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Article by DailyStocks_admin    (04-23-08 08:19 AM)

The Daily Magic Formula Stock for 04/23/2008 is DepoMed Inc. According to the Magic Formula Investing Web Site, the ebit yield is 11% and the EBIT ROIC is 100%.

Dailystocks.com only deals with facts, not biased journalism. What is a better way than to go to the SEC Filings? It's not exciting reading, but it makes you money. We cut and paste the important information from SEC filings for you to get started on your research on a specific company.


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BUSINESS OVERVIEW

COMPANY OVERVIEW

Depomed is a specialty pharmaceutical company focused on the development and commercialization of differentiated products that address large and growing markets and are based on proprietary oral drug delivery technologies. In 2004, we announced our determination to evolve from a solely product development focused company to an integrated specialty pharmaceutical company, with sales and marketing of our own products. Preliminary staffing for these activities began in 2005. In 2006 and 2007, we enhanced our internal sales and marketing capabilities through the hiring of additional sales and marketing employees and the engagement of consultants.

We have developed two commercial products. GLUMETZA® (metformin hydrochloride extended release tablets) is a once-daily treatment for adults with type 2 diabetes that we commercialize in the United States. ProQuin® XR (ciprofloxacin hydrochloride extended release tablets) is a once-daily treatment for uncomplicated urinary tract infections that we commercialize in the United States with Watson Pharma (Watson).

We have a three-pronged approach to product development designed to optimize the use and value of our drug delivery technologies, while managing the costs and risks associated with developing and commercializing pharmaceutical products. We develop products for our own account that are designed to compete in large growing markets and that can be highly differentiated from immediate release versions of the compounds upon which they are based. Second, we selectively enter into collaborative partnerships with other companies where the unique capabilities of our technology can provide superior value to a partner's compound, resulting in significantly greater value for Depomed than a traditional fee-for-service arrangement. Third, we enter into arrangements that enable our technology to be applied by other companies to a greater number of compounds than our infrastructure can support, so as to derive additional value from our technology. In the future, we plan to commercialize our proprietary products, relying on partners to cover the large primary care audiences, while maintaining co-promotion and distribution rights in order to be in a position to create our own sales force when appropriate, thereby increasing the value to us of our products, and our control over them.

Our most advanced product candidate in development is Gabapentin GR™, an extended release form of gabapentin. With respect to Gabapentin GR, we have completed a Phase 2 clinical trial for the treatment of women with menopausal hot flashes. We have also completed a Phase 3 clinical trial for the treatment of postherpetic neuralgia, and have initiated a second Phase 3 trial for the same indication. In addition, we have other product candidates in earlier stages of development, including a treatment for gastroesophageal reflux disease.

SIGNIFICANT DEVELOPMENTS DURING 2007

Among the significant developments in our business during 2007 were the following:


In February 2007, we entered into a license and development agreement with Biovail Corporation granting Biovail an option to license our AcuForm drug delivery technology to develop and commercialize up to two pharmaceutical products.


In April 2007, we completed a registered direct offering of 5,300,000 shares of common stock with selected institutional investors and received net proceeds of approximately $20.0 million.


In June 2007, we enrolled our first patient in a Phase 2 clinical trial for Gabapentin GR for menopausal hot flashes. We completed enrollment of the study in September, and announced positive top-line efficacy data in February 2008.


In July 2007, we announced the results of our Phase 3 clinical trial for Gabapentin GR for postherpetic neuralgia. The primary endpoint in the study was not achieved with statistical significance for either active treatment regimen, as compared to placebo, over the ten-week treatment period. However, important secondary endpoints related to efficacy were achieved

with statistical significance relative to placebo, and the incidence of certain adverse events associated with gabapentin was relatively low.


In July 2007, we terminated our license and supply arrangements with Esprit Pharma related to ProQuin XR, and the marketing and distribution rights in the United States for ProQuin XR were transferred back to us. We received $17.5 million in payments pursuant to the termination agreement.


In July 2007, we entered into a promotion agreement with Watson granting Watson a co-exclusive right to promote ProQuin XR to the urology specialty and long-term care facilities in the United States. In September 2007, we amended the agreement to also grant Watson a co-exclusive right to promote ProQuin XR to the ob/gyn specialty.


In August 2007, Dr. John W. Fara retired from his positions as our Chairman, President and Chief Executive Officer of Depomed. Dr. Fara continues to serve Depomed as a director and a consultant to the Company.


In August 2007, Carl A. Pelzel was appointed as our President and Chief Executive Officer, and Craig R. Smith, M.D., was appointed Chairman of the Board of Directors.


In August 2007, we announced the results of a Phase 2a pharmacokinetic/pharmacod ynamic proof-of-concept study of patients suffering with nocturnal acid breakthrough (NAB) associated with GERD.


In September 2007, we implemented a reduction in force affecting approximately one-fourth of our employees.


In October 2007, John F. Hamilton retired as our Vice President, Finance and Chief Financial Officer, and Tammy L. Cameron, our Corporate Controller, was appointed as our principal accounting and financial officer on an interim basis.


In October 2007, we terminated our promotion agreement with King Pharmaceuticals related to GLUMETZA. Pursuant to the termination agreement, King paid us $29.7 million in termination and other fees, and fulfilled its GLUMETZA promotion obligations through December 31, 2007.


In December 2007, Michael Sweeney, M.D. was appointed as our Vice President, Product Development.


Revenues for the year ended December 31, 2007 were $65.6 million, and included $48.6 million associated with our Esprit license, supply and termination agreements, compared to $9.6 million for the year ended December 31, 2006.


Operating expenses for the year ended December 31, 2007 were $15.4 million, compared to operating expenses of $49.6 million for the year ended December 31, 2006. Operating expenses for 2007 included a $29.6 million gain on termination of our promotion agreement with King, and a $5.0 million gain on termination of our Esprit license and supply agreements


Cash, cash equivalents and marketable securities were $69.5 million as of December 31, 2007, compared to $33.6 million as of December 31, 2006.

MARKETED PRODUCTS

GLUMETZA

General

The 500mg strength of GLUMETZA is our internally developed once-daily metformin product for type 2 diabetes. The FDA approved GLUMETZA for marketing in the United States in June 2005. At that time, a subsidiary of Biovail Corporation, or Biovail, held US and Canadian marketing rights to GLUMETZA pursuant to a license agreement we entered into with the Biovail subsidiary in 2002. We reacquired the US rights to GLUMETZA from Biovail in December 2005. In June 2006, we entered into a promotion arrangement with King Pharmaceuticals (King) related to GLUMETZA under which we and King jointly commercialize GLUMETZA in the United States. GLUMETZA was launched in the United States in September 2006. In February 2007, we obtained a waiver from the FDA of a Phase 4 pediatric study on GLUMETZA.

In October 2007, we terminated our promotion agreement with King related to GLUMETZA. Pursuant to the termination agreement, King paid us $29.7 million in termination and other fees, and fulfilled its GLUMETZA promotion obligations through December 31, 2007. We are not required to pay King promotion fees on sales of GLUMETZA for periods after September 30, 2007. We are in discussions with potential marketing partners for GLUMETZA in the United States.

In connection with the restructuring of our GLUMETZA agreements with Biovail in December 2005, we also acquired an exclusive US license to a 1000mg strength of GLUMETZA utilizing proprietary Biovail drug delivery technology. In December 2007, the FDA approved the 1000mg formulation for marketing in the United States. We expect the 1000mg GLUMETZA to be available late in the second quarter of 2008.

Our issued US patents covering the 500mg GLUMETZA expire between 2016 and 2021. Biovail has a patent application related to the 1000mg formulation that is pending.

