime rate, or 7.75% at March 31, 2006. The Company is charged an unused line credit fee of 0.375% of the unused line per annum. As of March 31, 2006 and December 31, 2005, the Company had no borrowings outstanding.

The Company is currently in discussions with Silicon Valley Bank regarding the renewal of the line of credit, however, the Company cannot offer assurance that such discussions will result in a renewal.

Note 6 — Contract and License Revenues

The Company recorded $275 in contract and licensing revenues for the three months ended March 31, 2006. In June 2005, the Company entered into the Promotion Agreement with Primus, under which the Company will promote Alcortin, a prescription topical antifungal steroid combination, and Novacort, a prescription topical steroid and anesthetic. Under the Promotion Agreement, the Company will receive a percentage of the gross profit arising from prescriptions written by dermatology professionals (or offices) that result in sales of the products in the United States. The majority of marketing expenses, excluding sales force compensation and sample product costs, related to the promotion of the Primus products will be funded by Primus. The majority of product sample costs and all sales force compensation will be funded by the Company. During the three months ended March 31, 2005, $132 of license revenue was recorded to reflect the unamortized portion of upfront license revenue from the License and Supply Agreement with Showa Yakuhin Kako Co., Ltd., which was terminated in March 2005.

Note 7 — Legal Settlements and Proceedings

Mutual

On April 8, 2004, the Company settled all pending litigation with Mutual. As part of the settlement, the Company paid to Mutual $2,000, which represented a portion of the anticipated fees and expenses that the Company would save as a result of the settlement of the pending actions with Mutual.

In connection with the settlement, the Company and Mutual entered into a License and Supply Agreement pursuant to which Mutual received a license to sell a branded version of Periostat and would purchase this product exclusively from the Company at prices below the Company’s average manufacturer’s price. The License and Supply Agreement also provided for the Company to make price adjustments to Mutual after a generic version of Periostat had become available on the market at a price lower than the selling price of Mutual’s branded version of Periostat. These adjustments were to take the form of rebates or credits to Mutual to reduce the acquisition cost of the branded version of Periostat in Mutual’s inventory or to offset rebates and similar retroactive price adjustments requested by, and actually provided by, Mutual to its customers.

On May 13, 2005, the FDA approved a third party generic version of Periostat that was launched in late May 2005. Upon this generic launch, the License and Supply Agreement terminated and Mutual was no longer obligated to purchase its branded version of Periostat from the Company and ceased purchasing from the Company in June 2005.

FDA

In June 2003, the Company commenced an action and filed a motion for a preliminary injunction in the United States District Court for the District of Columbia challenging the FDA’s decision to treat Periostat as an antibiotic drug, thus denying Periostat certain protections afforded non-antibiotic drugs under the Food, Drug, and Cosmetic Act and against FDA approval of generic copies of Periostat, or the FDA Litigation. On July 23, 2003, the United States District Court for the District of Columbia issued a preliminary injunction prohibiting the FDA from approving any Abbreviated New Drug Applications, or ANDAs, submitted for any generic version of Periostat. On January 20, 2005, the United States District Court for the District of Columbia reached its decision on the merits of the FDA Litigation, and dissolved the injunction that had prohibited the FDA from approving any ANDAs submitted for any generic version of Periostat. The Company lodged, but has now withdrawn, an appeal against this decision in the Court of Appeals for the District of Columbia Circuit.

IVAX and CorePharma

On October 1, 2004, the Company filed a complaint for patent infringement against IVAX Pharmaceuticals Inc., or IVAX, and CorePharma LLC, or CorePharma, in the United States District Court for the Eastern District of New York. In its complaint, the Company alleged that the submission of ANDAs by each of IVAX and CorePharma for 20 mg tablets of doxycycline hyclate infringed United States Patent RE 34,656, for which the Company is the exclusive licensee. The Company also alleged that any manufacture, importation, marketing and sale of generic 20 mg tablets of doxycycline hyclate by IVAX and CorePharma would infringe the RE 34,656 patent. The Company sought an injunction preventing IVAX and CorePharma from introducing 20 mg tablets of doxycycline hyclate in the United States. The injunction was denied by the Court on June 16, 2005. The litigation on the merits of the Company’s patent infringement claims is still pending before the Court in the Eastern District of New York.

Note 8 — Legal Expenses to Defend Periostat Patents

Under the Company’s license agreement with the Research Foundation of the State University of New York, or SUNY, covering Periostat, the Company is entitled to deduct costs incurred to defend its patents, including the $2,000 settlement payment to Mutual in April 2004, from current and future royalties due to SUNY on net sales of Periostat and sales to Mutual of its branded version of Periostat. The cumulative legal patent defense, litigation and settlement costs incurred as of March 31, 2006 exceed the amount of the royalties earned and payable to SUNY by $4,049. These amounts, which have been expensed, will be available to offset future royalties earned by SUNY, if any, on net sales of products based on the SUNY technology.

Note 9 — Accrued Expenses

Accrued expenses at March 31, 2006 and December 31, 2005 consist of the following:

	2006		2005
Contracted development and manufacturing costs	$	1,083	$	739
Sales and marketing costs	190		239
Payroll and related costs	785		2,097
Professional and consulting fees	477		232
Current portion of deferred revenue	110		58
Foreign taxes	945		945
Product returns	969		1,267
State and franchise taxes	75		110
Restructuring	75		96
Distribution fees and rebates	250		237
Other	138		4
	$	5,097	$	6,024

Note 10 — Common Stock Offering

On December 21, 2005, the Company entered into definitive agreements with institutional and other investors to sell 2,900,000 shares of the Company’s common stock for an aggregate purchase price of $29,000. On December 23, 2005, the Company closed on the first tranche of the offering and issued 1,550,000 shares of common stock in exchange for proceeds of $14,388, net of approximately $1,069 in placement agency fees and other estimated offering expenses that were accrued by the Company at December 31, 2005. All placement agency fees and related expenses accrued at December 31, 2005 were paid in the first quarter of 2006. On January 6, 2006, the Company closed on the second tranche of the offering and issued 1,350,000 shares of common stock in exchange for $12,663 of net proceeds.

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

Our management’s discussion and analysis of our financial condition and results of operations include the identification of certain trends and other statements that may predict or anticipate future business or financial results. There are important factors that could cause our actual results to differ materially from those indicated. See “Risk Factors.”

Overview

CollaGenex Pharmaceuticals, Inc. and subsidiaries is a specialty pharmaceutical company currently focused on developing and marketing innovative proprietary medical therapies to the dermatology market. We currently market three prescription pharmaceutical products to the dermatology market through our professional dermatology sales force and generate revenues from four prescription pharmaceutical products that we continue to sell to the dental market.

Our strategy is to become a leading developer and marketer of innovative prescription pharmaceutical products to the dermatology market. We intend to continue to market our current products and develop and launch new products based on our proprietary platform technologies as well as other technologies. Our lead development candidates are: Oracea™, for which a New Drug Application, or NDA, is currently under review by the United States Food and Drug Administration, or FDA, for the treatment of rosacea; incyclinide (formerly known as COL-3), which is currently in Phase II dose-finding clinical trials for the treatment of acne; COL-118, a pre-clinical topical compound based upon the SansRosa™ technology that we are developing for the treatment of erythema (skin redness) associated with dermatological conditions; and our Restoraderm® dermal drug delivery system, which is currently under development.

