Encysive Pharmaceuticals 10Q 2006 Q2 Quarterly report

UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark One)


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

FOR QUARTERLY PERIOD ENDED JUNE 30, 2006


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

Commission File Number: 0-20117

ENCYSIVE PHARMACEUTICALS INC.

(Exact name of registrant as specified in its charter)


Delaware		13-3532643

(State or other jurisdiction of		(I.R.S. Employer Identification No.)
incorporation or organization)


4848 Loop Central Drive, Suite 700, Houston, Texas		77081

(Address of principal executive office)		(Zip code)

(713) 796-8822

(Registrant’s telephone number, including area code)

Not Applicable

(Former name, former address and former fiscal year, if changed since last report)

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

Indicate the number of shares outstanding of each of the issuer’s classes of Common Stock, exclusive of treasury shares, as of the latest practicable date.


Class		Outstanding at July 31, 2006

Common stock, $0.005 par value		59,255,103

ENCYSIVE PHARMACEUTICALS INC.

TABLE OF CONTENTS


	PAGE NO.
Part I. Financial Information

Item 1: Financial Statements (Unaudited)

Consolidated Balance Sheets as of June 30, 2006 and December 31, 2005		1

Consolidated Statements of Operations and Comprehensive Loss for the three and six months ended June 30, 2006 and 2005		2

Consolidated Statements of Cash Flows for the six months ended June 30, 2006 and 2005		3

Notes to Consolidated Financial Statements		4

Item 2: Management’s Discussion And Analysis Of Financial Condition And Results Of Operations		12

Item 3: Quantitative And Qualitative Disclosures About Market Risk		22

Item 4: Controls And Procedures		22

Part II. Other Information

Item 1: Legal Proceedings		22

Item 1A: Risk Factors		22

Item 2: Unregistered Sales of Equity Securities and Use of Proceeds		24

Item 3: Defaults Upon Senior Securities		24

Item 4: Submission Of Matters To A Vote Of Security Holders		25

Item 5: Other Information		25

Item 6: Exhibits		25

SIGNATURES		26
Separation Agreement
Transition Agreement
Certification of CEO pursuant to Rule 13a-14(a)/15d-14(a)
Certification of CFO pursuant to Rule 13a-14(a)/15d-14(a)
Certification Pursuant to 18 U.S.C. Section 1350
Certification Pursuant to 18 U.S.C. Section 1350

ENCYSIVE PHARMACEUTICALS INC. AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS

($ in thousands, except per share data)

(Unaudited)


	June 30,			December 31,
	2006			2005
ASSETS
Current assets:
Cash and cash equivalents	$	65,443		$	127,913
Short-term investments		9,974			—
Accounts receivable		3,391			5,337
Other current receivables		40			139
Inventory		2,526			2,183
Prepaids		1,634			1,677

Total current assets		83,008			137,249
Equipment and leasehold improvements, net		6,006			4,942
Deferred debt origination costs, net of accumulated amortization of $867 and $538		3,796			4,125
Intangible assets, net of accumulated amortization of $632 and $580		334			386

Total assets	$	93,144		$	146,702


LIABILITIES AND STOCKHOLDERS DEFICIT
Current liabilities:
Accounts payable	$	4,680		$	3,218
Accrued expenses		20,696			21,645
Deferred revenue		1,288			1,288

Total current liabilities		26,664			26,151
Deferred revenue		642			1,286
Long-term debt		130,000			130,000

Commitments and contingencies		—			—

Stockholders’ deficit:
Preferred stock, par value $.005 per share. 5,000,000 Shares authorized; none issued or outstanding		—			—
Common stock, par value $.005 per share. 150,000,000 shares authorized. At June 30, 2006, 59,460,176 shares issued, 59,247,176 outstanding; at December 31, 2005, 58,869,398 shares issued, 58,656,398 shares outstanding		297			294
Additional paid-in capital		313,639			306,402
Deferred compensation expense		(5,493	)		(2,834	)
Treasury stock, 213,000 shares at June 30, 2006 and December 31, 2005		(1,602	)		(1,602	)
Accumulated deficit		(371,003	)		(312,995	)

Total stockholders’ deficit		(64,162	)		(10,735	)

Total liabilities and stockholders’ deficit	$	93,144		$	146,702

See accompanying notes to consolidated financial statements

ENCYSIVE PHARMACEUTICALS INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF OPERATIONS

AND COMPREHENSIVE LOSS

($ in thousands, except per share data)

(Unaudited)


	Three Months Ended						Six Months Ended
	June 30,						June 30,
	2006			2005			2006			2005
Revenues:
Royalty income	$	3,340		$	2,654		$	6,579		$	5,000
License fee and milestones		322			322			644			462

Total Revenues		3,662			2,976			7,223			5,462

Expenses:
Research and development		14,676			17,366			33,055			33,681
Sales and marketing		11,767			3,263			21,603			4,380
General and administrative		5,364			3,605			11,106			6,199

Total expenses		31,807			24,234			65,764			44,260

Operating loss		(28,145	)		(21,258	)		(58,541	)		(38,798	)
Investment income		1,085			1,339			2,384			1,933
Interest expense		(978	)		(976	)		(1,958	)		(1,147	)

Loss from continuing operations		(28,038	)		(20,895	)		(58,115	)		(38,012	)
Income from discontinued operations		—			1,661			—			1,335

Loss before cumulative effect of change in accounting principle	$	(28,038	)		(19,234	)		(58,115	)		(36,677	)
Cumulative effect of change in accounting principle		—			—			107			—

Net loss applicable to common shares	$	(28,038	)	$	(19,234	)	$	(58,008	)	$	(36,677	)

Other comprehensive income:
Reclassification adjustment for gains included in net loss		—			(222	)		—			(189	)
				��
Comprehensive loss	$	(28,038	)	$	(19,456	)	$	(58,008	)	$	(36,866	)

Loss per share:
Continuing operations, basic and diluted	$	(0.48	)	$	(0.33	)	$	(0.99	)	$	(0.63	)

Weighted average common shares used To compute net loss per share basic And diluted		58,464,618			57,895,298			58,367,915			57,776,253

See accompanying notes to consolidated financial statements

ENCYSIVE PHARMACEUTICALS INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS

($ in thousands)

(Unaudited)


	Six Months Ended June 30,
	2006			2005 (Revised)
Cash flows from operating activities:
Net loss	$	(58,008	)	$	(36,677	)
Adjustments to reconcile net loss to cash used In operating activities:
Income from discontinued operations		—			(1,335	)
Depreciation and amortization		499			494
Expenses paid with stock		50			616
Share-based compensation expense		4,101			111
Amortization of debt issue costs		329			203
Loss on disposition of fixed assets		33			7
Change in interest receivable included in short-term investments		—			(249	)
Changes in operating assets and liabilities:
Accounts receivable		1,946			1,952
Inventory		(343	)		—
Prepaids		43			(426	)
Other current receivables		99			117
Accounts payable and accrued expenses		513			4,681
Deferred revenue		(644	)		1,538

Net cash used in operating activities		(51,382	)		(28,968	)
Net cash used in discontinued operation		—			(603	)

Net cash used in operating activities		(51,382	)		(29,571	)


Cash flows from investing activities:
Purchases of equipment and leasehold improvements		(1,544	)		(1,473	)
Purchases of investments		(9,974	)		(73,274	)
Maturity of investments		—			51,261

Net cash used in investing activities		(11,518	)		(23,486	)


Cash flows from financing activities:
Borrowing of long-term debt		—			130,000
Debt issue costs		—			(4,663	)
Proceeds from option exercises		430			456

Net cash provided by financing activities		430			125,793


Effect of exchange rate changes on cash		—			(52	)

Net (decrease) increase in cash and cash equivalents		(62,470	)		72,684
Cash and cash equivalents at beginning of period		127,913			46,130

Cash and cash equivalents at end of period	$	65,443		$	118,814


Supplemental schedule of cash flow information:
Interest paid		1,625			6

See accompanying notes to consolidated financial statements

ENCYSIVE PHARMACEUTICALS INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

June 30, 2006 (unaudited)

(1) Basis of Presentation

The accompanying unaudited consolidated financial statements of Encysive Pharmaceuticals Inc., a Delaware corporation, and its subsidiaries (collectively referred to as the “Company” or “Encysive”) have been prepared in accordance with United States of America (“U.S.”) generally accepted accounting principles for interim financial information and with the instructions to Form 10-Q and Rule 10-01 of Regulation S-X. They do not include all information and notes required by U.S. generally accepted accounting principles for complete financial statements. It is recommended that these interim condensed consolidated financial statements be read in conjunction with the consolidated financial statements and notes thereto included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2005. Except as disclosed herein, there has been no material change in the information disclosed in the notes to the consolidated financial statements included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2005. In the opinion of management, all adjustments (consisting only of normal recurring accruals) considered necessary for a fair presentation have been included. Operating results for the three and six month periods ended June 30, 2006, are not necessarily indicative of the results that may be expected for any other interim period, or for the year ending December 31, 2006.