The 500mg GLUMETZA has also been approved for marketing in Canada, where it is marketed by Biovail, and in Korea, where it is marketed by LG Life Sciences under the trade name Novamet GR.

Diabetes

Diabetes is a disease in which levels of glucose, a type of sugar found in the blood, are above normal. Diabetic patients do not produce insulin, a hormone produced in the pancreas, or do not properly use insulin, making it difficult for the body to convert food into energy. Type 2 diabetes is the most common form of diabetes, accounting for 90 to 95 percent of all diabetes cases, according to the National Institute of Diabetes and Digestive and Kidney Diseases of the National Institutes of Health, or the NIDDK.

The body breaks down food into glucose, and delivers glucose to cells through the bloodstream. Cells use insulin to help process blood glucose into energy. In the case of type 2 diabetes, cells fail to use insulin properly or the pancreas cannot make as much insulin as the body requires. That causes the amount of glucose in the blood to increase, while starving cells of energy. Over time, high blood glucose levels damage nerves and blood vessels, which can lead to complications such as heart disease, stroke, blindness, kidney disease, nerve problems, gum infections, and amputation.

Target Market

According to the American Diabetes Association (ADA), 24 million people in the United States have diabetes. Of those, 17.5 million are diagnosed. The ADA estimates that the number of diagnosed diabetics in the United States is increasing by approximately one million per year. Among adults with diagnosed diabetes, 57 percent take oral medication only, and 12 percent take both insulin and oral medication, according to the 2001-2003 National Health Interview Survey of the Centers for Disease Control and Prevention. In 2006, the metformin market in the United States was approximately $1.4 billion in retail sales.

GLUMETZA Collaboration, Commercialization and Licensing Arrangements

We are currently seeking a commercialization partner for GLUMETZA in the United States.

Publicis Selling Solutions. In February 2008, we entered into a professional detailing services agreement with Publicis Selling Services pursuant to which approximately 33 part-time Publicis sales representatives detail GLUMETZA to physicians. The term of the contract is six months.

King Pharmaceuticals. In June 2006, we entered into a promotion agreement with King Pharmaceuticals pursuant to which we granted King the co-exclusive right to promote GLUMETZA in the United States. Under the agreement, King was required to promote GLUMETZA to physicians in the United States through its sales force, to deliver a minimum number of annual detail calls to potential GLUMETZA prescribers, and to maintain a sales force of a minimum size. In consideration for its promotion of GLUMETZA, King received a promotion fee equal to fifty percent of gross margin, which was defined in the agreement as sales of GLUMETZA, net of returns, discounts, rebates and chargebacks, minus cost of goods sold and certain adjustments. Out-of-pocket marketing expenses were shared with King at an agreed-upon ratio, in which Depomed's share was lower than King's.

In October 2007, we and King terminated the promotion agreement. Pursuant to the termination agreement, King paid us $29.7 million in termination and other fees, and fulfilled its GLUMETZA promotion obligations through December 31, 2007. We are not required to pay King promotion fees on sales of GLUMETZA for periods after September 30, 2007.

Biovail. We licensed US and Canadian rights to GLUMETZA to Biovail in 2002. In 2005, we received a $25.0 million license fee payment from Biovail under our original license agreement following FDA approval of GLUMETZA. In December 2005, we and Biovail entered into an Amended and Restated License Agreement relating to GLUMETZA. The Amended and Restated License Agreement supersedes our April 27, 2004 Amended License and Development Agreement with Biovail.

Pursuant to the amended and restated license agreement, Biovail has an exclusive license in Canada to manufacture and market the 500mg GLUMETZA, and we receive royalties of six percent of Canadian net sales of the 500mg GLUMETZA. We also receive payments from Biovail equal to one percent of Canadian net sales of the 1000mg GLUMETZA. The royalty payable by Biovail on net sales of the 500mg GLUMETZA was increased to ten percent for the period from June 30, 2007 to December 28, 2007, and returned to six percent when we obtained regulatory approval in the United States of the 1000mg formulation of GLUMETZA.

In December 2005, we also entered into a Manufacturing Transfer Agreement and a Supply Agreement with Biovail related to the 1000mg GLUMETZA with Biovail. Under those agreements, we received an exclusive license to market the 1000mg GLUMETZA in the United States, and an exclusive license to the "GLUMETZA" trademark in the United States for the purpose of marketing GLUMETZA. We will purchase 1000mg GLUMETZA exclusively from Biovail under the Supply Agreement, subject to back-up manufacturing rights in our favor. If we exercise our back-up manufacturing rights, compensation to Biovail will change from a supply-based arrangement to royalties of six percent of net sales of the 1000mg GLUMETZA in the United States (or, if less, thirty percent of royalties and other similar payments from our licensees) under the Manufacturing Transfer Agreement. Also, we will pay Biovail royalties of one percent of net sales of the 500mg GLUMETZA in the United States (or, if less, five percent of royalties and other similar payments from our licensees).

LG Life Sciences. In August 2004, we entered into a license and distribution agreement granting LG Life Sciences an exclusive license to the 500mg GLUMETZA in the Republic of Korea. LG Life Sciences launched the product, known as Novamet GR, in Korea in 2006.

We received a $0.6 million upfront license fee from LG in connection with entering into the agreement. In November 2006, we amended the agreement to provide for a $0.5 million milestone payment from LG with respect to LG's approval to market GLUMETZA in the Republic of Korea, rather than a $0.7 million payment, as reflected in the original agreement. We received the $0.5 million payment in November 2006, net of applicable Korean withholding taxes, and commenced negotiations to further amend the agreement to formally grant LG a license to manufacture the 500mg GLUMETZA in exchange for royalties on net sales of GLUMETZA in Korea, and to remove the provisions of the original agreement providing for the supply of 500mg GLUMETZA tablets by us to LG. In January 2007, we completed our negotiations with LG, and entered into an amended license agreement implementing the provisions.

ProQuin® XR

General

ProQuin XR is a once-daily formulation of the antibiotic ciprofloxacin for uncomplicated urinary tract infections. We developed ProQuin XR, and the FDA approved it for marketing in the United States in May 2005. Esprit Pharma licensed marketing rights to ProQuin XR in the United States in July 2005, and launched the product in the United States in November 2005.

Our issued US patents covering ProQuin XR expire between 2016 and 2020. We have additional US patent applications covering ProQuin XR that are pending.

Uncomplicated Urinary Tract Infection

A urinary tract infection, or UTI, is an infection in the urinary bladder. An uncomplicated UTI is a UTI that does not spread from the bladder to the kidney or the prostate. Common symptoms associated with UTIs include a frequent urge to urinate and a painful, burning feeling in the area of the bladder or urethra during urination, and an overall ill-feeling of malaise.

Uncomplicated UTIs are very common in women between 20 and 50. The NIDDK reports that infections of the urinary tract are the second most common type of infection in the body, account for approximately 8.3 million doctor visits each year, with one woman in five developing a UTI during her lifetime. According to the NIDDK, nearly 20% of women who experience a UTI will experience another. 30% of women who experience a second UTI will have a third UTI, and 80% of women who have at least three UTIs, or approximately one woman in one hundred, will have recurrences.

Target Market

Ciprofloxacin is a member of the family of drug compounds known as quinolones, which also includes levaquin. In 2006, there were approximately 8 million prescriptions for quinolones filled in the United States.