Our marketed dermatology products are: Pandel®, a prescription corticosteroid we licensed from Altana, Inc. in May 2002, Alcortin™, a prescription topical antifungal steroid combination, and Novacort™, a prescription topical steroid and anesthetic. In June 2005, we executed a Promotion and Cooperation Agreement with Primus Pharmaceuticals Inc., or Primus, to market Alcortin and Novacort to dermatologists.

Our original dental product, Periostat®, is an orally administered, prescription pharmaceutical product that was approved by the FDA in September 1998 for the treatment of adult periodontitis. We launched Periostat in January 1999, and by 2005 Periostat was the largest branded prescription pharmaceutical product in the dental market. Between April 2004 and June 2005, we also sold a separately branded version of Periostat to United Research Laboratories, Inc./Mutual Pharmaceutical Company, Inc., or Mutual, pursuant to a License and Supply Agreement executed in April 2004 as part of a settlement of our outstanding patent litigation with Mutual. On May 20, 2005, we terminated our dental sales force and promotional activities for Periostat following the introduction of a third party generic version of the product and, as a result of this generic launch, Mutual ceased purchasing product from us during June 2005. We also discontinued the promotion of our other dental products on May 20, 2005. We continue to generate sales from Periostat and the other dental products, which include Atridox®, Atrisorb FreeFlow® and Atrisorb-D®, also referred to as the Atrix Products, and are licensed from Atrix Laboratories, Inc. (now known as QLT USA, Inc.). Based on data provided by a leading independent prescription tracking service, we estimate that Periostat’s share of the 20 mg doxycycline market was approximately 9.0% at March 31, 2006.

In addition to our marketed products, we have a pipeline of product candidates in clinical and preclinical development. These products are based on our proprietary platform technologies, IMPACS™, SansRosa and Restoraderm. IMPACS (Inhibitors of Multiple Proteases And CytokineS) are a group of compounds that demonstrate a range of anti-inflammatory activities as well as the ability to inhibit the breakdown of connective tissue. Periostat is our first FDA-approved IMPACS product. Oracea and incyclinide are IMPACS compounds currently in clinical development for the treatment of rosacea and acne, respectively. Our IMPACS technology is licensed on a perpetual basis from the Research Foundation of the State University of New York at Stony Brook, or SUNY. Our SansRosa technology was acquired in connection with our acquisition of SansRosa Pharmaceutical Development Inc., or SansRosa, and is an early stage project to develop a topical treatment (COL-118) for the redness associated with rosacea. Our Restoraderm technology is a proprietary, foam-based, topical drug delivery technology that originated from a Swedish collaborator. We have acquired all rights, title and interest to the Restoraderm technology. We have formulated several potential products incorporating the Restoraderm technology with active ingredients commonly used to treat dermatological conditions, although we have not yet developed timetables for the initiation of clinical development or the commercial launch of any of these products.

We were founded in 1992 and completed an initial public offering of our common stock in 1996. We recorded our first profit in the third quarter of 2002. We incurred net losses allocable to common stockholders of $9.3 million for the three months ended March 31, 2006 and $18.8 million for the year ended December 31, 2005, respectively. Although we achieved net income of $6.5 million and $6.4 million for the years ended December 31, 2004 and 2003, respectively, we have incurred losses in every other year since inception and have an accumulated deficit of $98.0 million at March 31, 2006. We do not expect to generate profits for the year ending December 31, 2006.

Significant Recent Developments

In 2005, we completed two Phase III clinical trials for our leading IMPACS product candidate, Oracea, for the treatment of rosacea, a dermatological condition. Oracea is a modified release form of a sub-anti-microbial dose of doxycycline, the same active ingredient as Periostat. We submitted our NDA for Oracea to the FDA on August 1, 2005. On October 3, 2005, we announced that the NDA for Oracea had been accepted for review by the FDA. The Prescription Drug User Fee Act (PDUFA) target date for reviewing the submission is May 31, 2006. In April 2005, we announced the completion of a Phase II proof-of-concept clinical trial for our second generation IMPACS compound, incyclinide for the treatment of rosacea. In September 2005, we initiated a 300-patient, double-blinded, placebo-controlled, Phase II dose-finding clinical trial to evaluate the safety and efficacy of incyclinide for the treatment of acne. On November 9, 2005, we announced that the National Institutes of Health, or NIH, had awarded a grant of approximately $962,000 for additional research into the potent anti-inflammatory effects of incyclinide.

In February 2006, we announced that a Marketing Authorization Application, or MAA, for Oracea was filed with the United Kingdom’s Medicines & Healthcare Products Regulatory Agency, or MHRA. The U.K. will act as reference member state in this decentralized procedure. The MAA for Oracea was submitted to the MHRA on February 24, 2006.

In March 2006, we announced that the European Patent Office had published on their website that our patent application covering the use of sub anti-microbial doxycycline, including Oracea, for the treatment of acne and rosacea, will be allowed.

Results of Operations

Three Months Ended March 31, 2006 Compared to Three Months Ended March 31, 2005

Revenues

Revenues (dollars in thousands)	2006		Change		2005
Net Product Sales	$	3,341	(71.8	)%	$	11,836
Contract Revenues	252		546.2	%	39
License Revenues	23		(85.6	)%	160
Grant Revenues	105		100	%	—
Total	$	3,721	(69.1	)%	$	12,035

Net product sales during the three months ended March 31, 2006 included approximately $3.3 million in net product sales of Periostat, Pandel and the Atrix Products. The decrease in net product sales was primarily due to lower Periostat net sales and the elimination of sales of the branded version of Periostat to Mutual as a result of the launch of a third party generic competitor in May 2005. Based on data provided by a leading independent prescription tracking service, we estimate that Periostat’s share of the 20 mg doxycycline market was 9.0% at March 31, 2006. Contract revenues during the three months ended March 31, 2006 were derived primarily from our Promotion and Cooperation Agreement with Primus for the Alcortin and Novacort products. During the three months ended March 31, 2005, contract revenues were primarily derived from residual contract revenue from our expired agreement with Merck & Co., Inc. for Vioxx®. Licensing revenues of $23,000 during the three months ended March 31, 2006 consisted of international licensing revenues for Periostat. Licensing revenues during the three months ended March 31, 2005 consisted primarily of international licensing revenues for Periostat and $132,000 in license revenue representing the unamortized portion of upfront license revenue received in 2000 from the License and Supply Agreement with Showa Yakuhin Kako Co., Ltd., which was terminated in March 2005. Grant revenues, of $105,000 recognized during the three month period ended March 31, 2006, represent reimbursement received during the quarter from the NIH related to the November 2005 grant associated with our on-going incyclinide development program.

Cost of Product Sales

Cost of Product Sales (dollars in thousands)	2006			Change		2005
Cost of Product Sales	$	895		(63.7	)%	$	2,465
Percent of Net Product Sales	26.8		%	N/A		20.8		%

Cost of product sales includes product packaging, third party royalties, amortization of product licensing fees, and the costs associated with the manufacturing, storage and stability of Periostat, Mutual’s branded version of Periostat, Pandel and the Atrix Products, as well as charges taken to reflect decreases in inventory carrying value, if any.