(2) Organization and Significant Accounting Policies

(a) Organization

Encysive is a biopharmaceutical company focused on the discovery, development and commercialization of novel synthetic small molecule compounds to address unmet medical needs. The Company’s research and development programs are predominantly focused on the treatment and prevention of interrelated diseases of the vascular endothelium and exploit its expertise in the area of the intravascular inflammatory process, referred to as the inflammatory cascade, and vascular diseases. Since its formation in 1989, the Company has been engaged principally in research and drug discovery programs and clinical development of certain drug compounds.

The Company is presently working on a number of long-term development projects that involve experimental and unproven technology, which may require many years and substantial expenditures to complete, and which may or may not be successful. Sales of the Company’s first product approved by the U.S. Food and Drug Administration, (“FDA”), Argatroban, for which it receives royalty income, began during November 2000.

(b) Basis of Consolidation

��The Company’s consolidated financial statements include the accounts of the Company, its wholly owned subsidiaries, ImmunoPharmaceutics, Inc. (“IPI”), a California corporation; Encysive, L.P. (“ELP”), a Delaware limited partnership; EP-ET, LLC, a Delaware limited liability company; and Encysive (UK) Limited, a private company located in the United Kingdom (UK). The Company’s consolidated financial statements for the year ended December 31, 2005, and those related to prior year periods included in this Quarterly Report on Form 10-Q also included Revotar Biopharmaceuticals AG (“Revotar”), a German corporation, which was a majority-owned subsidiary until May 2005. In May 2005, the Company and the other shareholders of Revotar consummated a restructuring (the “Restructuring”) whereby the Company’s ownership of Revotar was divested. Financial statements included in this quarterly report on Form 10-Q for prior-year periods have been reclassified to reflect the Restructuring, and report the results of Revotar under the caption “Income from discontinued operations.”

(c) Share-Based Payment

At June 30, 2006, the Company had five stock-based compensation plans for employees and non-employee directors. Prior to January 1, 2006, the Company accounted for those plans under the recognition and measurement principles of Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees,” and related interpretations (“APB25”). Share-based employee compensation expense related to stock options was not recognized in the Company’s consolidated statements of earnings prior to January 1, 2006, as all stock option awards granted under the plans had an exercise price equal to the market value of the common stock on the date of the grant. Effective January 1, 2006, the Company adopted the provisions of Statement of Financial Accounting Standards No. 123R, “Share-Based Payment” (“FAS 123R”), using the modified prospective transition method. Under this transition method, compensation expense recognized during the three and six months ended June 30, 2006 included: (i) compensation expense for all share-based awards granted prior to, but not yet vested as of January 1, 2006, based on the grant date fair value estimated in accordance with the original provisions of Statement of Financial Accounting Standards No. 123, “Accounting for Stock-Based Compensation,” (“FAS 123”), and (ii) compensation expense for all share-based awards granted subsequent to January 1, 2006, based on the grant date fair value estimated in accordance with FAS 123R. In accordance with the modified prospective transition method, results for prior periods have not been restated. The adoption of FAS 123R resulted in a reduction of net earnings of $1,343,000 and $2,966,000, or $0.02 and $0.05 per share basic and diluted for the three month and six month periods ended June 30, 2006, respectively. See Note 10 for further detail on the impact of FAS 123R on the Company’s condensed consolidated financial statements.

Prior to the Company’s adoption of FAS 123R, if unvested shares of common stock were forfeited, the Company reversed any compensation expense that it had previously recorded on those shares at the time of forfeiture. Upon the adoption of FAS 123R, the Company will adjust the amount of expense recorded each period, based upon its estimate of future forfeitures. The cumulative effect of estimating future forfeitures of unvested common shares granted before January 1, 2006 was $107,000, which is reported as a cumulative effect of change in accounting principle during the six months ended June 30, 2006.

(d) Debt Issue Costs

The Company incurred costs, principally comprised of initial purchasers’ discounts and various legal and professional fees, of approximately $4,663,000 related to the issuance of its 2.50% Convertible Senior Notes due 2012 (the “Notes”) in March 2005. Debt issue costs are deferred, and recognized from the issuance of the Notes through the date that the Company has the ability to call the Notes, March 20, 2010. Interest expense in the three months ended June 30, 2006 and 2005, includes approximately $165,000 and $166,000, respectively, in amortized debt issue costs. Interest expense in the six months ended June 30, 2006 and 2005 includes amortized debt issue costs of approximately $329,000 and $203,000, respectively. Remaining unamortized debt issue costs were approximately $3,796,000 at June 30, 2006. For additional information about the Notes, see Note 9.

(e) Use of Estimates

Management of the Company has made a number of estimates and assumptions relating to the reporting of assets and liabilities, revenues and expenses, and the disclosure of contingent assets and liabilities to prepare these consolidated financial statements in conformity with U.S. generally accepted accounting principles Actual results could differ from these estimates.

(f) Reclassifications

As discussed above in Note 2(b), prior period financial statements have been reclassified to reflect discontinued operations and to conform to current-year presentation with no effect on net loss or stockholders’ equity previously reported. The Statement of Cash Flows for the six months ended June 30, 2005 has been revised to conform to current-year presentation of cash used in discontinued operations.

(3) Inventory

Based on management’s judgment of probable future commercial use and net realizable value, costs related to the production of work-in-process inventory of Thelin™ have been capitalized as inventory. The Company could be required to expense these costs upon a change in such judgment due to a denial or significant delay of approval by regulatory bodies, a delay in commercialization, or other potential factors.

(4) Capital Stock

In March 2005, the Company issued the Notes in the principal amount of $130,000,000. As the Notes are convertible into the Company’s common stock, the Company has reserved 9,322,001 shares for issuance upon conversion, including 213,000 treasury shares. For additional information about the Notes, see Note 9. The Company has reserved Common Stock for issuance as of June 30, 2006, as follows:


Stock option plans			7,958,293
2.50% Convertible Senior Notes due 2012			9,322,001

Total shares reserved			17,280,294

(5) Cash, Cash Equivalents, and Short-Term Investments

Cash equivalents are considered to be those securities or instruments with original maturities, when purchased, of three months or less and are recorded at cost. Short-term investments consist of debt securities with remaining maturities of less than one year and original maturities greater than three months at the purchase date. The Company classifies all short-term investments as held-to-maturity. Held-to-maturity securities are those securities in which the Company has the ability and intent to hold the security until maturity. Short-term investments are stated at amortized cost plus accrued interest. Interest income is accrued as earned. The Company evaluates the carrying value of its securities by comparing the carrying value of the securities to their market value. In the event that the fair value of a security were to decline below its carrying cost, and in the opinion of management such decline was other than temporary, the Company would record a loss and reduce the carrying value of such security to its fair value. All of the Company’s funds were invested in cash or cash equivalents at December 31, 2005. Investments at June 30, 2006 were as follows:


	June 30, 2006
			Gross		Gross		Estimated
	Amortized		Unrealized		Unrealized		Fair
	Cost		Gains		Losses		Value
Corporate commercial paper and loan participations	$	9,865	$	107	$	—	$	9,972

Total short-term held-to-maturity Investments	$	9,865	$	107	$	—	$	9,972

(6) Net Loss per Common Share

Basic net loss per common share is calculated by dividing the net loss by the weighted average number of common and common equivalent shares outstanding during the period.

Securities convertible into common stock comprised of stock options, shares of common stock reserved for issuance upon conversion of the Notes and unvested shares of restricted common stock totaling 15,849,804 and 15,110,860 shares at June 30, 2006 and 2005, respectively, were not used in the calculation of diluted net loss per common share because the effect would have been antidilutive.

(7) Income Taxes

The Company did not incur tax expense (benefit) during the three and six month periods ended June 30, 2006 and 2005, due to operating losses and the related increase in the valuation allowance.

(8) Entity-Wide Geographic Data

The Company operates in a single business segment that includes research and development of pharmaceutical products. The Company’s revenues are primarily derived from GlaxoSmithKline plc, (“GSK”), and Schering-Plough Corporation and Schering-Plough, Ltd. (collectively referred to as “Schering-Plough”). Each of these entities represents a significant percentage of total revenues. The following table summarizes the Company’s sources of revenues from its principal customers (dollars in thousands):


	Three Months Ended June 30,				Six Months Ended June 30,
	2006		2005		2006		2005
Entities:
GSK	$	3,340	$	2,654	$	6,579	$	5,000
Schering-Plough		322		322		644		462

Total	$	3,662	$	2,976	$	7,223	$	5,462

(9) Long-Term Debt

In March 2005, the Company issued $130,000,000 in Notes, due 2012. The Company will pay 2.50% interest per annum on the Notes on March 15 and September 15 of each year.