ProQuin XR Collaboration and Licensing Arrangements

Watson Pharma. In July 2007, following the termination of our ProQuin XR licensing arrangement with Esprit Pharma described below, we entered into a promotion agreement with Watson Pharma, a subsidiary of Watson Pharmaceuticals, granting Watson a co-exclusive right to promote ProQuin XR to the urology specialty and long-term care facilities in the United States. In September 2007, we amended the agreement to also grant Watson a co-exclusive right to promote ProQuin XR to the ob/gyn specialty. Watson is required to deliver a minimum number of annual sales detail calls and maintain a sales force of a minimum size. Watson will receive a promotion fee equal to an agreed upon portion of gross margin attributable to the urology and ob/gyn specialties and long-term care facilities above an agreed upon baseline level. We are responsible for the manufacture and distribution of ProQuin XR. Each party bears all of its own personnel and other costs, including marketing expenses. The term of the promotion agreement is three years, subject to early termination in certain circumstances, with up to two additional one-year renewal periods at the election of Watson. We have retained the right to promote ProQuin XR to physicians outside the urology and ob/gyn specialties and long-term care markets, either directly or through third parties. We and Watson re-launched ProQuin XR in October 2007.

Esprit Pharma. In July 2005, we entered into an exclusive license and marketing agreement with Esprit Pharma, Inc. pursuant to which we granted Esprit exclusive US marketing and distribution rights to ProQuin XR. The agreement obligated Esprit to pay us $50 million in license fees; $30 million, which was paid in 2005, and two $10 million installments in July 2006 and in July 2007. The agreement also provided for royalty payments to us of 15 percent to 25 percent of ProQuin XR net sales, based on escalating net sales, subject to minimum royalty obligations of $4.6 million in 2006, $5.0 million in 2007 and in subsequent years remains at $5.0 million, subject to annual increases in the consumer price index beginning in 2008. We also had a supply agreement with Esprit under which we provided Esprit with commercial quantities of ProQuin XR.

In July 2006, we amended the license agreement with Esprit to, among other matters, extend to December 2006 the due date on the $10 million license fee payment to Depomed that had been due in July 2006, to credit royalties paid to us for sales made in the fourth quarter of 2005 of ProQuin XR against Esprit's $4.6 million minimum royalty obligation in 2006, and to establish a joint marketing team to periodically review and discuss all aspects of the commercialization of ProQuin XR.

Also in July 2006, we entered into a co-promotion agreement with Esprit in which we obtained co-promotion rights to market ProQuin XR that permitted us to promote ProQuin XR in the United States to up to 40,000 physicians in exchange for an 18% promotion fee.

In December 2006, we delivered a notice to Esprit regarding alleged breaches by Esprit of the license agreement. The alleged breaches related to Esprit's failure to make a $10 million license fee payment due to the Company in December 2006, and to use commercially reasonable efforts to market ProQuin XR. In connection with the notice, we filed a demand for binding arbitration. Subsequent to the delivery of the notice and demand for arbitration, Esprit paid us the $10 million license fee payment in December 2006 and we withdrew without prejudice the notice and demand for arbitration. We also agreed to commence, in January 2007, discussions with Esprit toward a mutually agreeable, long-term restructuring of the license agreement.

In July 2007, we entered into a termination and assignment agreement with Esprit terminating the exclusive license and marketing agreement, and the related supply and co-promotion agreements. Upon entering into the termination and assignment agreement, the marketing and distribution rights in the United States for ProQuin XR were transferred back to us and Esprit paid us $17.5 million, representing (i) a $10.0 million payment in respect of the final license payment that would have been due to us in July 2007 under the exclusive license and marketing agreement; (ii) a $2.5 million payment in respect to a pro-rated portion minimum royalties for 2007; and (iii) a $5.0 million termination fee. The termination and assignment agreement removed Esprit's future minimum royalty obligations to us. Under the termination and assignment agreement, Esprit remains responsible for all returns and rebates associated with ProQuin XR product distributed by Esprit.

Madaus/Rottapharm. In November 2005, we entered into a distribution and supply agreement for ProQuin XR in Europe with a privately owned specialty pharmaceutical company, Madaus S.r.l., who was acquired by Rottapharm in June 2007. Under the terms of the agreement, we granted an exclusive right to Madaus for the commercialization of ProQuin XR in Europe and agreed to supply Madaus with commercial quantities of ProQuin XR tablets in bulk form. In March 2006, Madaus filed a Marketing Authorization Application for ProQuin XR with the Medical Products Agency in Sweden. We assisted Madaus with a response to comments and questions on the Marketing Authorization Application that Madaus received in May 2007. Madaus submitted its response to the Swedish Medical Products Agency's questions and comments in August 2007, and submitted responses to further questions and comments in December 2007. We anticipate that the Medical Products Agency will make a final determination on the application before the end of the second quarter of 2008.

COMPENSATION

Compensation Elements

Base Salary. The Company seeks to provide its executive officers with competitive annual base salaries in order to attract and retain talented individuals. However, the Company seeks to ensure that a substantial portion of its executives' compensation depends on the achievement of corporate and individual goals. In determining appropriate salary levels for a given executive officer, the Compensation Committee considers the following factors:


individual performance;


level of responsibility;


breadth, scope, and complexity of the position;


executives' salaries relative to each other; and


salary levels for comparable positions at peer companies.

In addition to the salary actions set forth in the table above:


In August 2007, the Compensation Committee set Mr. Pelzel's annual base salary at $400,000 in connection with his appointment as President and Chief Executive Officer;


In July 2007, Ms. Cameron's annual base salary was set at $185,000 in connection with the commencement of her employment as Controller;


In December 2007, the Compensation Committee set the annual base salary of Dr. Michael Sweeney at $310,000 in connection with the commencement of his employment as Vice President of Product Development.

Cash Bonus. The Company's executive officers participate in the Depomed, Inc. Bonus Plan (the "Bonus Plan"), which provides for annual cash bonuses based on the achievement of individual and corporate objectives. Executives' cash bonus target as a portion of base salary is 50% (in the case of the CEO), 40% (in the case of the COO) or 35% (in the case of all other executive officers). Payment of annual cash bonuses is designed to reward performance for achieving business goals, which the Company believes increases shareholder value.

Bonus payouts are tied in significant part to company-wide corporate objectives set by the Board, generally in the first quarter or early second quarter of the fiscal year. Corporate objectives are generally quantitative in nature, so that achievement can be objectively measured, and are weighted by relative importance. Following the completion of the fiscal year, the Compensation Committee assesses the Company's performance relative to the corporate goals, and applies a "corporate multiplier" based on that assessment. A corporate multiplier of 100% reflects 100% achievement of corporate objectives. The weighting of the achievement of corporate objectives as a portion of an executive's total bonus payout is 80% (in the case of the CEO), 70% (in the case of the COO) or 60% (in the case of all other executive officers). The Compensation Committee believes that the Company's corporate objectives are, on the whole, ambitious but achievable. The corporate multipliers established for 2005, 2006, and 2007 was 105%, 65% and 75%, respectively.

Corporate objectives for 2007 related to growth in shareholder value, product revenue, net loss, clinical development and marketing partnership activities related to the Company's Gabapentin GR® product candidate for postherpetic neuralgia, and clinical development of the Company's Gabapentin GR product candidate for menopausal hot flashes, among others. In January 2008, the Compensation Committee evaluated the Company's performance against the corporate objectives for the year. The committee determined that there had been significant achievement of many corporate goals for the year, including the goals related to revenue, net loss and clinical development of Gabapentin GR for menopausal hot flashes. The committee also determined that a number of important corporate goals, including those related to shareholder value and Gabapentin GR for postherpetic neuralgia, had not been achieved. The committee set the corporate multiplier for 2007 at 75%. The committee's determination of the corporate multiplier, which was ratified by the full Board, reflected an upward adjustment of 20%, from 55% to 75%, that the committee felt warranted in light of the Company's achievement of a number of objectives that were not specifically contemplated at the time the 2007 objectives were set. Those achievements include, among others: (i) the completion of a $20 million equity financing in April 2007; (ii) the Company's receipt of $17.5 million in connection with the termination of the Company's marketing arrangement with Esprit Pharma related to the Company's Proquin® XR product, and the establishment of a new Proquin XR marketing arrangement with Watson Pharma; (iii) the Company's receipt of approximately $29.7 million in connection with the termination of the Company's marketing arrangement with King Pharmaceuticals related to Glumetza®; (iv) the advancement of the Company's pre-clinical product pipeline; and (v) the progress of the Company's patent litigation against IVAX Corporation.