Cost of product sales for the three months ended March 31, 2005 includes a charge of approximately $844,000 associated with the estimated excess inventories of Periostat and Mutual’s branded version of Periostat as a result of the anticipated launch by a third party generic competitor which occurred in May 2005. The increase in cost of product sales as a percentage of net product sales is a direct result of decreased Periostat revenues in 2006, which is a higher margin product than our other existing products.

Research and Development

Research and Development (dollars in thousands)	2006		Change		2005
Research and development	$	3,713	(9.3	)%	$	4,094

Research and development expenses consist primarily of funds paid to third parties for the provision of services and materials for drug development, pre-launch manufacturing and production costs related to Oracea, including milestone fees, manufacturing and formulation enhancements, clinical trials, purchased in-process research and development, statistical analysis and report writing and regulatory compliance costs (including a drug approval submission and filing fees).

Significant development projects conducted during the three months ended March 31, 2006 included:

· continuing clinical and manufacturing development work and regulatory compliance costs for Oracea of approximately $1.2 million;

· clinical and manufacturing development work for incyclinide was $ 1.5 million; and

· in-process research and development costs related to COL-118 of approximately $200,000.

Personnel and direct internal overhead expenses, including consulting, regulatory and stock-based compensation costs incurred during the three months ended March 31, 2006, were approximately $800,000.

We estimate that if Oracea and incyclinide are developed to the point of commercialization, the additional formulation and clinical development expenses and milestone fees expected to be incurred over the next five years would be approximately $35.0 million. We have discontinued all development work on Periostat-MR™ following the launch of generic competition to Periostat in May 2005 and our decision to exit the dental business. We are currently conducting some formulation and stability work on various products incorporating our Restoraderm technology, and we are reviewing product options and the timetable associated with clinical development or commercial launch. Accordingly, it is premature to estimate other future costs associated with the Restoraderm technology. It is also premature to estimate future development and clinical costs associated with the SansRosa technology.

Significant development projects conducted during the three months ended March 31, 2005 included:

· continuing clinical and manufacturing development work for Oracea of approximately $1.8 million;

· clinical and manufacturing development and formulation work for Periostat-MR, our once daily, modified release formulation of doxycycline, 40 mg, for the treatment of adult periodontitis, which accounted for total costs of approximately $886,000;

· clinical and manufacturing development work for incyclinide was $491,000; and

· stability testing and formulation costs for two potential products utilizing our Restoraderm technology, which accounted for total costs of approximately $250,000.

Personnel and direct internal overhead expenses, including consulting, regulatory fees and other miscellaneous expenses, incurred during the three months ended March 31, 2005 were approximately $666,000.

Selling, General and Administrative

Selling, General and Administrative (dollars in thousands)	2006		Change		2005
Selling, General and Administrative	$	8,511	9.9	%	$	7,746

Selling, general and administrative expenses consist primarily of personnel salaries and benefits, including non-cash share-based compensation expense in 2006, direct marketing costs, professional, legal and consulting fees, insurance and general office expenses.

Significant components of selling, general and administrative expenses incurred during the three months ended March 31, 2006 included approximately $3.6 million in direct selling and sales training expenses, approximately $2.4 million in marketing expenses (including advertising and promotion expenditures the Primus products, Pandel and pre-launch costs associated with the anticipated Oracea trade launch) and approximately $2.6 million in general and administrative expenses, which include business development, finance, legal and corporate activities. Significant components of selling, general and administrative expenses incurred during the three months ended March 31, 2005 included approximately $3.8 million in direct selling and sales training expenses, approximately $1.9 million in marketing expenses (including advertising and promotion expenditures for Periostat, the Atrix Products and Pandel) and approximately $2.0 million in general and administrative expenses, which include business development, finance, legal and corporate activities. The increase in selling, general and administrative expense of $765,000 during the three months ended March 31, 2006 compared to the three months ended March 31, 2005, was primarily due to non-cash share-based compensation expense of approximately $700,000. This was offset in part by lower sales force compensation costs during the beginning portion of the three months ended March 31, 2006. Total sales representatives and sales managers grew from 33 at January 1, 2006 to 75 at March 31, 2006 in anticipation of a September 2006 Oracea trade launch date. This is compared to an average headcount of 80 professional sales representatives and managers during the three months ended March 31, 2005.

Other Income/Expense

Other Income/Expense (dollars in thousands)	2006		Change		2005
Interest income	$	546	157.5	%	$	212

The increase in interest income was due to higher average investment balances and yields in 2006.

Preferred Stock Dividend

Preferred stock dividends included in net loss allocable to common stockholders were $464,000 during the three months ended March 31, 2006 and $400,000 during the three months ended March 31, 2005. Such preferred stock dividends are paid in cash and are the result of our obligations in connection with the issuance of our Series D Cumulative Convertible Preferred Stock, or the Series D Stock, in May 1999. On December 15, 2005, we executed a Restructuring and Exchange Agreement with each of the holders of our outstanding Series D Stock, pursuant to which, among other things, the Series D stockholders agreed to effect an exchange, whereby we exchanged all 200,000 outstanding shares of our Series D Stock for 200,000 shares of our Series D-1 Cumulative Convertible Preferred Stock, or the Series D-1 Stock.

Pursuant to the terms of our Series D-1 Stock, the holders of the Series D-1 Stock are entitled to dividends payable in cash at a current rate of 9.0% per annum, which are declared and paid every six months. The annual dividend rate increases by 1.0% per annum on May 19, 2006 and each subsequent anniversary thereof until the earlier of the date that all of the shares of Series D-1 Stock are (i) converted into shares of common stock, or (ii) redeemed.

Liquidity and Capital Resources

Cash Requirements/Sources and Uses of Cash

We require cash to fund our operating expenses, capital expenditures and dividend payments on our outstanding Series D-1 Stock. We have historically funded our cash requirements primarily through the following:

· Public offerings and private placements of our preferred and common stock;

· Cash flows from operations; and

· Exercise of stock options and warrants.

We believe that other key factors that could affect our internal and external sources of cash are:

· The success of our dermatology franchise;

· Receipt of marketing approvals from the FDA and similar foreign regulatory authorities for our product candidates;

· The success of our preclinical, clinical and development programs (research and development expenses are estimated to be approximately $17.0 million in 2006);

· Revenues and profits from sales of Periostat, Pandel and our other product candidates, as well as the products we co-promote;

· The terms and conditions of our outstanding Series D-1 Stock;

· Our ability to continue to meet the covenant requirements under our revolving credit facility with Silicon Valley Bank and our ability to renew or replace our credit facility; and

· The receptivity of the capital markets to our future financings.

In December 2005 and January 2006, we raised $27.1 million in a public offering, net of placement agency fees and all offering expenses that were payable by us from the sale of 2.9 million shares of our common stock at a price of $10.00 per share.

On June 7, 2004, we entered into a Loan Modification Agreement with Silicon Valley Bank to renew and amend our revolving credit facility, which had expired on March 15, 2004. The amended credit facility expires on May 31, 2006. Under the amended credit facility, we may borrow up to the lesser of $5.0 million or 80% of eligible accounts receivable, as defined under the amended credit facility. The amount available to us is reduced by any outstanding letters of credit that may be issued under the amended credit facility in amounts totaling up to $2.0 million. As we pay down amounts under any letter of credit, the amount available to us under the credit facility increases. We are not obligated to draw amounts under the amended credit facility and any borrowings shall bear interest, payable monthly, at the current prime rate. As of March 31, 2006, we had no outstanding borrowings or letters of credit. We are currently in discussions with Silicon Valley Bank regarding the renewal of the line of credit, however, we cannot offer assurance that such discussions will result in a renewal.