Holders of the Notes may convert the Notes into shares of common stock at any time prior to the maturity date of the Notes at a conversion rate of 71.7077 shares of common stock per $1,000 principal amount of Notes, which is equal to an initial conversion price of approximately $13.95 per share, subject to adjustment as set forth in the indenture governing the Notes. In the event of certain types of fundamental changes, the Company will increase the number of shares issuable upon conversion or, in lieu thereof, the Company may in certain circumstances elect to adjust the conversion rate and related conversion obligation so that the Notes are convertible into shares of the acquiring or surviving company, or at the option of the Company, the Company may elect to pay the additional value represented by an increase in the conversion rate in cash to holders electing to convert their Notes. On or after March 20, 2010, the Company may redeem some or all of the Notes for cash at 100% of the principal amount plus accrued interest, if the trading price of the Company’s common stock exceeds 140% of the conversion price of the Notes then in effect for at least 20 trading days within a period of 30 consecutive trading days ending on the trading day prior to the date on which the redemption notice is mailed. Upon the occurrence of a fundamental change meeting certain conditions, holders of the Notes may require the Company to repurchase for cash all or part of their Notes.

The Notes are senior unsecured obligations and rank equally in right of payment with any senior unsecured indebtedness that the Company may incur in the future. The Notes will be effectively subordinated to all future secured indebtedness and all existing and future liabilities of the Company’s subsidiaries, including trade payables and senior in right of payment to any future subordinated indebtedness that the Company may incur.

(10) Share-Based Payment

The Company has share-based awards outstanding under five different plans as follows:

The Amended and Restated 1990 Incentive Stock Option Plan (“1990 Plan”) allows for the issuance of incentive and non-qualified options to employees, directors, officers, non-employee independent contractors and non-employee directors, pursuant to which 43,750 shares of Common Stock are reserved for issuance out of authorized but unissued shares of the Company. No new issuances are being made under the 1990 Plan.

The Amended and Restated 1992 Incentive Stock Option Plan (“1992 Plan”) allows for the issuance of incentive and non-qualified options to employees, directors, officers, non-employee independent contractors and non-employee directors, pursuant to which 118,383 shares of Common Stock are reserved for issuance out of authorized but unissued shares of the Company. No new issuances are being made under the 1992 Plan.

The Amended and Restated 1995 Stock Option Plan (“1995 Plan”) allows for the issuance of incentive and non-qualified options, shares of restricted stock and stock bonuses to employees, officers, and non-employee independent contractors, pursuant to which 747,533 shares of Common Stock are reserved for issuance out of authorized but unissued shares of the Company. No new issuances are being made under the 1995 Plan.

The Amended and Restated 1995 Non-Employee Director Stock Option Plan (“1995 Director Plan”) allows for the issuance of non-qualified options to non-employee directors, pursuant to which 441,000 shares of Common Stock are reserved for issuance out of authorized but unissued shares of the Company. No new issuances are being made under the 1995 Director Plan.

The Amended and Restated 1999 Stock Incentive Plan (“1999 Plan”) allows for the issuance of incentive and non-qualified options, shares of restricted stock and stock bonuses to directors, employees, officers and non-employee independent contractors, pursuant to which 6,607,627 shares of Common Stock are reserved for issuance out of authorized but unissued shares of the Company. Beginning in the second quarter of 2006, the Company granted restricted stock units to its international employees. Grants of restricted stock units vest in a manner similar to grants of restricted common stock, and can be settled upon vesting with either shares of common stock or cash, at the sole discretion of the Company.

Prior to January 1, 2006, the Company accounted for those plans under the recognition and measurement principles of APB25. Share-based employee compensation expense related to stock options was not recognized in the Company’s consolidated statements of earnings prior to January 1, 2006, as all stock option awards granted under the plans had an exercise price equal to the market value of the common stock on the date of the grant. Effective January 1, 2006, the Company adopted the provisions of FAS 123R using the modified prospective transition method. Under this transition method, compensation expense recognized during the three and six months ended June 30, 2006 included: (i) compensation expense for all share-based awards granted prior to, but not yet vested as of January 1, 2006, based on the grant date fair value estimated in accordance with the original provisions of FAS 123, and (ii) compensation expense for all share-based awards granted subsequent to January 1, 2006, based on the grant date fair value estimated in accordance with FAS 123R. In accordance with the modified prospective transition method, results for prior periods have not been restated.

As a result of adopting FAS 123R, the charge to earnings from continuing operations and net earnings related to stock option grants for the three and six months ended June 30, 2006 was $1,343,000 and $2,966,000, respectively. The impact of adopting FAS 123R on both basic and diluted earnings per share for the three and six months ended June 30, 2006 was $0.02 and $0.05 per share, respectively.

The following table illustrates the effect on net earnings and earnings per share for the three and six months ended June 30, 2005, as if the Company had applied the fair value recognition provisions of FAS 123 to options granted under the Company’s share-based payment plans. For purposes of this pro forma disclosure, the value of the stock options is estimated using a Black-Scholes option pricing model and amortized to expense over the options’ vesting periods.


	Three Months			Six Months
	Ended			Ended
(In thousands, except per share amounts)	June 30, 2005			June 30, 2005
Net loss, as reported	$	(19,234	)	$	(36,677	)
Add: Total stock-based employee compensation expense included in reported net loss		25			38
Deduct: Total stock-based employee compensation expense determined under fair value based method for all awards		(1,392	)		(2,416	)

Pro forma net loss	$	(20,601	)	$	(39,055	)

Loss per share:
As reported, basic and diluted	$	(0.33	)	$	(0.63	)

Pro forma, basic and diluted	$	(0.36	)	$	(0.68	)

Compensation expense related to all share-based awards during the three months ended June 30, 2006 was $2,015,000, of which $1,343,000 related to stock options resulting from the adoption of FAS 123R and $672,000 related to unvested shares of restricted common stock. Compensation expense related to all share-based awards during the six months ended June 30, 2006 was $4,208,000, of which $2,966,000 related to stock options resulting from the adoption of FAS 123R and $1,242,000 related to unvested shares of restricted common stock. During the three and six months ended June 30, 2005, compensation expense related to the Company’s share-based awards was $25,000 and $38,000, respectively, which primarily related to nonvested shares.

Cash received from stock options exercised during the three months ended June 30, 2006 and 2005 was $10,000 and $195,000, respectively. Cash received from stock options exercised during the six months ended June 30, 2006 and 2005 was $430,000 and $456,000, respectively.

The fair value of the Company’s stock option awards is estimated on the date of grant using a Black-Scholes option-pricing model that uses the assumptions in the table below. The fair value of the Company’s stock option awards, which are subject to graded vesting, is expensed over the vesting life of the stock options using the straight-line method. Expected volatility is based on an average of (i) historical volatility of the Company’s stock, (ii) implied volatility from the Company’s convertible debt and (iii) implied volatility from traded options on the Company’s stock. The risk-free rate for periods within the contractual life of the stock option award is based on the yield curve of a zero-coupon U.S. Treasury bond for the month during which the stock option award is granted with a maturity equal to the expected term of the stock option award granted. The Company uses historical data to estimate stock option exercises and forfeitures within its valuation model. The expected term of stock option awards granted is derived from historical exercise experience under the Company’s share-based payment plans and represents the period of time that stock option awards granted are expected to be outstanding.

The significant weighted average assumptions relating to the valuation of the Company’s stock options for the three and six months ended June 30, 2006 and 2005 were as follows:


	Three Months Ended						Six Months Ended
	June 30,						June 30,
	2006			2005			2006			2005
Expected dividend yield		0.0	%		0.0	%		0.0	%		0.0	%
Risk-free interest rate		5.1	%		3.8	%		4.7	%		4.1	%
Expected volatility		71.8	%		59.8	%		64.9	%		67.8	%
Expected life in years		4.0			4.9			3.9			4.9

A summary of the Company’s stock option activity for the three and six months ended June 30, 2006 was as follows:


				Weighted		Weighted Average		Aggregate
	Stock			Average		Remaining		Intrinsic Value
	Options			Exercise Price		Contractual Term		(in Thousands)
Outstanding
at December 31, 2005		5,340,142		$	8.07		6.63
Grants		512,958		$	8.85
Forfeited or expired		(46,081	)	$	9.85
Exercises		(96,614	)	$	4.34

Outstanding
at March 31, 2006		5,710,405		$	8.18		6.75	$	2,050
Grants		60,000		$	3.57
Forfeited or expired		(44,454	)	$	8.93
Exercises		(10,833	)	$	0.93
Outstanding
at June 30, 2006		5,715,118		$	8.13		6.39	$	5,265
Vested and expected to vest in the future at
June 30 2006		5,677,782		$	8.12		0.39	$	5,261
Exercisable
at June 30, 2006		3,990,935		$	7.40		5.46	$	5,099
Available for grant at
June 30, 2006		2,243,175