In addition to corporate goals, the Compensation Committee sets individual goals for the CEO, and the CEO or COO sets individual goals for each of the other executive officers. The weighting of individual goals as a portion of an executive's total bonus payout is 20% (in the case of the CEO), 30% (in the case of the COO) or 40% (in the case of all other executive officers). Mr. Pelzel's bonus for 2007 was pro-rated for the period he served as COO (January 1, 2007—August 26, 2007) and the period he served as CEO (August 27, 2007—December 31, 2007). Individual objectives are generally quantitative in nature, weighted by relative importance, and linked with corporate goals. Following the completion of the year, the Compensation Committee (in the case of the CEO) and the Compensation Committee in consultation with the CEO (in the case of other executive officers) review the achievement of individual goals, and determine the extent to which each goal was achieved, where a rating of "1" indicates full achievement of a given goal. An executive may earn a rating of greater than "1" with respect to a particular goal if his performance in achieving the goal exceeds expectations. Based on each executive's achievement of his individual goals and the weighting of the goals, he receives an overall individual rating.

Each executive's total annual cash bonus is determined by applying the corporate multiplier to the portion of his bonus target tied to corporate objectives, and by applying his overall individual rating to the portion of his bonus target tied to individual goals. For their 2007 performance, the named executive officers received the cash bonuses set forth below under " Summary Compensation Table ".

Stock Options and Equity Awards

Stock Options. The Company grants stock options to executive officers to aid in their retention, to motivate them to assist with the achievement of corporate objectives, and to align their interests with those of the Company's shareholders by providing executives with an equity stake. Stock options granted to executive officers have an exercise price equal to 100% of the fair market value of the Company's common stock (the closing sales price on the Nasdaq Global Market) on the date of grant, so they have value only to the extent that the market price of the Company's common stock increases after the date of grant. Typically, stock options vest and become exercisable over four years. One-quarter of the shares subject to the option vesting after one year in the case of initial option grants. Options generally vest monthly in the case of annual "refresher" grants. The Compensation Committee makes stock option grants to executive officers.

Stock options typically are granted to executive officers when they join the Company, and often in connection with significant changes in responsibilities. In considering initial option grants for executives, the committee takes into account the total compensation package offered to the executive, equity grants to comparable executives at similarly situated companies, and the number of stock options granted to the new executive relative to the stock options held by or granted to the Company's other executives. In 2007, the committee granted to Tammy L. Cameron the options set forth below under " Grants of Plan-Based Awards " in connection with the commencement of her employment with the Company as Controller. The committee granted Michael Sweeney options to purchase 95,000 shares of Common Stock in connection with the commencement of his employment as the Company's Vice President, Product Development.

The Compensation Committee also considers annual "refresher" grants for executive officers based on the same factors it considers in making initial option grants, as well as the executive's performance, the Company's performance relative to corporate objectives, and recent growth or decline in shareholder value. Refresher grants are generally made in the first quarter of the fiscal year. The dates of meetings of the Compensation Committee vary, are not set in advance, and are not coordinated with the release of information concerning the Company's business. In March 2007, in connection with its determinations regarding executive compensation, the committee decided that given the relatively small size of the pool of Company stock options available for future grant, it would make refresher grants to Messrs. Pelzel (50,000 shares) and Gosling (25,000 shares) only. In choosing to make grants to Messrs. Pelzel and Gosling at that time, the committee considered their performance and the number of stock options held by Messrs. Pelzel and Gosling, as well as the exercise prices of those options, relative to other officers of the Company.

In May 2007, following approval by the Company's shareholders of an increase in the size of the Company's option pool, and in light of the committee's view that the Company had made considerable progress through that point in the year, the committee made refresher grants to all of the Company's executive officers at 125% of the level the committee considered in March 2007. Dr. Fara received an option to purchase 93,750 shares, Mr. Pelzel received an option to purchase 12,500 shares (25% of the number he received in March 2007), Mr. Hamilton received an option to purchase 43,750 shares, Mr. Shell received an option to purchase 31,250 shares, and Mr. Gosling received an option to purchase 6,250 shares (25% of the number he received in March 2007).

In August 2007, at the time that Mr. Pelzel was appointed as President and CEO, the committee made stock option grants to all Company employees. One-half of the shares subject to the options vest in August 2008, and thereafter in 12 equal monthly installments, so that the options are fully vested on the second anniversary of the grant date. The committee felt that these special option grants were necessary to ensure that it would retain and properly motivate its employees during what the committee considers to be a critical period in the Company's development.

CEO Compensation

In setting Mr. Pelzel's initial base salary and equity compensation as President and CEO, the Compensation Committee reviewed an analysis of 2006 compensation paid to Dr. Fara and 21 other CEOs of publicly-traded Bay Area pharmaceutical and biotechnology companies (including those identified above under " Competitive Market Review "). The analysis summarized base salary and bonus, stock option holdings as a percentage of outstanding shares, tenure in office, market capitalization, and revenue and earnings per share. The Compensation Committee set Mr. Pelzel's base salary at $400,000 per year and agreed to grant him options to purchase 500,000 shares, or slightly over 1% of the Company's outstanding shares of Common Stock. Mr. Pelzel's base salary and equity compensation were in the bottom quartile of the peer group. The Compensation Committee felt that the overall compensation package was appropriate given the Company's relatively low market capitalization at that time (16 th of the 22 companies reviewed), and the fact that Mr. Pelzel had not previously served as CEO of a publicly traded company.

Of the options to purchase 500,000 shares of Common Stock the Company agreed to grant Mr. Pelzel in connection with his appointment as President and CEO, 400,000 vest in equal monthly installments over four years, and 100,000 are performance vesting options that will vest in proportion to the Company's aggregate achievement of its 2008 corporate objectives. Shares that do not vest on the basis of 2008 performance will vest in August 2011. The Compensation Committee felt that the performance vesting options were an important reflection of the need to quickly make considerable progress toward the Company's strategic objectives.

Of the performance vesting options, 37,500 were granted in August 2007 and 62,500 were granted in January 2008. The grant of the performance vesting options was split between 2007 and 2008 due to an inconsistency in the Company's option plan regarding the treatment of a new CEO hired from outside the Company relative to a new CEO promoted from within the Company. The Company's 2004 Equity Incentive Plan has a 750,000 share limitation on option grants made to new hires, which was intended as a ceiling on the number of options that might be granted to a newly hired CEO at some point after the plan's adoption. However, because Mr. Pelzel was promoted from within the Company, rather than brought in from the outside, a separate 500,000 share annual limitation applied to option grants made to Mr. Pelzel made in 2007. As Mr. Pelzel had already been granted options to purchase 62,500 shares prior to August 2007 in connection with his service as the Company's COO, and because the committee and Mr. Pelzel had agreed that Mr. Pelzel should receive options to purchase 500,000 shares in connection with his appointment as CEO, the committee agreed to grant Mr. Pelzel the balance of 62,500 shares after January 1, 2008 at the same exercise price as the grant made to Mr. Pelzel in August 2007. When the Compensation Committee met in January 2008, it was clear that granting Mr. Pelzel shares at the agreed-upon $1.98 exercise price would be impractical under the IRS's final deferred compensation regulations. As a result, in order to compensate Mr. Pelzel for the incrementally higher exercise price of the balance of 62,500 shares granted at $3.60 rather than $1.98 and as a reward for his performance in 2007, the committee agreed to issue Mr. Pelzel 30,000 shares in 2009, which the committee believed would have the effect of encouraging Mr. Pelzel to work to increase shareholder value throughout 2008.