At March 31, 2006, we had cash, cash equivalents and short-term investments of approximately $44.3 million compared to the approximately $44.4 million balance at December 31, 2005.

In accordance with investment guidelines approved by our Board of Directors, cash balances in excess of those required to fund operations have been invested in government notes, commercial paper and money market funds. Our working capital at March 31, 2006 was $39.7 million compared to $34.6 million at December 31, 2005. During the three months ended March 31, 2006, we invested approximately $151,000 in capital expenditures and $200,000 for in-process research and development, paid $900,000 in cash dividends to the holders of our Series D-1 Stock and purchased approximately $3.2 million (net of sales) of short-term investments.

We anticipate that our current cash, cash equivalents and short-term investments at March 31, 2006, will be sufficient to fund our operations through at least mid-2007. However, our forecast of the period of time through which our financial resources will be adequate to support our operations is a forward-looking statement that involves risks and uncertainties, and actual results could vary materially.

Cash Flows/Cash Management

The principal use of cash in operating activities during the three months ended March 31, 2006 was the payment of operating expenses and related working capital liabilities. Cash flows from operations can vary significantly due to various factors including the timing of payments

made to our vendors, including research and development vendors, vendor payment terms, customer mix and customer payment terms.

Investing activities during the three months ended March 31, 2006 consisted primarily of purchases and sales of short-term investments, capital purchases and acquired in-process research and development. Financing activities during the three months ended March 31, 2006 consisted primarily of the cash inflows from the completion of the second tranche of our common stock offering, stock option exercises and the payment of preferred dividends to the holders of our Series D-1 Stock.

Contractual Obligations

Our major outstanding contractual obligations relate to cash dividends on our outstanding Series D-1 preferred stock and operating leases for our office space. The disclosures relating to our contractual obligations in our Annual Report on Form 10-K for the year ended December 31, 2005 have not materially changed since we filed that report.

Critical Accounting Policies and Estimates

Management’s discussion and analysis of its financial position and results of operations are based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these financial statements requires management to make judgments and estimates that affect the reported amounts of assets, liabilities, revenues and expenses and related disclosure of contingent assets and liabilities. Management believes the critical accounting policies and areas that require the most significant judgments and estimates to be used in the preparation of the consolidated financial statements pertain to revenue recognition, stock compensation and the valuation of deferred taxes, acquired product rights and inventory.

Revenue Recognition

Except for Periostat, we recognize product sales revenue upon shipment to wholesale customers, net of estimated future returns, estimates for chargebacks, wholesale distribution fees, if applicable, rebates, generic introductions and current inventory levels in the distribution channel provided that collection was probable and no significant obligations remained. Following the launch of generic competition to Periostat, and commencing with the second quarter of 2005, we began to recognize Periostat sales revenue primarily based on sales to end-users, which we estimate using prescription demand data generated by a leading independent prescription tracking service, as well as on-hand inventory estimates in the distribution channel. Accordingly, since the launch of generic competition to Periostat may increase the rate of product returns from the distribution channel, we have accrued $866,000 for estimated potential Periostat returns in the distribution channel in accrued expenses on the consolidated balance sheet at March 31, 2006.

Pursuant to our Promotion and Cooperation Agreement with Primus, contract revenues for Alcortin and Novacort are fee-based arrangements where revenue is earned as prescriptions are filled and recognized as a percentage of the gross profit earned by Primus. We do not take title to the inventory sold by Primus under the Promotion Agreement.

During the fourth quarter of 2005, we received notice of a grant from the NIH for additional research into the anti-inflammatory effects of incyclinide. We expense such expenditures as research and development as they are incurred and recognize grant revenue for the portion of the expenditures that are reimbursed by the NIH. These revenues are recorded at the time they are submitted for reimbursement.

Deferred Taxes

In assessing the realizability of deferred tax assets, we consider the likelihood that part or all of the deferred tax assets will not be realized. This assessment requires significant judgment and estimates. The ultimate realization of the deferred tax assets is dependent upon the generation of future taxable income during the period in which those temporary differences become deductible. We consider our history of losses, scheduled reversal of deferred tax assets and liabilities and projected future taxable income over the periods in which the deferred tax asset items are deductible. The Tax Reform Act of 1986 contains provisions that may limit the net operating loss and research and experimentation credit carryforwards available to be used in any given year upon the occurrence of certain events, including significant changes in ownership interest. We have incurred a net loss for the three months ended March 31, 2006 and for the year ended December 31, 2005, and uncertainty regarding our future profitability has prevented us from reaching the “more likely than not” conclusion required under the applicable literature to recognize deferred tax assets on our consolidated balance sheet.

Acquired Product Rights

Product rights are stated at cost, amortized over the shorter of the estimated useful life of the products or the contract term which such rights have been licensed, using the straight-line method. Amortization of product rights is charged to cost of product sales.

We are required to test for asset impairment of acquired product rights whenever events or circumstances indicate that the carrying value of an asset may not be recoverable. We apply SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets,” in order to determine whether or not an asset was impaired. This standard requires an impairment analysis when indicators of impairment are present. If such indicators are present, the standard indicates that if the sum of the future expected cash flows from the asset, undiscounted and without interest charges, is less than the carrying value, an asset impairment must be recognized in the financial statements. The amount of the impairment is the difference between the fair value of the asset and the carrying value of the asset.

In making future cash flow analyses of our acquired product rights, we make assumptions relating to: (i) the intended use of the product rights and the expected future cash flows resulting directly from such use; (ii) generic competitor activities and regulatory initiatives that affect our products; and (iii) customer preferences and expected managed care reimbursement.

As a result of a change in the contractual life of the Licensing and Marketing Agreement with QLT USA, Inc., we adjusted the current and future amortization of its acquired product rights asset to reflect an estimated useful life through December 31, 2007.

Inventories

Critical accounting estimates and assumptions, related to inventory carrying values are evaluated periodically and consider the saleable quantities of inventory versus quantities of inventory on-hand.

During the three months ended March 31, 2005, we recorded a charge of $844,000 for the estimated excess inventory of Periostat and Mutual’s branded version of Periostat due to the anticipated decreased demand following the introduction of a third party generic version of Periostat that occurred in May 2005.

Pre-Launch Manufacturing Costs

We classify direct manufacturing costs relating to inventory and samples manufactured in advance of a new product launch as research and development expense until such time as we receive an approval letter from the FDA for a new product, and then we begin to capitalize the inventory costs relating to that product. If we are successful in attaining regulatory approval, the direct manufacturing costs associated with future product sales of approved products in subsequent periods will be recorded net of previously expensed direct manufacturing costs incurred in periods prior to regulatory approval.

Stock-Based Compensation

As part of our adoption of SFAS No. 123R as of January 1, 2006, we recognized the fair value of share-based compensation awards in our consolidated financial statements using the modified prospective method. We apply the Black-Scholes option-pricing model in order to determine the fair value of stock options on the date of grant, and we apply judgment in estimating key assumptions that are important elements in the model, such as the expected stock-price volatility and expected stock option life. Our estimates of these important assumptions and expected forfeiture rates are based on historical data and judgment regarding market trends and factors.

Critical accounting estimates and the related assumptions are evaluated periodically as conditions warrant, and changes to such estimates are recorded as new information or changed conditions require revision.