The weighted average grant date fair value of options granted and total intrinsic value of options exercised during the three and six months ended June 30, 2006 and 2005 was as follows:


	Three Months Ended				Six Months Ended
	June 30,				June 30,
	2006		2005		2006		2005
Weighted average:
Grant date fair value per option	$	2.05	$	5.24	$	4.34	$	6.39
Total intrinsic value of options exercised	$	41,000	$	402,000	$	532,000	$	888,000

The fair value of unvested shares of restricted common stock is determined based on the closing trading price of the Company’s common stock on the day before the grant date. The weighted average grant date fair value of unvested restricted shares granted during the three months ended June 30, 2006 and 2005 was $3.57 and $9.95, respectively, and during the six months ended June 30, 2006 and 2005 was $8.10 and $10.50, respectively. A summary of the Company’s unvested restricted share activity for the three and six months ended June 30, 2006 was as follows:


				Weighted Average
	Restricted			Grant Date
	Shares			Fair Value
Unvested at December 31, 2005		441,923		$	8.60
Activity during quarter ended March 31, 2006
Grants		436,659		$	8.85
Vested		(127,438	)	$	2.84
Forfeited		(12,870	)	$	11.22

Unvested at March 31, 2006		738,274		$	9.69
Activity during quarter ended June 30, 2006
Grants		65,127		$	3.57
Vested		(10,000	)		7.00
Forfeited		(15,678	)	$	10.34

Unvested at June 30, 2006		777,723		$	9.21

The fair value of unvested restricted stock units is determined based on the closing trading price of the Company’s common stock on the day before the grant date. The weighted average grant date fair value of unvested restricted stock units granted during the three months ended June 30, 2006 was $3.86. A summary of the Company’s unvested restricted stock unit activity for the three months ended June 30, 2006 was as follows:


			Weighted Average
			Grant Date
	Shares		Fair Value
Unvested at March 31, 2006		—		—
Activity during quarter ended June 30, 2006
Grants		34,962	$	3.86
Vested		—		—
Forfeited		—		—

Unvested at June 30, 2006		34,962	$	3.86

At June 30, 2006, there was $13.4 million of unrecognized compensation expense related to unvested share-based awards granted under the Company’s share-based payment plans of which $7.9 million relates to stock options expected to be recognized over a weighted-average period of 1.5 years, and $5.5 million relates to unvested shares and restricted stock units expected to be recognized over a weighted average period of 2.1 years.

(11) Commitments and Contingencies

(a) Foreign Currency Exchange Risk

The Company is exposed to market risk primarily from changes in foreign currency exchange rates. We have contracts with entities outside the U.S. that are denominated in a foreign currency. To date, these currencies have not fluctuated materially.

(b) Other contingencies

Like other biopharmaceutical companies, the Company is subject to other contingencies, including legal proceedings and claims arising out of its business that cover a wide range of matters, including, among others, environmental matters, contract and employment claims, and product liability. The Company may be involved in legal actions from time to time. The Company has used various substances in its research and development that have been or may be deemed to be hazardous or dangerous, and the extent of its potential liability, if any, under environmental, product liability and workers’ compensation statutes, rules, regulations and case law is unclear.

Item 2.

ENCYSIVE PHARMACEUTICALS INC. AND SUBSIDIARIES

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

Three and Six Months Ended June 30, 2006, and June 30, 2005

OVERVIEW

The following discussion of our financial condition and results of operations should be read in conjunction with our consolidated financial statements and the related notes to the financial statements included in our Annual Report on Form 10-K for the year ended December 31, 2005, and with the consolidated financial statements and related notes to the financial statements included elsewhere in this Form 10-Q. This Form 10-Q contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. Forward-looking statements represent our management’s judgment regarding future events. In many cases, you can identify forward-looking statements by terminology such as ‘‘may,’’ ‘‘will,’’ ‘‘should,’’ ‘‘could,’’ ‘‘plan,’’ ‘‘expect,’’ ‘‘anticipate,’’ ‘‘estimate,’’ ‘‘believe,’’ ‘‘predict,’’ ‘‘intend,’’ ‘‘potential,’’ or ‘‘continue’’ or the negative of these terms or other words of similar import, although some forward-looking statements are expressed differently. All statements, other than statements of historical fact, included in this Form 10-Q regarding our financial position, business strategy and plans or objectives for future operations are forward-looking statements. Among the factors that could cause actual results to differ materially from those indicated by such forward-looking statements are: additional delays in regulatory approval of Thelin™ (sitaxsentan sodium) in the U.S. and Europe and Encysive’s other products under development; the results of clinical trials with respect to products under development; the availability of sufficient funds to continue research and development efforts and the commercialization of Thelin™ and Encysive’s other products; reduced estimates of patient populations; the impact of reimbursement policies and governmental regulation of prices; the scope of Encysive’s patents and challenges by others of the scope of Encysive’s patents; the ability of Encysive to attract and retain qualified personnel; the impact of competitive products; the impact of strategic relationships among our competitors; the breadth of approved labeling for approved products; the speed with which reimbursement and pricing approvals, and product launches may be achieved; the availability of materials necessary for the manufacture of our products; as well as more specific risks and uncertainties facing Encysive such as those set forth in “Item 1A – Risk Factors” below.

You should read these forward-looking statements carefully because they discuss our expectations about our future performance, contain projections of our future operating results or our future financial condition, or state other “forward-looking” information. You should be aware that the occurrence of any of the events described in “Business,” “Risk Factors,’’ “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and elsewhere in our Annual Report on Form 10-K for the year ended December 31, 2005 and in this Form 10-Q could substantially harm our business, results of operations and financial condition and that upon the occurrence of any of these events, the trading price of our common stock could decline, and you could lose all or part of your investment.

All subsequent written and oral forward-looking statements attributable to us or to persons acting on our behalf are expressly qualified in their entirety by the applicable cautionary statements. We cannot guarantee any future results, levels of activity, performance or achievements. Except as required by law, we undertake no obligation to update any of the forward-looking statements in this Form 10-Q after the date hereof.

As used in this Form 10-Q, the words “we,” “our,” “us,” “Encysive,” and the “Company” refer to Encysive Pharmaceuticals Inc., its predecessors and subsidiaries, except as otherwise specified. This Form 10-Q may contain trademarks and service marks of other companies.

Encysive Pharmaceuticals is a biopharmaceutical company engaged in the discovery, development and commercialization of novel, synthetic, small molecule compounds to address unmet medical needs. Our research and development programs are predominantly focused on the treatment and prevention of interrelated diseases of the vascular endothelium and exploit our expertise in the area of the intravascular

inflammatory process, referred to as the inflammatory cascade, and vascular diseases. We have successfully developed one FDA approved drug, Argatroban, for the treatment of Heparin-Induced Thrombocytopenia, or HIT, that is marketed by GSK. Our lead drug candidate, Thelin™ (sitaxsentan sodium) is an endothelin receptor antagonist that has successfully completed pivotal Phase III clinical trials for the treatment of pulmonary arterial hypertension, or PAH.

In addition, we have earlier stage clinical product candidates in development including TBC3711, a next generation endothelin receptor antagonist. As discussed below, all clinical trials of TBC3711 have been suspended and placed on clinical hold while we work with the FDA to resolve an outstanding issue.

We have entered into a worldwide research collaboration and license agreement with Schering-Plough, to discover, develop and commercialize VLA-4 antagonists. In March 2005, the initiation of clinical studies for TBC4746, an oral VLA-4 antagonist, by Schering-Plough triggered a milestone payment to us. VLA-4 is a potential target in the inflammatory cascade taking place within the vasculature. TBC4746 has the potential to address a number of diseases, including asthma and multiple sclerosis.

Bimosiamose has been licensed to and is being developed by Revotar Biopharmaceuticals AG, or Revotar, which was formerly a majority-owned subsidiary.

In March 2005, we issued $130 million of 2.50% Convertible Senior Notes, or the Notes, due 2012. For additional information about the Notes, see Note 9 to the consolidated financial statements included herein.

Thelin™ — for the treatment of Pulmonary Arterial Hypertension

In March 2006, we received a complete response from the FDA which indicated that Thelin™ (sitaxsentan sodium) is approvable, which we refer to elsewhere as the “March Approvable Letter”. In the March Approvable Letter, the FDA identified several concerns and observations that needed to be resolved before the drug could be approved, including a request for additional clinical trial work. The FDA accepted for review the Company’s complete response to the concerns and observations noted in the March Approvable Letter, and designated the review as a Class 1 resubmission. A new Prescription Drug User Fee Act (PDUFA) target action date of July 24, 2006 was established. On July 24, 2006 we received a second approvable letter, which we refer to elsewhere as the “July Approvable Letter.” One of the substantive items raised in the March Approvable Letter remains unresolved. The FDA acknowledged that the unresolved item is a matter of judgment and expressed a willingness to consider new arguments to address this remaining item. The FDA again offered the alternative of conducting additional clinical work. We are working closely with the FDA in an attempt to resolve this remaining issue.