In January 2008, the Compensation Committee awarded Mr. Pelzel a bonus for his 2007 performance of $150,000. The bonus award reflected the committee's assessment of Mr. Pelzel's performance as COO through August 2007, and his performance as CEO thereafter. In particular, the committee considered (a) the substantial increase in the price of the Company's Common Stock subsequent to Mr. Pelzel's promotion, from $1.98 on August 24, 2007 to $3.60 on January 25, 2008 when the committee determined the bonus award, and (b) Mr. Pelzel's role in non-dilutive transactions described above under " Cash Bonus " that significantly enhanced the Company's financial reserves.

Severance Agreements

In May 2006, the Company adopted the management continuity agreements described below in the section entitled " Potential Payments upon Termination or Change in Control ". The Company adopted the agreements in order to support its objectives of an overall executive compensation package that is competitive with the Company's peers, and the retention of qualified executives. As the Company sought to support those objectives without overcompensating executives in the event of a change in control, the Company adopted agreements that it believes contain terms, taken as a whole, that are somewhat less favorable to executives than similar arrangements among peer companies. In January 2008, the term of the agreements was extended by one year, to May 15, 2009.

MANAGEMENT DISCUSSION FROM LATEST 10K

OVERVIEW

Depomed is a specialty pharmaceutical company focused on the development and commercialization of differentiated products that address large and growing markets and are based on proprietary oral drug delivery technologies. We have developed two commercial products. GLUMETZA® (metformin hydrochloride extended release tablets) is a once-daily treatment for adults with type 2 diabetes. ProQuin® XR (ciprofloxacin hydrochloride extended release tablets) is a once-daily treatment for uncomplicated urinary tract infections that we commercialize in the United States with Watson Pharma.

We have a three-pronged approach to product development designed to optimize the use and value of our drug delivery technologies, while managing the costs and risks associated with developing and commercializing pharmaceutical products. We develop products for our own account that are designed to compete in large growing markets and that can be highly differentiated from immediate release versions of the compounds upon which they are based. Second, we selectively enter into collaborative partnerships with other companies where the unique capabilities of our technology can provide superior value to a partner's compound, resulting in significantly greater value for Depomed than a traditional fee-for-service arrangement. Third, we enter into arrangements that enable our technology to be applied by other companies to a greater number of compounds than our infrastructure can support, so as to derive additional value from our technology. In the future, we plan to commercialize our proprietary products, relying on partners to cover the large primary care audiences, while maintaining co-promotion and distribution rights in order to be in a position to create our own sales force when appropriate, thereby increasing the value to us of our products, and our control over them.

Our most advanced product candidate in development is Gabapentin GR™, an extended release form of gabapentin. With respect to Gabapentin GR, we have completed a Phase 2 clinical trial for the treatment of women with menopausal hot flashes. We have also initiated a Phase 3 clinical trial for the treatment of postherpetic neuralgia. In addition, we have other product candidates in earlier stages of development, including a treatment for gastroesophageal reflux disease.

CRITICAL ACCOUNTING POLICIES AND ESTIMATES

A detailed discussion of our significant accounting policies can be found in Note 1 of the Notes to Consolidated Financial Statements, and the impact and risks associated with our accounting policies are discussed throughout this Annual Report on Form 10-K and in the footnotes to the consolidated financial statements. Critical accounting policies are those that require significant judgment and/or estimates by management at the time that financial statements are prepared such that materially different results might have been reported if other assumptions had been made. We consider certain accounting policies related to revenue recognition and use of estimates to be critical policies. These estimates form the basis for making judgments about the carrying values of assets and liabilities. We base our estimates and judgments on historical experience and on various other assumptions that we believe to be reasonable under the circumstances. Actual results could differ materially from these estimates.

We believe the following policies to be the most critical to an understanding of our financial condition and results of operations because they require us to make estimates, assumptions and judgments about matters that are inherently uncertain.

Revenue Recognition

We recognize revenue from the sale of our products, license fees and royalties earned on license agreements and collaborative arrangements. Revenue arrangements with multiple elements are divided into separate units of accounting if certain criteria are met, including whether the delivered element has stand-alone value to the customer and whether there is objective and reliable evidence of the fair value of the undelivered items. The consideration received is allocated among the separate units based on their respective fair values, and the applicable revenue recognition criteria are applied to each of the separate units. Revenue is recognized when there is persuasive evidence that an arrangement exists, delivery has occurred and title has passed, the price is fixed or determinable and we are reasonably assured of collecting the resulting receivable.

We sell GLUMETZA and ProQuin XR product to wholesalers and retail pharmacies. We began selling GLUMETZA in September 2006, and we relaunched ProQuin XR in October 2007. Our returns policy allows product returns within the period beginning six months prior to expiration and ending twelve months following product expiration. Given our limited history of selling GLUMETZA and ProQuin XR, we currently cannot reliably estimate expected returns of the product at the time of shipment. Accordingly, we defer recognition of revenue on product shipments of GLUMETZA and ProQuin XR until the right of return no longer exists, which occurs at the earlier of the time GLUMETZA and ProQuin XR units are dispensed through patient prescriptions or expiration of the right of return. We estimate patient prescriptions dispensed using an analysis of third-party information, including third-party market research data and information obtained from wholesalers with respect to inventory levels and inventory movement. We have not had significant history estimating the number of patient prescriptions dispensed. If we underestimate or overestimate patient prescriptions dispensed for a given period, adjustments to revenue may be necessary in future periods. As a result of this policy, we recognized $12.5 million in product sales, which is net of wholesaler fees, prompt payment discounts, patient support programs, chargebacks and Medicaid rebates for the year ended December 31, 2007. We have a deferred revenue balance of $6.5 million at December 31, 2007 related to GLUMETZA and ProQuin XR product shipments that have not been recognized as revenue, which is net of wholesaler fees, prompt payment discounts, chargebacks and Medicaid rebates. We will recognize revenue upon the earlier of prescription units dispensed or expiration of the right of return until we can reliably estimate product returns, at which time we will record a one-time increase in net revenue related to the recognition of revenue previously deferred. In addition, the costs of manufacturing GLUMETZA and ProQuin XR associated with the deferred revenue are recorded as deferred costs, which are included in inventory, until such time the deferred revenue is recognized.

Revenues from product sales are recorded net of wholesaler fees, prompt payment discounts, patient support programs, chargebacks and Medicaid rebates. These gross-to-net sales adjustments are recognized in the same period the related revenue is recognized and are based on estimates of the amounts earned or to be claimed on the related sales. We believe our estimates related to gross-to-net sales adjustments for wholesaler fees, prompt payment discounts, patient support programs and chargebacks do not have a high degree of estimation complexity or uncertainty as the related amounts are settled within a relatively short period of time. We do consider our estimates related to Medicaid rebates to be more complex. However, they have historically not been material amounts. If Medicaid reimbursement for our products increases or we enter into new managed care contracts for our products, these estimates may be material in future periods.