Recently Issued Accounting Pronouncements

Item 3. Quantitative and Qualitative Disclosures About Market Risk.

We had cash and cash equivalents and short-term investments at March 31, 2006 which are exposed to the impact of interest rate changes and our interest income fluctuates as interest rates change. Due to the short-term nature of our investments in money market funds, the carrying values of our cash equivalents approximate their fair value at March 31, 2006. Our short-term investments in commercial paper certificates of deposit and government notes are carried at fair value.

Item 4. Controls and Procedures.

Our management, with the participation of our chief executive officer and chief financial officer, evaluated the effectiveness of the Company’s disclosure controls and procedures as of March 31, 2006. The term “disclosure controls and procedures,” as defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act, means controls and other procedures of a company that are designed to ensure that information required to be disclosed by a company in the reports that it files or submits under the Exchange Act 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 a company in the reports that it files or submits under the Exchange Act is accumulated and communicated to the company’s management, including its principal executive and principal financial officers as appropriate to allow timely decisions regarding required disclosure. Our management recognizes that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving their objectives and management necessarily applies its judgment in evaluating the cost-benefit relationship of possible controls and procedures. Based on the evaluation of our disclosure controls and procedures as of March 31, 2006, our chief executive officer and chief financial officer concluded that, as of such date, our disclosure controls and procedures were effective at the reasonable assurance level.

No change in our internal control over financial reporting (as defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) occurred during the fiscal quarter ended March 31, 2006 that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

PART II. OTHER INFORMATION

Item 1A. Risk Factors

Statements contained or incorporated by reference in this Quarterly Report on Form 10-Q that are not based on historical fact are “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995, Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Exchange Act of 1934, as amended. These forward-looking statements regarding future events and our future results are based on current expectations, estimates, forecasts, and projections and the beliefs and assumptions of our management including, without limitation, our expectations regarding results of operations, selling, general and administrative expenses, research and development expenses, the sufficiency of our cash for future operations, and the success of our preclinical, clinical and development programs and our dermatology franchise. Forward-looking statements may be identified by the use of forward-looking terminology such as “may,” “could,” “will,” “expect,” “estimate,” “anticipate,” “continue,” or similar terms, variations of such terms or the negative of those terms.

We cannot assure investors that our assumptions and expectations will prove to have been correct. Important factors could cause our actual results to differ materially from those indicated or implied by forward-looking statements. Such factors that could cause or contribute to such differences include those factors discussed below. We undertake no intention or obligation to update or revise any forward-looking statements, whether as a result of new information, future events or otherwise. If any of the following risks actually occur, our business, financial condition or results of operations would likely suffer.

The following discussion includes one revised risk factor (“If we are not able to obtain and enforce patent protection for Oracea or our other discoveries, our ability to commercialize our product candidates successfully will be harmed and we may not be able to operate our business profitably.”) that reflects developments subsequent to the discussion of risk factors included in our most recent Annual Report on Form 10-K. In addition, we have deleted the risk factor entitled “Changes in stock option accounting rules may have a significant adverse affect on our operating results.”

We are depending heavily on the success of our most advanced product candidate, Oracea, for the treatment of rosacea, which is still under regulatory review. If we are unable to obtain approval for and commercialize Oracea, or experience significant delays in doing so, our business will be materially harmed.

We have invested a significant portion of our recent efforts and financial resources in the development of our most advanced product candidate, Oracea, for the treatment of rosacea. Our ability to generate substantial product revenues from Oracea, if ever, will depend heavily on the successful development and commercialization of Oracea. The success of Oracea will depend on several factors, including the following:

· receipt of marketing approvals from the FDA and similar foreign regulatory authorities; and

· acceptance of the product by patients, the medical community and third party payors.

If we are unable to obtain FDA approval for and successfully commercialize Oracea, we may never realize revenue from this product candidate and we may have to curtail our other product development programs. As a result, our business would be materially harmed.

We cannot rely on regulatory protections to prevent the approval of generic equivalents of our products.

In connection with the regulatory approval process, some approved new drug products can obtain exclusivity that will prevent generic versions of the products from entering the marketplace for a period of time. In the United States, market exclusivity is available for new chemical entities and for significant changes in already approved drug products, such as a new use.

Market exclusivity is, however, not available to drugs that contain an active ingredient that has already been approved as an antibiotic. On January 19, 2005, the United States District Court for the District of Columbia upheld the FDA’s application of this principle to Periostat and determined that Periostat was not entitled to market exclusivity because its active ingredient, doxycycline, had previously been approved as an antibiotic. Because Oracea also contains doxycycline as its active ingredient, it will also not be entitled to market exclusivity.

In the European Community regulatory market exclusivity is a function of how long the competent authorities may determine that data submitted in marketing approval applications may not be referenced by others. The period of so-called data exclusivity to which a new product may be entitled can vary from eleven years to none at all. This depends on how a product is classified and can turn on the application of regulatory standards of which there has been no authoritative interpretation to date. We cannot predict what period of data exclusivity, if any, may be enjoyed by Oracea in the European Community.

With limited or no market exclusivity it can be more difficult for us to prevent competitors from seeking approval for copies of our proprietary products, and in such a case the value of such products would be materially adversely affected. Without market exclusivity, generic versions of our products could quickly gain market entry if they meet regulatory approval criteria. Thus, even if we gain approval of Oracea, because it will not be entitled to patent or non-patent market exclusivity, third parties may enter the market which would materially harm our business.

If we are not able to obtain and enforce patent protection for Oracea or our other discoveries, our ability to commercialize our product candidates successfully will be harmed and we may not be able to operate our business profitably.

Our success depends, in part, on our ability to protect proprietary methods and technologies that we develop under the patent and other intellectual property laws of the United States and other countries, so that we can prevent others from using our inventions and proprietary information. However, we may not hold or obtain proprietary rights to some patents related to our current or future products and technologies, and we may not, under relevant patent laws, be considered to be inventors of technologies we believe we have developed.

Because publications of discoveries in scientific literature lag behind actual discoveries, and such publications may not come to light despite diligent searches, we cannot be certain that we were the first to make the inventions claimed in our issued patents or pending patent applications. Similarly, because patent applications in the United States and many foreign jurisdictions are typically not published until 18 months after filing, or in some cases not at all, we cannot be certain that we were the first to make the inventions claimed or to file for protection of the inventions set forth in our patent applications. As a result, we may not be

granted additional patents or our existing patents may be found to be invalid. We may also be required to obtain licenses under third-party patents to market our proposed products. If licenses are not available to us on acceptable terms, or at all, we will not be able to market the affected products.

Our strategy depends on our ability to identify our discoveries rapidly and to seek patent protection for them. This process is expensive and time consuming, and we may not be able to file and prosecute all necessary or desirable patent applications at a reasonable cost or in a timely manner. Despite our efforts to protect our proprietary rights, unauthorized parties may be able to obtain and use information that we regard as proprietary. The issuance of a patent does not guarantee that it is valid or enforceable, so even if we obtain patents, they may not be valid or enforceable against third parties. In addition, the issuance of a patent does not guarantee that we have the right to practice the patented invention. Third parties may have blocking patents that could be used to prevent us from marketing our own patented product and practicing our own patented technology.