In June 2006, we received a positive opinion recommending approval of Thelin™ from the Committee for Medicinal Products for Human Use, or CHMP, of the European Agency for the Evaluation of Medicinal Products, or EMEA. The CHMP’s positive opinion will be considered by the European Commission, and a final decision regarding marketing approval for Thelin™ is expected within approximately 90 days from the opinion date. The European Commission’s centralized licensing procedure will permit Encysive to market Thelin™ in all 25 member states of the European Union. We anticipate that Thelin™ will be launched first in the United Kingdom and Germany during the fourth quarter of 2006, with subsequent launches in other countries as their national governments approve pricing and reimbursement.

We also have regulatory applications for Thelin™ under review by regulatory authorities in Australia and Canada. Additionally, during 2004, we obtained orphan drug designation for Thelin™ from both the FDA and the European Commission. Orphan drug designation grants exclusivity to Thelin™ upon product approval for seven years in the U.S., however we anticipate that patent protection for Thelin may extend beyond expiration of orphan drug exclusivity. In the European Union, orphan drug designation grants exclusivity for ten years from product approval.

We have retained worldwide rights to Thelin™ and have announced our intention to market and sell Thelin™ ourselves in North America and Europe. In anticipation of receiving regulatory approval to market Thelin™, we have made preparations for commercial launch in the U.S. and Europe in 2006.

During 2005, we significantly increased our staff, hiring a U.S. field sales force, marketing staff and other key personnel.

Argatroban

Argatroban, licensed from Mitsubishi Pharma Corporation (“Mitsubishi”) and developed in North America by Encysive, is a synthetic direct thrombin inhibitor approved by the FDA in 2000. It is indicated for prophylaxis or treatment of thrombosis for patients with HIT, a profound allergic reaction to anticoagulation therapy with heparin, and for use in HIT patients undergoing percutaneous coronary intervention. Argatroban was approved in Canada in 2002 for use as an anticoagulant therapy in patients with HIT syndrome. GSK markets Argatroban in the U.S. and Canada, and had Hatch-Waxman market exclusivity in the U.S. until June 2005. We have access to a formulation patent, which expires in 2014, and a process patent that expires in 2017. We are not aware of any regulatory submissions by other parties for generic compounds which could compete with Argatroban. In the three and six months ended June 30, 2006, Encysive earned royalties from the sales of Argatroban totaling $3.3 million and $6.6 million, respectively.

Other Development Programs

Our research and development programs include plans to develop oral Thelin™ more broadly in PAH and to explore indications beyond PAH. We have initiated a trial for Thelin™ as a treatment for diastolic heart failure. In addition, we began a dose-ranging study in patients with diagnosed resistant hypertension with TBC3711, a more potent and selective endothelin-A, or ET_A, receptor antagonist with an improved metabolic profile, pre-clinically. On March 23, 2006, however, the TBC3711 clinical studies were placed on clinical hold, and all clinical trials have been suspended, due to an unusual finding following dosing with intravenous TBC3711 in a single rat that had displayed abnormalities at baseline. We are continuing to work with the FDA to resolve this issue.

In addition to Thelin™, TBC3711and Argatroban, we have a number of projects in late preclinical development. The Company’s next clinical candidates may be an intravenous or oral vasoactive antagonist or an oral antagonist for an inflammatory disease target. It is anticipated that we may submit two Investigational New Drug Applications in 2006.

In April 2005, the stockholders of Revotar agreed to restructure Revotar’s capitalization in an arrangement referred to as the “Restructuring.” As a result, we are no longer funding any drug development activities at Revotar. For additional information about the Restructuring, see Note 2(b) to the consolidated financial statements included herein.

Encysive’s Research Programs

Our research efforts are concentrated on targets within the vasculature, and the potential indications of our drug candidates include cardiovascular diseases and a potentially wide variety of inflammatory diseases involving two complementary sets of targets. The first set of targets relate to vascular G-protein coupled receptors (“GPCRs”). Historically, GPCRs have been some of the most amenable targets for developing commercially successful pharmaceuticals, such as beta-blockers, antihistamines, and most anti-psychotics and anti-depressants. Endothelin receptors, targeted by Thelin™ and TBC3711, are examples of GPCRs.

Encysive also has developed expertise in pharmacologically intervening in the intravascular inflammatory cascade, representing a second set of intravascular targets. Bimosiamose and TBC4746 are examples of drug candidates that we designed to target two distinct steps in this cascade, the selectins and VLA-4, respectively. Some of the targets in this cascade are GPCRs. Thus, our focus on endothelial cell and related vascular biology has opened up a broad range of disease targets with high, unmet medical need.

Critical Accounting Policies

Revenue Recognition

	•		We recognize royalty revenue as a licensee sells products and we have received sufficient information to record a receivable. Our royalty revenue is based on net sales of product, that is, sales net of discounts, returns and allowances. Argatroban is licensed to GSK, which distributes and sells the product, and from which we receive a quarterly royalty payment. At the time of each payment, GSK provides us with limited quarterly data related to the product’s gross sales, sales returns, discounts and allowances. While we are informed of the amount of product returns recorded each quarter, we do not have information necessary to identify the period or periods to which such returns correspond. We believe that substantially all discounts and allowances pertain to current period sales. We also believe that a portion of sales recorded in each period will ultimately be returned, and therefore estimate future returns and their impact on royalty revenues. In the pharmaceutical industry, product returns are primarily influenced by remaining or expired shelf life, product withdrawals or recalls, significant price changes from competitors or the introduction of generic products or other new competition. We are not aware of any pending product recalls or withdrawals, significant price fluctuations or generic or new competition. Accordingly, we have estimated only the impact of product dating on returns.

			Since we do not manufacture, sell or distribute Argatroban, we do not have information related to levels of inventory in the distribution channels. However, due to the cost of the drug and pressures on hospitals to minimize operating expenditures, we believe inventory levels are maintained at a minimally acceptable level. Inventory level is therefore not a part of the Company’s estimate process.

			We have estimated remaining shelf life, which is an important reason for product returns, based upon the fact that Argatroban has an expiration date of two years from manufacture. Common industry practice is that prescription drugs can be returned to the manufacturer at any time; however, product is normally returned when the remaining shelf life is reduced to six months or less. Our reserve is therefore based upon an estimate of the percentage of sales made in the preceding 18-month period that may be returned in future periods. Initially, lacking any historical sales data for Argatroban and based upon management’s experience with other pharmaceutical products in the industry, management estimated that four percent of gross sales of Argatroban would be returned during future periods. Based upon subsequent analysis of historical sales data, we believe that differences between estimated and actual future returns will not have a material effect upon our results of operations or financial condition.

	•		Revenue from collaborative research and development activities is recognized as services are performed.

	•		We defer the recognition of milestone payments related to contractual agreements that are still in the development stage. Such deferred revenues are amortized into income over the estimated remaining development period. Milestone payments received under contractual agreements which have completed the development stage are evaluated, and either recognized into income when earned, or amortized over a future period, depending upon whether we continue to have obligations under the terms of the arrangement.

	•		License fees received under the terms of licensing agreements for our intellectual property are deferred and amortized into income over the estimated development period of the licensed item or items.

	•		Revenue from grants is recognized as earned under the terms of the related grant agreements, typically as expenses are incurred.

Amounts received in advance of services being performed under contracts are recorded as deferred revenue, and recognized as services are performed. We periodically evaluate our estimates of remaining development periods, and adjust the recognition of remaining deferred revenues over the adjusted development period remaining. At June 30, 2006, remaining deferred revenue was approximately $1.9 million, of which we expect to recognize approximately $1.3 million over the next 12 months. A future change in our estimate of development periods could accelerate or decelerate the timing of future recognition of deferred revenue.

Share-Based Payments

At June 30, 2006, the Company had five stock-based compensation plans for employees and non-employee directors. Prior to January 1, 2006, the Company accounted for those plans under the recognition and measurement principles of Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees,” and related interpretations (“APB25”). Share-based employee compensation expense related to stock options was not recognized in the Company’s consolidated statements of earnings prior to January 1, 2006, as all stock option awards granted under the plans had an exercise price equal to the market value of the common stock on the date of the grant. Effective January 1, 2006, the Company adopted the provisions of Statement of Financial Accounting Standards No. 123R, “Share-Based Payment” (“FAS 123R”) using the modified prospective transition method. Under this transition method, compensation expense recognized during the three and six months ended June 30, 2006 included: (i) compensation expense for all share-based awards granted prior to, but not yet vested as of January 1, 2006, based on the grant date fair value estimated in accordance with the original provisions of Statement of Financial Accounting Standards No. 123, “Accounting for Stock-Based Compensation” (“FAS 123”), and (ii) compensation expense for all share-based awards granted subsequent to January 1, 2006, based on the grant date fair value estimated in accordance with FAS 123R. In accordance with the modified prospective transition method, results for prior periods have not been restated. The adoption of FAS 123R resulted in a reduction of net earnings of $1,343,000, or $0.02 per share basic and diluted, and $2,966,000 or $0.05 per share, basic and diluted, for the three months and six months ended June 30, 2006, respectively, arising from unvested stock options. See Note 10 to the consolidated financial statements for further detail on the impact of FAS 123R on the Company’s condensed consolidated financial statements.