Revenue from license arrangements, including license fees creditable against future royalty obligations (if any), of the licensee, is recognized when an arrangement is entered into if we have substantially completed our obligations under the terms of the arrangement and our remaining involvement is inconsequential and perfunctory. If we have significant continuing involvement under such an arrangement, license fees are deferred and recognized over the estimated performance period.

License fee payments received in excess of amounts earned are classified as deferred revenue until earned.

Research and Development Expense and Accruals

Research and development expenses include related salaries, clinical trial costs, consultant fees and allocations of corporate costs. All such costs are charged to research and development expense as incurred. These expenses result from our independent research and development efforts as well as efforts associated with collaborations. Our expense accruals for clinical trials are based on estimates of the services received from clinical trial centers and clinical research organizations. If possible, we obtain information regarding unbilled services directly from service providers. However, we may be required to estimate these services based on information available to our product development or administrative staff. If we underestimate or overestimate the activity associated with a study or service at a given point in time, adjustments to research and development expenses may be necessary in future periods. Historically, our estimated accrued liabilities have approximated actual expense incurred.

Stock-Based Compensation

As of January 1, 2006, we began accounting for stock-based compensation in accordance with Statement of Financial Accounting Standards No. 123 (revised 2004), Share-Based Payment (FAS123(R)), using the modified prospective transition method. We use the Black-Scholes option valuation model to estimate the fair value of stock options and Employee Stock Purchase Plan (ESPP) shares. The Black-Scholes model requires the input of highly subjective assumptions. The most significant assumptions are our estimates of the expected volatility and the expected term of the award. For our volatility assumption, we use the historical volatility of our common stock over the expected term of the options. We have concluded that our historical share option exercise experience does not provide a reasonable basis upon which to estimate expected term and therefore, as of January 1, 2006, we estimate the expected term of options granted by taking the average of the vesting term and the contractual term of the option, as illustrated in SEC Staff Accounting Bulletin No. 107 (SAB 107). As required, we review our valuation assumptions at each grant date and, as a result, we are likely to change our valuation assumptions used to value employee stock-based awards granted in future periods. FAS 123(R) requires that employee and director stock-based compensation costs be recognized over the vesting period of the award, and we have elected to use the straight-line attribution method.

Prior to January 1, 2006, we measured compensation expense for our employee stock-based compensation plans using the intrinsic value method under APB No. 25. Under APB No. 25, no stock-based compensation was recognized for the ESPP or for option grants when the exercise price of the options granted was equal to or greater than the fair value market price of the stock on the grant date. In accordance with the provisions of FAS 123(R), we eliminated the balance of the deferred compensation calculated under APB No. 25 to the common stock account on January 1, 2006.

FAS 123(R) requires forfeitures to be estimated at the time of grant and revised, if necessary, in subsequent periods if actual forfeitures differ from those estimates. We estimated forfeitures based on historical experience. Prior to the adoption of FAS 123(R), pro forma information required under FAS 123 included forfeitures as they occurred.

RESULTS OF OPERATIONS

Revenues

Product sales

We began selling GLUMETZA to wholesalers and retail pharmacies in September 2006 and defer recognition of revenue on product shipments of GLUMETZA until the right of return no longer exists, which occurs at the earlier of the time GLUMETZA units are dispensed through patient prescriptions or expiration of the right of return. At December 31, 2007, we have a deferred revenue balance, which is classified as a liability on the consolidated balance sheet, of $6.1 million associated with the deferral of revenue on GLUMETZA product shipments, which is net of estimated wholesaler fees, prompt payment discounts, chargebacks and Medicaid rebates. In October 2007, we terminated our promotion agreement related to GLUMETZA with King and King's promotion obligations ended in December 2007. In February 2008, we began detailing GLUMETZA through a contract sales organization, as we do not have an established sales organization. We expect product sales for GLUMETZA to increase in 2008, however, this may be dependent on the success of our contract sales organization as well as the timing of, or the ability to find one or more commercialization partners for GLUMETZA.

ProQuin XR product sales in 2006 and 2005 relate to our supply agreement with Esprit. We began supplying Esprit with commercial quantities of ProQuin XR in the fourth quarter of 2005. In 2007, there were no sales pursuant to the supply agreement. We terminated the license and supply agreements with Esprit in July 2007 and the marketing and distribution rights in the United States for ProQuin XR reverted back to us.

In October 2007, we re-launched ProQuin XR with Watson, and began selling to wholesalers and retail pharmacies. We defer recognition of revenue on product shipments of ProQuin XR until the right of return no longer exists, which occurs at the earlier of the time ProQuin XR units are dispensed through patient prescriptions or expiration of the right of return. At December 31, 2007, we have a deferred revenue balance, which is classified as a liability on the consolidated balance sheet, of $0.4 million associated with the deferral of revenue on ProQuin XR product shipments, which is net of estimated wholesaler fees, stocking allowances, prompt payment discounts, chargebacks and Medicaid rebates. We expect product sales of ProQuin XR to increase in 2008.

Royalties

Our agreements with Esprit provided for royalty payments by Esprit to us of 15 percent to 25 percent of ProQuin XR net sales in the United States, based on escalating net sales and subject to certain minimum royalty amounts. Esprit's minimum royalty amount for 2006 was $4.6 million and under our amended license agreement entered into in July 2006, amounts paid by Esprit for 2005 royalties were creditable against the 2006 minimum royalty obligation. Net sales of ProQuin XR by Esprit for 2005 and 2006 did not reach levels that would obligate Esprit to pay an amount greater than the minimum royalty obligation, and accordingly, Esprit paid us $4.6 million in total royalties for 2005 and 2006. In July 2007, we terminated our license agreement with Esprit, and Esprit paid us $2.5 million in royalties, representing a pro-rated amount of minimum royalties that would have been due to us under the original agreements. Esprit is no longer obligated to pay us royalties on ProQuin XR sales.

GLUMETZA royalties relate to royalties we received from Biovail based on net sales of GLUMETZA in Canada and royalties we received from LG based on net sales of LG's version of GLUMETZA, Novamet GR, in Korea. We began receiving royalties from Biovail in the first quarter of 2006 and from LG in the first quarter of 2007.

As a result of the termination of the Esprit agreements, we expect royalty revenue to decrease in 2008.

License revenue

Our license agreement with Esprit for ProQuin XR provided for $50.0 million in license fees from Esprit. We received $30.0 million in license fees in July 2005 and an additional $10.0 million in December 2006. The final $10.0 million installment was due in July 2007. The first $40.0 million in license fees received were recognized as revenue ratably commencing on our receipt of the fees through June 2020, which represented the length of time we were obligated to manufacture ProQuin XR under our ProQuin XR supply agreement with Esprit. In July 2007, we and Esprit terminated the license and supply agreements.

As a result of the termination of our agreements with Esprit, we no longer have continuing obligations to Esprit. Accordingly, all deferred revenue related to license fees previously received from Esprit was fully recognized as revenue in July 2007, resulting in recognition of approximately $36.1 million of license revenue. In addition, the final $10 million payment received in July 2007 was fully recognized as license revenue on receipt, resulting in total recognition of $46.1 million of license revenue related to our agreements with Esprit during the third quarter of 2007.

We received $25.0 million in GLUMETZA license fees from Biovail in July 2005. We are recognizing the $25.0 million license fee payment as revenue ratably until February 2023, which represents the estimated length of time our obligations exist under the arrangement related to royalties we are obligated to pay Biovail on net sales of GLUMETZA in the United States and for our obligation to use Biovail as our sole supplier of the 1000mg GLUMETZA, should the 1000mg GLUMETZA obtain approval in the United States. At December 31, 2007, we have $22.0 million remaining in deferred revenue related to this agreement.