Our pending patent applications may not result in issued patents. The patent position of pharmaceutical or biotechnology companies, including ours, is generally uncertain and involves complex legal and factual considerations. The standards which the United States Patent and Trademark Office, or USPTO, and its foreign counterparts use to grant patents are not always applied predictably or uniformly and can change. There is also no uniform, worldwide policy regarding the subject matter and scope of claims granted or allowable in pharmaceutical or biotechnology patents. The laws of some foreign countries do not protect proprietary information to the same extent as the laws of the United States, and many companies have encountered significant problems and costs in protecting their proprietary information in these foreign countries. 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 to others. The allowance of broader claims may increase the incidence and cost of patent interference proceedings and/or opposition proceedings. On the other hand, the allowance of narrower claims may limit the value of our proprietary rights.

If issued, our patent for Oracea may not contain claims sufficiently broad to protect us against third parties with similar products, or provide us with any competitive advantage. Moreover, once issued, any of our patents may be challenged, narrowed, invalidated or circumvented. In addition, the patent rights in our products that derive from claims under method of use patents may be hard to assert or enforce if medical professionals prescribe similar (including generic), though non-approved, doxycycline products for indications covered by our patents. If our patents are invalidated or otherwise limited, other companies will be better able to develop products and technologies that compete with ours, which could adversely affect our competitive business position, business prospects and financial condition.

We cannot assure you that our pursuit of business in the dermatology market will be successful.

We continue to implement our plans to expand into the dermatology market. We recently submitted a New Drug Application with the FDA for Oracea to treat rosacea, and we continue to seek additional product licensing opportunities to enhance our near-term offerings to the dermatology market. We have also been allowed patents by the USPTO and European patent

office for the use of sub-anti-microbial tetracyclines for the treatment of acne and acne rosacea, including Oracea.

While we have experience in the sales and marketing of dental products, we have limited experience in the dermatology market. This market is very competitive and some of our competitors have substantially greater resources than we have. Our future success will depend on, among other things, our ability to: (i) achieve market acceptance for any current or future dermatological offerings; (ii) hire and retain personnel with experience in the dermatology market; (iii) execute our business plan with respect to this market segment; and (iv) adapt to technical or regulatory changes once operational.

At the same time, new product development is a lengthy, complex and uncertain process that will require significant attention and resources from management. A product candidate can fail at any stage of the development process due to, among other things, efficacy or safety concerns, the inability to obtain necessary regulatory approvals, the difficulty or excessive cost to manufacture and/or the infringement of patents or intellectual property rights of others. Furthermore, the sales of new products may prove to be disappointing and fail to reach anticipated levels. We therefore cannot assure you that we will be successful in our pursuit of business in the dermatology market, or that we can sustain any business in which we achieve initial success.

The success of our current technology platforms, and that of any other future technology platforms we may purchase or in-license, will depend on the quality and integrity of the technologies licensed or sold to us. Despite our due diligence and the safeguards we have in place, we cannot guarantee the effectiveness or integrity of such technologies, nor can we be certain that others do not have intervening rights in such technologies. If any of our in-licensed technologies proved ineffective, or if a third party successfully asserted any right to such technologies, our ability to develop new products and implement our strategies would be materially adversely affected.

If we are not able to obtain required regulatory approvals, we will not be able to commercialize our product candidates, and our ability to generate revenue will be materially impaired.

Failure to obtain regulatory approval for a product candidate will prevent us from commercializing the product candidate. Other than Periostat, we have not received regulatory approval to market any of our product candidates in any jurisdiction. We have only limited experience in filing and prosecuting the applications necessary to gain regulatory approvals. Securing FDA approval requires the submission of extensive preclinical and clinical data, information about product manufacturing processes and inspection of facilities and supporting information to the FDA for each therapeutic indication to establish the product candidate’s safety and efficacy. Our future products may not be effective, may be only moderately effective or may prove to have undesirable or unintended side effects, toxicities or other characteristics that may preclude our obtaining regulatory approval or prevent or limit commercial use.

The process of obtaining regulatory approvals is expensive, often takes many years, if approval is obtained at all, and can vary substantially based upon, among other things, the type, complexity and novelty of the product candidates involved. Changes in the regulatory approval policy during the development period, changes in or the enactment of additional statutes or

regulations, or changes in regulatory review for each submitted product application, may cause delays in the approval or rejection of an application.

The FDA, and comparable authorities in other countries, have substantial discretion in the approval process and may refuse to accept any application or may decide that our data is insufficient for approval and require additional preclinical, clinical or other studies. In addition, varying interpretations of the data obtained from preclinical and clinical testing could influence how a product candidate is classified and delay, limit or prevent regulatory approval of a product candidate. Any regulatory approval we ultimately obtain may be limited or subject to restrictions or post-approval commitments that render the product not commercially viable.

Even if regulatory approval of a product is granted, the approval may be subject to limitations on the indicated uses for which the product may be marketed or to the conditions of approval, or contain requirements for costly post-marketing testing and surveillance to monitor the safety or efficacy of the product.

If we lose our sole supplier of doxycycline or our manufacturer of Oracea, our sales of Oracea, if any, will be interrupted, halted or less profitable.

We do not have the resources, facilities or capabilities to manufacture any of our products or product candidates. We have no current plans to establish a manufacturing facility. We expect that we will be dependent, to a significant extent, on contract manufacturers for commercial scale manufacturing of our products or product candidates in accordance with regulatory standards.

We rely on a supplier, Hovione International Limited, or Hovione, as our sole supplier for doxycycline, the active ingredient in Oracea. We are seeking a back-up supplier, but there are relatively few alternative suppliers of doxycycline, and Hovione produces the majority of the doxycycline used in the United States. Our current supply agreement with Hovione expires on May 14, 2006 and thereafter automatically renews for successive two-year periods unless, 90 days prior to the expiration of any such periods, either party gives the other party written notice of termination. In addition, in the event of a default, uncured for 90 days, the non-defaulting party can terminate the supply agreement effective immediately at the end of such ninety-day period. Although Hovione maintains two manufacturing locations, if we achieve FDA approval for Oracea and are unable to procure a commercial quantity of doxycycline from Hovione on an ongoing basis at a competitive price, if Hovione fails to comply with current Good Manufacturing Practices or if we cannot find a replacement supplier in a timely manner or with favorable pricing terms, our costs may increase significantly and we may experience delays in the supply of Oracea.

We entered into an agreement effective December 31, 2005 with Cardinal Health PTS, LLC, or PTS, pursuant to which PTS has agreed to manufacture Oracea for us. Pursuant to the terms of the agreement, we agree to (i) furnish to PTS on a monthly basis a rolling forecast of product quantities for the subsequent twelve-month period, the first three months of which shall become binding, and (ii) pay PTS a fee for the product, subject to an annual adjustment. The agreement has an initial term of four years unless terminated earlier pursuant to its terms.

We intend to contract with additional manufacturers for the commercial manufacture of an Oracea capsule. We believe, however, that it could take up to one year to validate successfully a secondary manufacturer. We cannot be certain that we will be able to enter into

additional agreements on acceptable terms, if at all. In the event that Oracea is approved by the FDA and we are unable to obtain sufficient quantities of doxycycline or Oracea on commercially reasonable terms, or in a timely manner, our business, financial condition and results of operations would be materially adversely affected.

If the federal regulatory status of Alcortin or Novacort changes, we may be unable to continue to market one or both of these products.