Drug Manufacturing and Packaging

Costs arising from the manufacturing and packaging of drug product, which is intended for use in clinical trials, are recognized as incurred and included in research and development expenses. We capitalize inventory costs associated with certain products prior to regulatory approval and product launch, based on management’s judgment of probable future commercial use and net realizable value. We could be required to expense previously capitalized costs related to pre-approval or pre-launch inventory upon a change in such judgment, due to a denial or additional delays of approval by regulatory bodies, additional delays in commercialization, or other potential factors. At June 30, 2006, we had $2.5 million of capitalized inventory costs.

Costs Related to Issue of Long-Term Debt

Costs incurred in the issuance of the Notes, primarily comprised of initial purchasers’ discounts, legal and other professional fees have been deferred, and will be amortized and reported as a component of interest expense during the periods beginning with the Notes’ issuance date to the date that we have the ability to call the debt.

Results of Operations

The preparation of financial statements in conformity with U.S. generally accepted accounting principles requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities, disclosures of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Our operating results have fluctuated significantly during each quarter and year and we anticipate that such fluctuations, which are largely attributable to varying research and development and other operating commitments and expenditures, will continue for the next several years. We have been unprofitable to date and expect to incur substantial operating losses for the next several years as we invest in product research and development, preclinical and clinical testing, commercialization expenses related to Thelin™ and regulatory compliance. We have sustained net losses of approximately $371.0 million from the date of our inception to June 30, 2006. We have primarily financed our operations to date through a series of private placements and public offerings of our common stock, the sale of Notes and several collaborative agreements with third parties to jointly pursue product research and development. See “Liquidity and Capital Resources” below. See also Item IA – Risk Factors, in our Annual Report on Form 10-K for the year ended December 31, 2005 and Item 1A – Risk Factors, in this Form 10-Q.

Three and six month periods ended June 30, 2006 and 2005

Revenues

Total revenues increased $0.7 million in the three months ended June 30, 2006, compared with the three months ended June 30, 2005. This increase is primarily due to an increase in royalties earned on sales of Argatroban by GSK resulting from higher sales of Argatroban. Total revenues increased $1.8 million in the six months ended June 30, 2006, compared with the six months ended June 30, 2005, primarily due to an increase in royalties earned on higher sales of Argatroban by GSK in the six months ended June 30, 2006. Additionally, license fees and milestones revenue increased $0.2 million in the six months ended June 30, 2006, reflecting the amortization of the receipt of a milestone payment from Schering-Plough received in March 2005. As discussed above, regulatory approval of Thelin™ in the U.S. has been delayed, pending satisfaction of the one substantive item contained in the July Approvable Letter. We are working closely with the FDA to resolve such remaining item, however we cannot assure you that we will be able to do so in the near future. Since the outcome of regulatory filings for Thelin™ in the U.S., Europe, Canada and Australia is uncertain, we do not anticipate providing specific financial guidance for 2006.

Research and Development Expense

Research and development expense decreased $2.7 million in the three months ended June 30, 2006, compared with the three months ended June 30, 2005. Research and development expense in the three months ended June 30, 2006, included incremental share-based compensation expense of $1.0 million, resulting from our adoption of FAS 123R on January 1, 2006. The decrease in research and development expense in the three months ended June 30, 2006 is primarily due to reduced clinical trial and regulatory activities during the period, compared with the prior year period. Research and development expenses during the three months ended June 30, 2005 included costs associated with the STRIDE-2X and STRIDE-3 clinical trials, costs associated with the preparation of the New Drug Application for Thelin™, or NDA, which was submitted to the FDA in May 2005, and submission of a Marketing Authorization Application for Thelin™ or “MAA” with the EMEA in July 2005.

Research and development expense decreased $0.6 million in the six months ended June 30, 2006, compared with the six months ended June 30, 2005. Research and development expense in the six months ended June 30, 2006 included incremental share-based compensation expense of $1.9 million, resulting from our adoption of FAS 123R on January 1, 2006. The decrease in research and development expenses in the six months ended June 30, 2006 is primarily due to reduced clinical trial and regulatory activities during the period, compared with the prior year period. As discussed above, research and development expenses during the six months ended June 30, 2005 included costs associated with the STRIDE-2X and STRIDE-3 clinical trials, costs associated with the preparation of the Thelin™ NDA, which was submitted to the FDA in May 2005, and submission of the Thelin™ MAA with the EMEA in July 2005.

Sales and Marketing Expense

Sales and marketing expense increased $8.5 million and $17.2 million in the three and six months ended June 30, 2006, compared with the three and six months ended June 30, 2005, respectively, as we prepared for the commercial launch of Thelin™, assuming that we will receive regulatory approvals. The increases are primarily due to costs associated with preparation for the potential commercial launch of Thelin™, including the addition of a U.S. sales force, and related sales launch activities. We have also begun to prepare for commercial launch of Thelin™ in Europe, and have added a vice president of European operations, and staff, and are presently in the process of building a European sales force. Sales and marketing expense also included incremental share-based compensation expense of $0.4 million, and $0.8 million in the three and six months ended June 30, 2006, respectively, resulting from our adoption of FAS 123R on January 1, 2006.

General and Administrative Expense

General and administrative expense increased $1.8 million and $4.9 million in the three and six months ended June 30, 2006, compared with the three and six months ended June 30, 2005, respectively. The increases are due to costs associated with building the infrastructure to support the potential commercial launch of Thelin™, including the addition of several key management appointments, such as a chief financial officer, chief operating officer and general counsel. General and administrative expense in the three and six months ended June 30, 2006, also included incremental share-based compensation expense of $0.6 million and $1.3 million, respectively, resulting from our adoption of FAS 123R on January 1, 2006.

Total Operating Expenses

Total operating expenses increased $7.6 million and $21.5 million in the three and six months ended June 30, 2006, compared to the three and six months ended June 30, 2005, respectively, primarily due to the Thelin™ pre-commercialization activities discussed above. As previously discussed, regulatory approval of Thelin™ in the U.S. has been delayed, pending satisfaction of one substantive item included in the July Approvable Letter. We intend to continue to develop the infrastructure necessary to commercialize Thelin™ should we receive regulatory approval in the U.S. and Europe. Accordingly, we expect, to continue to incur significant operating expenses for the remainder of 2006. As discussed in “Liquidity and Capital Resources,” below, if we are unable to obtain FDA regulatory approval of Thelin™ in the near future, and if we are not able to secure additional funding, we will not be able to sustain our current levels of operations.

Operating Loss

Operating loss in the three and six months ended June 30, 2006, increased $6.9 million and $19.7 million, respectively, compared with the three and six months ended June 30, 2005, due to increased operating expenses in current year periods. The effect of increased operating expenses was partially offset by increased royalty revenues during the current year periods.

Interest Expense

Interest expense in each of the three and six month periods ended June 30, 2006 and 2006, is primarily due to interest payable on the Notes.

Investment Income

Investment income in the three month period ended June 30, 2006, decreased approximately $0.3 million compared with the three month period ended June 30, 2005, as we had less cash available for investment in the current period. Investment income in the six months ended June 30, 2006 increased approximately $0.5 million, compared with the six months ended June 30, 2005, as we invested proceeds received upon issuance of the Notes in March 2005.

Income from discontinued operations

The results of Revotar in the three and six months ended June 30, 2005 have been reclassified as discontinued operations as a result of the Restructuring, and are primarily comprised of a gain recorded on the Restructuring.

Liquidity and Capital Resources

We have financed our research and development activities and other operations primarily through public and private offerings of our common stock and the Notes and from funds received through our collaborations, research agreements and partnerships. We also have received royalty revenue from sales of Argatroban. At June 30, 2006, we had cash and short-term investments of $75.4 million, which we believe is sufficient to fund our cash requirements through 2006. We now anticipate that we will require additional funding in order to continue our ongoing research and development programs beyond 2006, and fund the commercial launch of Thelin™ in both the U.S. and Europe. If Thelin™ is not approved by the FDA in the near future, we believe that additional funding will be significantly more difficult to obtain on commercially acceptable terms. Such additional funding could be arranged through public or private equity, debt financings, bank debt, or, if we choose to do so, collaborative arrangements. As we assess the options regarding the worldwide marketing of Thelin™, we will also continue to review the possibility of licensing rights to Thelin™ outside of North America and Europe. We cannot assure you that any licensing arrangements will be available on acceptable terms, or that we will choose this approach. As we review our operations and research and development programs, we may also consider various methods to reduce our costs in order to sustain our cash resources. Those measures may include scaling back, delaying or terminating one or more research and development programs, curtailing capital expenditures or reducing other operating activities. We may also consider relinquishing, licensing or otherwise disposing of rights to technologies, product candidates or products that we could otherwise seek to develop or commercialize ourselves on terms that are less favorable than might otherwise be available or at an earlier stage than would otherwise be desirable.