We received a $0.6 million upfront license fee from LG in August 2004 and a $0.5 million milestone payment received in November 2006 with respect to LG's approval to market Novamet GR in the Republic of Korea. These payments were originally deferred and amortized as license revenue over the estimated length of time we were obligated to provide assistance in development and manufacturing. In January 2007, we amended our agreement with LG, granted LG a license to certain of the Company's intellectual property rights to manufacture the 500mg Novamet GR in exchange for royalties on net sales of Novamet GR in Korea, and removed the provisions of the original agreement providing for the supply of 500mg Novamet GR tablets by us to LG. Under the amended agreement, we no longer have continuing performance obligations that are other than inconsequential or perfunctory to LG. Accordingly, the remaining $0.9 million of previously deferred revenue was recognized as license revenue in the first quarter of 2007.

In February 2007, we received $0.5 million from Biovail upon entering into a license and development agreement with Biovail granting Biovail an option to license our AcuForm drug delivery technology to develop and commercialize up to two pharmaceutical products. We have no continuing performance obligations that are other than inconsequential or perfunctory under the agreement. Accordingly, we have recognized the entire upfront license fee as revenue in the first quarter of 2007.

As a result of the termination of the Esprit agreements, we expect license revenue to decrease in 2008.

Collaborative revenue

Collaborative revenue decreased in 2007 from 2006 as a result of services performed for Esprit, which were completed in 2006. Collaborative revenue decreased in 2006 from 2005 as a result of services performed in 2005 under our agreement with Boehringer Ingelheim Pharmaceuticals, which were completed in December 2005.

Cost of Sales

Cost of sales consists of costs of the active pharmaceutical ingredient, contract manufacturing and packaging costs, product quality testing, internal employee costs related to the manufacturing process, distribution costs and shipping costs related to our product sales.

Cost of sales increased in 2007 over 2006 primarily as a result of an increase in GLUMETZA product sales and increased in 2006 over 2005 as a result of an increase in supply of ProQuin XR to Esprit. The costs of manufacturing associated with deferred revenue on GLUMETZA and ProQuin XR product shipments are recorded as deferred costs, which are included in inventory, until such time the deferred revenue is recognized.

Research and Development Expense

Our research and development expenses currently include costs for scientific personnel, supplies, equipment, outsourced clinical and other research activities, consultants, depreciation, facilities and utilities. The scope and magnitude of future research and development expenses cannot be predicted at this time for our product candidates in the early phases of research and development, as it is not possible to determine the nature, timing and extent of clinical trials and studies, the FDA's requirements for a particular drug and the requirements and level of participation, if any, by potential partners. As potential products proceed through the development process, each step is typically more extensive, and therefore more expensive, than the previous step.

In 2006 and 2007, the majority of our research and development expense was related to Gabapentin GR. The decrease in research and development expense in 2007 from 2006 was primarily due to reduced expense related to the completion of our Phase 3 clinical trials for Gabapentin GR for the treatment of postherpetic neuralgia partially offset by the commencement of a Phase 2 clinical trial for Gabapentin GR for the treatment of menopausal hot flashes in 2007.

The increase in research and development expense in 2006 from 2005 was primarily due to completion of our Phase 2 and commencement of our Phase 3 clinical trials for Gabapentin GR for the treatment of postherpetic neuralgia and completion of our Phase 2 clinical trial for Gabapentin GR for the treatment of diabetic peripheral neuropathy. The adoption of FAS 123(R) on January 1, 2006 resulted in an increase in stock compensation expense of $1.0 million for 2006.

We categorize our research and development expense by project. The table below shows research and development costs for our major clinical development programs, as well as other expenses associated with all other projects in our product pipeline.

We expect that the pharmaceutical products that we develop internally will take, on average, from four to eight years to research, develop and obtain FDA approval in the United States, assuming that we are successful. We generally must conduct preclinical testing on laboratory animals of new pharmaceutical products prior to commencement of clinical studies involving human beings. These studies evaluate the potential efficacy and safety of the product. We then submit the results of these studies to the FDA as part of an Investigational New Drug Application, or IND, which, if successful, allows the opportunity for clinical study of the potential new medicine.

Typically, human clinical evaluation involves a time-consuming and costly three-phase process:


In Phase 1, we conduct clinical trials with a small number of subjects to determine a drug's early safety profile and its blood concentration profile over time. A Phase 1 trial for our average potential product may take 6 to 12 months to plan and complete.


In Phase 2, we conduct limited clinical trials with groups of patients afflicted with a specific disease in order to determine preliminary efficacy, optimal dosages and further evidence of safety. A Phase 2 trial for our average potential product may take 9 to 18 months to plan and complete.


In Phase 3, we conduct large-scale, multi-center, comparative trials with patients afflicted with a target disease in order to provide enough data to demonstrate the efficacy and safety required by the FDA prior to commercialization of the product. A Phase 3 trial for our average potential product may take 1 to 3 years to plan and complete.

The most significant expenses associated with clinical development derive from the Phase 3 trials as they tend to be the longest and largest studies conducted during the drug development process. In March 2008, we commenced an additional Phase 3 trial for Gabapentin GR for the treatment of postherpetic neuralgia, and expect to commence a Phase 3 trial for Gabapentin GR for the treatment of menopausal hot flashes either alone or with a collaborative partner, which may result in increased research and development expense in 2008.

The successful development of pharmaceutical products is highly uncertain. The FDA closely monitors the progress of each phase of clinical testing. The FDA may, at its discretion, re-evaluate, alter, suspend or terminate testing based upon the data accumulated to that point and the FDA's assessment of the risk/benefit ratio to patients. The FDA may also require additional clinical trials after approval, which are known as Phase 4 trials. Various statutes and regulations also govern or influence the manufacturing, safety, labeling, storage and record keeping for each product. The lengthy process of seeking FDA approvals, and the subsequent compliance with applicable statutes and regulation, require the expenditure of substantial resources.

Selling, General and Administrative Expense

Selling, general and administrative expenses primarily consist of personnel expenses to support our operating activities, marketing and promotion expenses associated with GLUMETZA, facility costs and professional expenses, such as legal and accounting fees.

In 2004, we announced our determination to evolve from a solely product development focused company to an integrated specialty pharmaceutical company with sales and marketing of our own products. Preliminary staffing for these activities began in 2005. In 2006 and 2007, we enhanced our internal sales and marketing capabilities through the hiring of additional sales and marketing employees and the engagement of consultants. We anticipate the build-up of our commercial infrastructure will continue over the next several years.

The increase in selling, general and administrative expense in 2007 from 2006 was primarily due to an increase of approximately $1.8 million in expense related to marketing costs associated with GLUMETZA, an increase of $1.5 million in legal fees due to our patent infringement case against IVAX and an increase of $0.6 million increase in promotion fees due to King under the promotion agreement related to GLUMETZA.

The increase in selling, general and administrative expense in 2006 from 2005 was primarily due to approximately $3.0 million in expense related to marketing costs associated with GLUMETZA, which was launched in September 2006, $2.4 million in related promotion fees due to King under the promotion agreement related to GLUMETZA, an increase of $1.7 million in legal fees due to our patent infringement case against IVAX, and an increase in stock compensation expense of $1.2 million as a result of the adoption of FAS 123(R) on January 1, 2006.

We expect that selling, general and administrative expense will be flat or slightly higher in 2008 from 2007 levels, but this may change based on the terms of any agreement, if any, that we may enter into with a promotion partner with respect to GLUMETZA.