We market two products, Alcortin and Novacort, under a Promotion and Cooperation Agreement with Primus. The majority of sample product costs and all sales force compensation related to our promotion of Alcortin and Novacort are funded by us. Primus is responsible for the manufacture of Alcortin and Novacort and it has not sought FDA approval for these products because it believes that no approval is required. We cannot be sure that FDA will not object to the lack of approval for these products. If the FDA were to assert that these products required approval, it could at any time seek to take administrative or judicial actions which could prevent us from marketing these products. Our inability to market these products could result in a temporary or permanent loss of revenue, which may be partially offset by a reduction in our promotional expenses related to these products.

Our products could be subject to restrictions or withdrawal from the market and we may be subject to penalties if we fail to comply with regulatory requirements. Both before and after approval or clearance, we, our vendors and suppliers, and our products and product candidates are subject to extensive regulatory requirements. Failure to comply with these requirements could subject us to administrative and judicial sanctions.

Both before and after approval or clearance of our products, we, our products, and our manufacturers are subject to extensive regulatory requirements covering, among other things, manufacturing, advertising and promotion, labeling, adverse event reporting, post-approval commitments, registration, record-keeping, export, and distribution of samples. Failure to comply with regulatory requirements may result in:

· restrictions on such products, manufacturers or manufacturing processes;

· warning letters;

· withdrawal of the products from the market;

· refusal to approve pending applications or supplements to approved applications that we submit;

· recall;

· fines;

· suspension or withdrawal of regulatory approvals;

· refusal to permit the import or export of our products;

· product seizure; and

· injunctions or the imposition of civil or criminal penalties.

We cannot predict with certainty the effect on our business of the decline in revenues generated by the dental business following the commercial launch of generic versions of Periostat and the termination of our dental sales force.

We have historically relied on sales of Periostat and Mutual’s branded version of Periostat, together with revenues generated by the other products that made up our dental business, for most of our revenue. During the three months ended March 31, 2006 and each of the years ended December 31, 2005, 2004 and 2003, Periostat and Mutual’s branded version of Periostat supplied by us (with respect to the three months ended March 31, 2006 and the years ended December 31, 2005 and 2004), accounted for approximately 42%, 76%, 88% and 82% of our total net revenues, respectively.

On May 13, 2005, the FDA approved a third party generic version of Periostat and a generic product was launched soon thereafter in late May 2005. Upon this generic launch, Mutual was no longer obligated to purchase and is not expected to purchase their branded product from us. We do not anticipate future shipments of Mutual’s branded version of Periostat supplied by us. In addition, we have had to disband our dental sales force and delay or discontinue certain research and development activities in the dental business. Consequently, while we continue to generate cash flow from our dental business, our revenues and margins from Periostat and the other dental products we sell have decreased significantly and will likely continue to decrease as a result of the third party introduction of a generic version of Periostat. If this decrease is more significant than we expect, and is combined with slow growth in, or a lack of revenues, if any, from new products, we may experience difficulty in managing our cash, which could have a material adverse effect on our ability execute our strategies and develop our dermatology business.

We will need substantial additional funding and may be unable to raise capital when needed, which would force us to delay, reduce or eliminate our product development programs and commercialization efforts.

We expect that our research and development expenses will increase in connection with our ongoing activities and that we will incur significant commercialization expenses as we expand our marketing and sales efforts. We will need substantial additional funding and may be unable to raise capital when needed or on attractive terms, which would force us to delay, reduce or eliminate our research and development programs and commercialization activities.

We anticipate that our current cash, cash equivalents and short-term investments at March 31, 2006 will be sufficient to fund our operations through at least mid-2007. However, our forecast of the period of time through which our financial resources will be adequate to support our operations involves risks and uncertainties, and actual results could vary materially. Our future funding requirements will depend on many factors, including:

· the cost of commercialization activities, including product marketing and sales;

· the success of our dermatology franchise;

· the success of our preclinical, clinical and development programs;

· revenues and profits from sales of Periostat, Pandel and our other product candidates, as well as the products we co-promote;

· the terms and conditions of our outstanding Series D-1 Stock;

· our ability to continue to meet the covenant requirements under our revolving credit facility with Silicon Valley Bank;

· the costs involved in preparing, filing, prosecuting, maintaining and enforcing patent claims and other patent-related costs, including potential litigation costs and the results of such litigation;

· the extent to which we acquire or invest in businesses, products and technologies;

· the costs involved in obtaining regulatory approvals and clearances required to market and sell our products;

· our ability to establish and maintain additional collaborations; and

· the receptivity of the capital markets to our future financings.

Until such time, if ever, as we can generate substantial product revenues, we expect to finance our cash needs through public or private equity offerings, debt financings and corporate collaboration and licensing arrangements. If we raise additional funds by issuing equity securities, our stockholders may experience dilution. Debt financing, if available, may involve agreements that include covenants limiting or restricting our ability to take specific actions, such as incurring additional debt, making capital expenditures or declaring dividends. Any debt financing or additional equity that we raise may contain terms, such as liquidation and other preferences, that are not favorable to us or our stockholders. If we raise additional funds through collaboration and licensing arrangements with third parties, it may be necessary to relinquish valuable rights to our technologies, research programs or products or grant licenses on terms that may not be favorable to us.

We cannot assure you that our clinical trials will be completed in a timely manner or will meet agreed upon end-points.

As part of our plans to expand into the dermatology market, we will need to conduct extensive testing of our products, pursuant to protocols that measure end points agreed with the FDA or other regulatory agencies. We cannot guarantee that Phase I, Phase II, or Phase III testing for our products in development will be completed successfully within any specified period of time, if at all. Many products that initially appear promising are found, after clinical evaluation, not to be safe and effective. Also, we, or the FDA, may suspend clinical trials at any time on various grounds, including a finding that the subjects or patients are being exposed to an unacceptable health risk.

Delays in patient enrollment in clinical trials may result in increased costs and delays, which could have a harmful effect on our ability to develop products.

It may take several years to complete the testing of a product, and failure can occur at any stage of testing. For example:

· interim results of preclinical or clinical studies do not necessarily predict their final results, and results in early studies might not be seen in later studies;

· potential products that appear promising at early stages of development may ultimately fail for a number of reasons, including the possibility that the products may be ineffective, less effective than products of our competitors or cause harmful side effects;

· any preclinical or clinical test may fail to produce results satisfactory to the FDA or foreign regulatory authorities;

· preclinical and clinical data can be interpreted in different ways, which could delay, limit or prevent regulatory approval;

· we may not be able to manufacture the investigational or commercial product in sufficient quantity or quality or at acceptable cost;

· negative or inconclusive results from a preclinical study or clinical trial or adverse medical events during a clinical trial could cause a preclinical study or clinical trial to be repeated or a program to be terminated, even if other studies or trials relating to the program are successful;

· the FDA can place a hold on a clinical trial if, among other reasons, it finds that patients enrolled in the trial are or would be exposed to an unreasonable and significant risk of illness or injury;

· we may encounter delays or rejections based on changes in regulatory agency policies during the period in which we develop a drug or the period required for review of any application for regulatory agency approval; and

· our clinical trials may not demonstrate the safety and efficacy needed for our products to receive regulatory approval.