Cash, cash equivalents and investments in marketable securities, including accrued interest thereon, was $75.4 million at June 30, 2006, compared with $127.9 million at December 31, 2005. We used $51.4 million in cash in continuing operations during the six months ended June 30, 2006, compared to $29.6 million during the six months ended June 30, 2005. Cash used in discontinued operations was $0.1 million in the six months ended June 30, 2005. In March 2005, we received a $2 million milestone payment from Schering Plough which is included in deferred revenue at June 30, 2005. The primary operating uses of cash in the 2006 and 2005 periods were to fund our general operating expenses and the ongoing research and development programs, as well as preparations for the commercialization of Thelin, partially offset by cash received from investment income and milestone payments.

Investing activities are primarily comprised of purchases of equipment and leasehold improvements, and of our investments in debt securities. Cash is generated from investing activities when marketable securities mature and the resulting cash is utilized primarily to fund operating activities. Purchases of equipment and leasehold improvements were $1.5 million in each of the six months ended June 30, 2006 and 2005. During the six months ended June 30, 2006, we purchased a short-term investment security of $10.0 million. Cash used in investing activities during the six months ended June 30, 2005, was primarily comprised of the investment of funds received from our sale of the Notes in March 2005.

Cash provided by financing activities of $0.4 million during the six months ended June 30, 2006 was comprised of proceeds of employee stock option exercises. Cash provided by financing activities in the six months ended June 30, 2005, included net proceeds of $125.3 million from the sale of the Notes in March 2005 and approximately $0.5 million in proceeds from the exercise of employee stock options.

Material Commitments

Our material contractual obligations are comprised of (i) amounts borrowed through the issuance of the Notes, (ii) obligations under our operating lease agreements and (iii) a contingent obligation to pay the other party to a research agreement a termination fee in the event that we elect to terminate the project prior to completion. In addition, we have signed a long-term purchase agreement for the manufacturing and

supply of Thelin™; however, our obligations under the agreement are contingent upon receiving regulatory approval for the marketing of Thelin™ in the U.S.

As of June 30, 2006, the Company had contractual obligations as follows (dollars in thousands):


			Less than		1-3		3-5		After 5
Contractual Obligations	Total		1 year		Years		Years		years
Long-term debt	$	130,000	$	—	$	—	$	—	$	130,000
Operating leases		2,738		1,820		918		—		—
Purchase obligations		232		232		—		—		—

Total	$	132,970	$	2,052	$	918	$	—	$	130,000

Outlook for 2006

We believe royalty revenues in 2006 will be comparable to 2005. We anticipate that our operating expenses will be significant in 2006. We have incurred and expect to incur significant expenses related to commercialization-related activities and expenses, including establishing a sales and marketing organization in the U.S. and Europe, marketing expenses and training expenses in anticipation of receiving regulatory approval of Thelin™ in the U.S. and Europe. We intend to enroll patients in additional clinical trials of Thelin™ for other indications. We have initiated a clinical trial to study the use of Thelin in patients with diastolic heart failure, or DHF, and have announced plans to initiate a combination clinical trial involving Thelin™ and a PDE5 compound. As previously discussed, we have initiated a phase II dose-ranging clinical trial for TBC3711, and are assuming that the issue which resulted in placing such trials on clinical hold can be resolved. We also intend to continue development work of compounds in our research pipeline. Since the outcomes of regulatory filings for Thelin™ in the U.S., Europe, Canada and Australia are uncertain, we do not anticipate providing specific financial guidance for 2006.

Longer-Term Outlook

We expect to incur substantial research and development expenditures as we design and develop biopharmaceutical products for the prevention and treatment of cardiovascular and other diseases. We anticipate that our operating expenses will significantly increase in subsequent years because:

•

In anticipation of the commercial launch of Thelin™ in the U.S. and Europe, we have incurred and will incur significant commercialization expenses. These costs include:

	–		developing post-marketing surveillance systems;

	–		market research;

	–		hiring a general counsel, vice president of sales, chief financial officer, chief operating officer and other key staff personnel;

	–		hiring a marketing and field sales force in the U.S., Canada and Europe;

	–		establishing appropriate infrastructure to support the field sales force;

	–		preparation and production of educational and promotional materials;

	–		engaging an advertising agency to support our product promotion;

	–		hiring personnel and engaging third party support to administer reimbursement from government and private third-party payers; and

	–		establishing manufacturing, warehousing and distribution processes for our products.

•

We expect to incur significant expenses in conjunction with clinical trial costs for our ongoing long-term safety study of Thelin™, for clinical trials in new indications for Thelin™ and for clinical trials related to other compounds. These costs include:

	–		hiring personnel to direct and carry out all operations related to clinical trials;

	–		hospital and procedural costs;

	–		services of a contract research organization; and

	–		purchasing and formulating large quantities of the compound to be used in such trials.

We will require substantial additional spending to complete the research and development of our product candidates, to establish commercial scale manufacturing facilities, if necessary, and to market our products. Estimates of our future capital requirements will depend on many factors, including:

	•		expenses and risks associated with clinical trials to expand the indications for Thelin™;

	•		regulatory approval of Thelin™, including breadth of approved label;

	•		continued scientific progress in our drug discovery programs;

	•		the magnitude of these programs;

	•		progress with preclinical testing and clinical trials;

	•		the time and costs involved in obtaining regulatory approvals;

	•		the costs involved in filing, prosecuting and enforcing patent claims;

	•		competing technological and market developments and changes in our existing research relationships;

	•		increased administrative costs and costs to commercialize our products as our products are further developed and marketed;

	•		working capital requirements to support inventory and accounts receivable;

	•		our ability to maintain and establish additional collaborative arrangements; and

	•		effective commercialization activities and arrangements.

Off-Balance Sheet Arrangements

We have not engaged in off-balance sheet financing arrangements.

Impact of Inflation and Changing Prices

The pharmaceutical research industry is labor intensive and wages and related expenses increase in inflationary periods. The leases of space and related building services for our Houston office and laboratory facilities each contain clauses that escalate rent and related services each year based on the increase in building operating costs and the increase in the Houston Consumer Price Index, respectively. To date, inflation has not had a significant impact on our operations.

Item 3.Quantitative and Qualitative Disclosures About Market Risk

Foreign Currency Exchange Risk

Item 4.Controls and Procedures

Evaluation of Disclosure Controls and Procedures

As of the end of the period covered by this report, our management carried out an evaluation, with the participation of our principal executive officer (the “CEO”) and our principal financial officer (the “CFO”), of the effectiveness of our disclosure controls and procedures pursuant to Rule 13a-15 of the Securities Exchange Act of 1934. Based on those evaluations, the CEO and CFO concluded:

(i) that our disclosure controls and procedures are designed to ensure that information required to be disclosed by us in the reports that we file or submit under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms, and that such information is accumulated and communicated to our management, including the CEO and CFO, as appropriate to allow timely decisions regarding required disclosure; and

(ii) that our disclosure controls and procedures are effective.

Changes in Internal Controls Over Financial Reporting

There have been no changes in our internal controls over financial reporting during the period covered by this report that have materially affected, or that are reasonably likely to materially affect, our internal control over financial reporting.

PART II. OTHER INFORMATION

Item 1. Legal Proceedings

None

Item 1A. Risk Factors

Unless we receive regulatory approval for Thelin™ in the U.S. and receive additional funding, we will not be able to continue our current level of operations.

In November 2000, we began to market our first product, Argatroban, through our agreement with GSK. However, the royalties produced to date by Argatroban have not made us profitable, and are unlikely to make us profitable in the future. To date, the majority of our resources have been dedicated to the research and development of Argatroban, Thelin™ and other small molecule drugs for certain vascular and related inflammatory diseases. We do not have any drug candidates that are likely to be commercialized in the near future other than Thelin™.

At June 30, 2006, we had cash and short-term investments of $75.4 million, which we believe is sufficient to fund our cash requirements through 2006. We now anticipate that we will require additional funding in order to continue our ongoing research and development programs beyond 2006, and fund the commercial launch of Thelin™ in the U.S. and Europe. If Thelin™ is not approved by the FDA in the near future, we believe that additional funding will be significantly more difficult to obtain on commercially acceptable terms. We will also consider various methods to reduce our costs in order to sustain our cash resources. Those measures may include scaling back, delaying or terminating one or more research and development programs, curtailing capital expenditures or reducing other operating expenses. We may also

consider relinquishing, licensing or otherwise disposing of rights to technologies, product candidates or products that we could otherwise seek to develop or commercialize ourselves on terms that are less favorable than might otherwise be available or at an earlier stage than would otherwise be desirable.

We believe that the anticipated commercial launch of Thelin™ in Europe and in the U.S. will require additional funding due to higher levels of sales and marketing expenditures, particularly in Europe, than in recent periods. The amount of, and timing of future revenues from Thelin™ sales will be dependent upon a number of factors, including market acceptance of Thelin™, pricing and reimbursement approvals, and the content of those approvals by third parties, and how quickly government pricing and reimbursement approvals, and product launches may be achieved. We cannot predict when we will become profitable, and cannot assure you that we will ever achieve profitability.

We have a history of losses and we may never become profitable.

We have been unprofitable to date. As the outcome of our regulatory filings with the FDA and other regulatory authorities is uncertain, we are unable to project revenues for Thelin™. Even if we receive regulatory approval to market Thelin™ in the U.S. and Europe, significant uncertainties with respect to the market acceptance of Thelin™ and reimbursement policies of third party payers, and the speed with which government or other third party payers grant pricing and reimbursement approvals and product launches are achieved could materially affect any revenue projections. Accordingly, we could continue to incur operating losses in future quarters as we invest in product research and development, preclinical and clinical testing, regulatory compliance and commercialization. At June 30, 2006, we had an accumulated deficit of approximately $371.0 million, and for the fiscal years ended December 31, 2005, 2004 and 2003 we have incurred net losses of approximately $74.9 million, $54.7 million and, $35.3 million, respectively. If we do not become profitable, we may require substantial additional funding to complete the research and development of our product candidates, to establish commercial scale manufacturing facilities, if necessary, and to market our products. To become profitable, we, either alone or with our collaborators, must successfully develop, manufacture and market our product candidates, or continue to identify, develop, acquire, manufacture and market other new product candidates. We may never have any significant revenues or become profitable.

We face substantial competition that may result in others developing and commercializing products more successfully than we do.

The biopharmaceutical industry is highly competitive. Our success will depend on our ability to develop products and apply technology and to establish and maintain a market for our products. Potential competitors in the U.S. and other countries include major pharmaceutical and chemical companies, specialized biotechnology firms, universities and other research institutions. Many of our competitors have substantially greater research and development capabilities and experience and greater manufacturing, marketing and financial resources than we do. Accordingly, our competitors may develop products or other novel technologies that are more effective, safer or less costly than any that have been or are being developed by us or may obtain FDA and other applicable regulatory approval for products more rapidly than we are able.

Should we receive regulatory approval, we will have significant competition from other companies for Thelin™ for the treatment of PAH. These include:

•

Based on industry research analysts, other pharmaceutical companies and our internal market research, we estimate that PAH afflicts approximately 100,000 to 200,000 individuals in the United States, Canada and Europe. A number of companies have endothelin receptor antagonists, or ETRA, compounds either on the market, or in clinical development.

–

Actelion Ltd., a biotechnology company located in Switzerland, markets Tracleer^{^®} (bosentan) an oral compound for the treatment of PAH in the United States, Europe, Japan and other countries and they continue to develop bosentan for other indications. Actelion’s compound, bosentan, will compete directly with Thelin™.

	–		Myogen, Inc. is evaluating ambrisentan, an oral endothelin receptor antagonist, in PAH and has announced that it intends to file an NDA with the FDA in the fourth quarter of 2006. GSK has the right to market ambrisentan in all territories outside the U.S. If Myogen’s compound receives regulatory approval, it will compete directly with Thelin™.

	–		Abbott Laboratories is developing atrasentan for treatment of cancer and we cannot assure you that it will not compete with Thelin™.

	–		Speedel is developing SPP301, which started Phase III clinical development for diabetic nephropathy in July 2005.

•

In addition to ETRA compounds, other agents are being marketed for the treatment of PAH.

	–		Pfizer Inc. markets Revatio™ (sildenafil citrate) in PAH for patients in WHO Group I. We believe that phosphodiesterase type-5 inhibitors such as Revatio™ may be used as first-line therapy and as additive or combination therapy with endothelin antagonists.

	–		Myogen markets Flolan^® (epoprostenol), a vasodilator requiring continuous infusion through a central venous catheter and special infusion pump in the U.S. Outside the U.S., Flolan is marketed by GSK. Flolan is costly, is associated with significant adverse events including those related to its delivery, and is typically reserved by clinicians for patients with the most severe symptoms, WHO functional class IV status.

	–		CoTherix, Inc. markets Ventavis^® (iloprost), an inhalation solution for the treatment of PAH in WHO Group I, patients with NYHA Class III or IV symptoms in the U.S. Ventavis^® is marketed outside the U.S. by Schering, A.G. or one of its subsidiaries. During clinical trials, Ventavis^® was administered six to nine times a day.

	–		United Therapeutics Corporation markets Remodulin^® (treprostinil sodium injection), a prostaglandin analog that is required to be administered subcutaneously or intravenously through an infusion pump, and is also being studied for potential use through inhalation

We have significant competition for Argatroban for the treatment of HIT. The products that compete with Argatroban include:

	•		Refludan^{^®}, which was approved by the FDA in 1997 for the treatment of HIT;

	•		Orgaran^{^®}, which is a low molecular weight heparinoid that has been approved for the treatment of deep vein thrombosis, but is believed to be used without an approved indication (“off-label”) for the treatment of HIT in the U.S.; and

	•		Angiomax^{^®}, which is approved for use in the U.S. as an anticoagulant in patients with unstable angina undergoing percutaneous transluminal coronary angioplasty and for the treatment of HIT.

We cannot assure you that technological development by others will not render our products or product candidates uncompetitive or that we will be successful in establishing or maintaining technological competitiveness.

Item 2. Unregistered Sales of Equity Securities and Use of Proceeds

None.

Item 3. Defaults Upon Senior Securities

None

Item 4. Submission of Matters to a Vote of Security Holders

On May 12, 2006, we held an annual meeting of our stockholders. The holders of 29,589,255 shares of common stock were present in person or represented by proxy at the meeting. At the meeting, the stockholders elected the following persons to serve as directors of the Company until the next annual meeting of stockholders or until their successors are duly elected and qualified:


	Number of Votes		Number of Votes
Name of Nominee	Voted For		Withheld
Ron J. Anderson, M.D.		50,708,574		1,315,701
J. Kevin Buchi		50,607,752		1,416,523
Robert J. Cruikshank		49,949,695		2,074,580
John H. Dillon II		50,610,655		1,413,620
Richard A. F. Dixon, Ph.D.		50,694,699		1,329,576
Bruce D. Given, M.D.		50,711,025		1,313,250
Suzanne Oparil, M.D.		50,696,237		1,328,038
John M. Pietruski		50,702,320		1,321,955
James A. Thomson, Ph.D.		50,059,019		1,965,256
James T. Willerson, M.D.		50,069,362		1,954,913

Item 5. Other Information

None.

Item 6. Exhibits


Exhibit No.		Description
	10.1	Separation Agreement and Release dated July 6, 2006 between the Company and Terrance C. Coyne, M.D.

	10.2	Transition Agreement dated March 30, 2006 between the Company and Stephen L. Mueller.

	31.1	Certification of Chief Executive Officer pursuant to Rule 13a-14(a) / Rule 15d-14(a), promulgated under the Securities Exchange Act of 1934, as amended.

	31.2	Certification of Chief Financial Officer pursuant to Rule 13a-14(a) / Rule 15d-14(a), promulgated under the Securities Exchange Act of 1934, as amended.

	32.1	Certification Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

	32.2	Certification Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

ENCYSIVE PHARMACEUTICALS INC.

August 9, 2006

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, on the 9th day of August 2006.


	ENCYSIVE PHARMACEUTICALS INC.
	By:	/s/ Bruce D. Given, M.D.
		Bruce D. Given, M.D.
		President and Chief Executive Officer



	By:	/s/ Gordon H. Busenbark
		Gordon H. Busenbark
		Chief Financial Officer (Principal Financial and Accounting Officer)

INDEX TO EXHIBITS


Exhibit No.		Description
10.1		Separation Agreement and Release dated July 6, 2006 between the Company and Terrance C. Coyne, M.D.

10.2		Transition Agreement dated March 30, 2006 between the Company and Stephen L. Mueller.

31.1		Certification of Chief Executive Officer pursuant to Rule 13a-14(a) / Rule 15d-14(a), promulgated under the Securities Exchange Act of 1934, as amended.

31.2		Certification of Chief Financial Officer pursuant to Rule 13a-14(a) / Rule 15d-14(a), promulgated under the Securities Exchange Act of 1934, as amended.

32.1		Certification Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

32.2		Certification Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

Positive
Negative
Uncertain
Constraining
Legalese
Litigious
Readability	H.S. sophomore Avg

Encysive Pharmaceuticals (ENCY) Inactive 10-Q2006 Q2 Quarterly report

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