If we are required to conduct additional clinical trials or other studies beyond those that we currently contemplate, if we are unable to successfully complete our clinical trials or other studies or if the results of these trials or studies are not positive or are only modestly positive, we may be delayed in obtaining marketing approval, we may not be able to obtain marketing approval or we may obtain approval for indications that are not as broad as intended. Our product development costs will also increase if we experience delays in testing or approvals. Significant clinical trial delays could allow our competitors to bring products to market before we do and impair our ability to commercialize our products or potential products. If any of this occurs, our business will be materially harmed.

If we infringe or are alleged to infringe intellectual property rights of third parties, it will adversely affect our business.

Our research, development and commercialization activities, as well as any product candidates or products resulting from these activities, may infringe or be claimed to infringe patents or patent applications under which we do not hold licenses or other rights. Third parties may own or control these patents and patent applications in the United States and abroad. These

third parties could bring claims against us or our collaborators that would cause us to incur substantial expenses and, if successful against us, could cause us to pay substantial damages. Further, if a patent infringement suit were brought against us or our collaborators, we or they could be forced to stop or delay research, development, manufacturing or sales of the product or product candidate that is the subject of the suit.

As a result of patent infringement claims, or in order to avoid potential claims, we or our collaborators may choose or be required to seek a license from the third party and be required to pay license fees or royalties or both. These licenses may not be available on acceptable terms, or at all. Even if we or our collaborators were able to obtain a license, the rights may be nonexclusive, which could result in our competitors gaining access to the same intellectual property. Ultimately, we could be prevented from commercializing a product, or be forced to cease some aspect of our business operations, if, as a result of actual or threatened patent infringement claims, we or our collaborators are unable to enter into licenses on acceptable terms. This could harm our business significantly.

There has been substantial litigation and other proceedings regarding patent and other intellectual property rights in the pharmaceutical and biotechnology industries. In addition to infringement claims against us, we may become a party to other patent litigation and other proceedings, including interference proceedings declared by the USPTO and opposition proceedings in the European Patent Office, regarding intellectual property rights with respect to our products and technology. The cost to us of any patent litigation or other proceeding, even if resolved in our favor, could be substantial. Some of our competitors may be able to sustain the costs of such litigation or proceedings more effectively than we can because of their substantially greater financial resources. Uncertainties resulting from the initiation and continuation of patent litigation or other proceedings could have a material adverse effect on our ability to compete in the marketplace. Patent litigation and other proceedings may also absorb significant management time.

We depend upon third party researchers and providers of clinical services to perform as contractually required if we are to be successful in bringing new products to market.

We do not have the ability independently to conduct the clinical trials required to obtain regulatory approval for our products. We rely on independent clinical investigators, contract research organizations and other third party service providers for successful execution of our clinical trials, but do not control many aspects of their activities. We are responsible for ensuring that each of our clinical trials is conducted in accordance with the general investigational plan, protocols for the trial and applicable regulatory requirements. Moreover, the FDA requires us to comply with standards, commonly referred to as Good Clinical Practices, for conducting and recording and reporting the results of clinical trials to assure that data and reported results are credible and accurate and that the rights, integrity and confidentiality of trial participants are protected. Our reliance on third parties that we do not control does not relieve us of these responsibilities and requirements. Third parties may not, however, complete activities on schedule, or may not conduct our clinical trials in accordance with regulatory requirements or our stated protocols. Furthermore the data that they generate may not be accurate or may, in extreme cases, be fraudulent.

Our ability to bring our future products to market depends on the quality and integrity of the data we present to regulatory authorities in order to obtain marketing authorizations. We

cannot guarantee the authenticity or accuracy of such data, nor can we be certain that such data has not been fraudulently generated. The failure of these third parties to carry out their obligations would materially adversely affect our ability to develop and market new products and implement our strategies.

We depend upon certain key relationships to generate much of the technology required to maintain our competitive position in the marketplace.

Our IMPACS technology is licensed from SUNY, referred to herein as the SUNY License, and other academic and research institutions collaborating with SUNY. Under the SUNY License, we have an exclusive worldwide license to SUNY’s rights in certain patents and patent applications to make and sell products employing tetracyclines to treat certain disease conditions. The SUNY License imposes various payment and reporting obligations on us, and our failure to comply with these requirements permits SUNY to terminate the SUNY License. If the SUNY License is terminated, we would lose our right to exclude competitors from commercializing similar products, and we could be excluded from marketing the same products if SUNY licensed the underlying technology to a competitor after terminating the SUNY License. The SUNY License is terminable by SUNY on 90 days prior notice only upon our failure to make timely payments, reimbursements or reports, if the failure is not cured by us within 90 days. The termination of the SUNY License, or the failure to obtain and maintain patent protection for our technologies, would have a material adverse effect on our business, financial condition, liquidity and results of operations.

If our products cause injuries, we may incur significant expense and liability.

Our business may be adversely affected by potential product liability claims arising out of the testing, manufacturing and marketing of Periostat and other products developed by or for us or for which we have licensing or promotion and cooperation rights. We have an aggregate of $10.0 million in product liability insurance covering Periostat and Mutual’s branded version of Periostat, our product candidates and products for which we have licensing or promotion and cooperation rights.

Our insurer has also notified us that our general product liability policy will not cover claims arising from our past sales of Vioxx, to the extent such claims are made after December 31, 2004. This does not affect our rights under the Co-Promotion Agreement with Merck, which provides for indemnification of us by Merck against any claims arising from manufacturing or design defects in the Vioxx product or for which we, as the seller of the product, may be strictly liable as a seller of an inherently dangerous product.

Our insurance may not adequately protect us against product liability claims. Insufficient insurance coverage or the failure to obtain indemnification from third parties for their respective liabilities may expose us to product liability claims and/or recalls and could cause our business, financial condition and results of operations to decline.

Our stock price is highly volatile and, therefore, the value of your investment may fluctuate significantly.

The market price of our common stock has fluctuated and may continue to fluctuate as a result of variations in our quarterly operating results. These fluctuations may be exaggerated if the trading volume of our common stock is low. In addition, the stock market in general has

experienced dramatic price and volume fluctuations from time to time. These fluctuations may or may not be based upon any business or operating results. Our common stock may experience similar or even more dramatic price and volume fluctuations that may continue indefinitely.

The following table sets forth the high and low last sale prices per share for our common stock for each of the quarters in the period beginning April 1, 2004 through March 31, 2006, as reported on the Nasdaq National Market:

Quarter Ended	High		Low
June 30, 2004	$	13.21	$	8.70
September 30, 2004	$	9.49	$	6.09
December 31, 2004	$	7.49	$	5.37

March 31, 2005	$	7.52	$	4.50
June 30, 2005	$	7.61	$	3.99
September 30, 2005	$	9.95	$	7.15
December 31, 2005	$	12.07	$	8.50

March 31, 2006	$	14.80	$	11.27

Item 6. Exhibits.

31.1		Certification pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

31.2		Certification pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

32.1		Certification Pursuant to 18 U.S.C. Section 1350.

SIGNATURES

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

		CollaGenex Pharmaceuticals, Inc.


Date: May 8, 2006	By:	/s/ Colin W. Stewart
		Colin W. Stewart
		President and Chief Executive Officer
		(Principal Executive Officer)


Date: May 8, 2006	By:	/s/ Nancy C. Broadbent
		Nancy C. Broadbent
		Chief Financial Officer (Principal
		Financial and Accounting Officer)

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Collagenex Pharmaceuticals Inactive 10-Q2006 Q1 Quarterly report

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