Interest income increased in 2007 over 2006 due to higher investment balances in 2007 resulting from of our receipt of $29.7 million in termination fees from King and $17.5 million in license and termination fees from Esprit in the second half of 2007. Interest income increased in 2006 over 2005 due to higher investment balances in 2006 resulting from of our receipt of license fees from Esprit and Biovail in 2005 and also due to higher interest rates earned on our investment portfolio. Interest

expense in 2005 was mainly due to interest on a promissory note, issued to Elan Corporation plc, or Elan. The note was fully repaid in June 2005.

Gain on Termination of King Promotion Agreement

In conjunction with the termination and assignment agreement entered into with King in October 2007, we received a $29.7 million termination payment from King, of which $29.6 million has been classified as a gain within operating income for the year ended December 31, 2007.

Gain on Termination of Esprit Pharma Agreement

In conjunction with the termination and assignment agreement entered into with Esprit in July 2007, we received a $5.0 million termination payment from Esprit, which has been classified as a gain within operating income for the year ended December 31, 2007.

Gain from Extinguishment of Debt

In connection with the formation of DDL, an Elan joint venture, Elan made a loan facility available to us for up to $8.0 million in principal to support our 80.1% share of the joint venture's research and development costs pursuant to a convertible promissory note issued by us to Elan. The funding term of the loan expired in November 2002. The note had a six-year term, was due in January 2006, and bore interest at 9% per annum, compounded semi-annually, on any amounts borrowed under the facility. However, in June 2005, we repurchased the promissory note with an outstanding balance of $10.7 million, including $2.9 million of accrued interest, for $9.7 million including commissions paid to a financial consultant and legal fees. A gain on the extinguishment of the debt of $1.1 million was recorded in other income in 2005.

Series A Preferred Stock and Deemed Dividends

In January 2000, we issued 12,015 shares of Series A Preferred Stock at a price of $1,000 per share. The Series A Preferred Stock accrued a dividend of 7% per annum, compounded semi-annually and payable in shares of Series A Preferred Stock. The Series A Preferred Stock was convertible at anytime between January 2002 and January 2006 into our common stock. The original conversion price of the Series A Preferred Stock was $12.00. However, as a result of our March 2002 and October 2003 financings, the conversion price was adjusted to $9.51 per share. In December 2004, we entered into an agreement with the Series A Preferred shareholder to resolve a misunderstanding between us and the shareholder relating primarily to prior adjustments to the conversion price of the Series A Preferred Stock (the December 2004 Agreement). Pursuant to the December 2004 Agreement, among other matters, we agreed to adjust the conversion price to $7.50 per share. We and the shareholder also agreed to binding interpretations of certain other terms related to the Series A conversion price.

Prior to December 2004, the amounts calculated as Series A Preferred stock dividends were accounted for as an adjustment to the conversion price following EITF Issue No. 98-5, Accounting for Convertible Securities with Beneficial Conversion Features or Contingently Adjustable Conversion Ratios (Issue No. 98-5). As a result of the December 2004 Agreement, we determined that a significant modification of the preferred stock agreement had occurred, and, therefore, a new commitment date was established for the Series A Preferred Stock. Further, we determined that the fair value of the modified preferred stock was below the carrying value of such securities as of the date of the modification, therefore, no deemed dividend resulted from this modification. Also, we determined that although a new commitment date had been established, this change did not result in a beneficial conversion feature subject to recognition pursuant to Emerging Issues Task Force Issue No. 00-27, Application of Issue No. 98-5 to Certain Convertible Instruments .

MANAGEMENT DISCUSSION FOR LATEST QUARTER

RESULTS OF OPERATIONS


Three and Nine Months Ended September 30, 2007 and 2006

Product sales



The GLUMETZA product that we began selling to wholesalers and retail pharmacies in September 2006 is subject to rights of return of up to twelve months after product expiration. Given the limited sales history of GLUMETZA and return privileges, we currently cannot reliably estimate expected returns of the product at the time of shipment. We defer recognition of revenue on product shipments of GLUMETZA until the right of return no longer exists, which occurs at the earlier of the time GLUMETZA units are dispensed through patient prescriptions or expiration of the right of return. We estimate the volume of prescription units dispensed by pharmacies based on an analysis of third-party information, including third-party market research data, information obtained from certain wholesalers with respect to inventory levels and out-movement and retail pharmacy re-stocking activity. For the three and nine months ended September 30, 2007, we recognized approximately $3.8 million and $7.7 million of product sales of GLUMETZA, respectively, which is net of estimated patient support program discounts, wholesaler fees, stocking allowances, prompt payment discounts, chargebacks and Medicaid rebates. We have deferred recognition of revenue on GLUMETZA product shipments to customers which we estimate have not been dispensed through patient prescriptions. At September 30, 2007, we have a deferred revenue balance, which is classified as a liability on the consolidated balance sheet, of $4.7 million associated with the deferral of revenue on GLUMETZA product shipments, which is net of estimated patient support program discounts, wholesaler fees, stocking allowances, prompt payment discounts, chargebacks and Medicaid rebates.



ProQuin XR product sales in 2006 relate to our supply agreement with Esprit. We began supplying Esprit with commercial quantities of ProQuin XR in the fourth quarter of 2005, and in 2007, there were no sales pursuant to the supply agreement. We terminated the license and supply agreements in July 2007 and the marketing and distribution rights in the United States for ProQuin XR reverted back to us. In October 2007, we re-launched ProQuin XR with Watson and expect to begin recognizing product sales as revenue in the fourth quarter of 2007.

Royalties



In July 2007, we terminated our license agreement with Esprit that provided for royalty payments by Esprit to us on ProQuin XR net sales in the United States. Under the termination and assignment agreement related to our license and supply agreements, Esprit paid us $2.5 million in royalties in July 2007, which was recognized as royalty revenue in the third quarter of 2007. Esprit is no longer obligated to pay us royalties on ProQuin XR sales.



GLUMETZA royalties for the three and nine months ended September 30, 2007 relate to royalties we received from Biovail based on net sales of GLUMETZA in Canada and royalties we received from LG based on net sales of LG's version of GLUMETZA, Novamet GR, in Korea. In July 2007, the royalty payable by Biovail was increased to ten percent on Canadian net sales of the 500mg GLUMETZA. We began receiving royalties from LG in the first quarter of 2007.



License revenue



Our license agreement with Esprit for ProQuin XR provided for $50.0 million in license fees from Esprit. We received $30.0 million in license fees in July 2005 and an additional $10.0 million in December 2006. The final $10.0 million installment was due in July 2007. The first $40.0 million in license fees received were recognized as revenue ratably commencing on our receipt of the fees through June 2020, which represented the length of time we were obligated to manufacture ProQuin XR under our ProQuin XR supply agreement with Esprit. In July 2007, we and Esprit terminated the license and supply agreements.



As a result of the termination of our agreements with Esprit, we no longer have continuing obligations to Esprit. Accordingly, all deferred revenue related to license fees previously received from Esprit was fully recognized as revenue in July 2007, resulting in recognition of approximately $36.1 million of license revenue. In addition, the final $10 million payment received in July 2007 was fully recognized as license revenue on receipt, resulting in total recognition of $46.1 million of license revenue related to our agreements with Esprit during the third quarter of 2007.



We received $25.0 million in GLUMETZA license fees from Biovail in July 2005. We are recognizing the $25.0 million license fee payment as revenue ratably until February 2023, which represents the estimated length of time our obligations exist under the arrangement related to royalties we are obligated to pay Biovail on net sales of GLUMETZA in the United States and for our obligation to use Biovail as our sole supplier of the 1000mg GLUMETZA, should the 1000mg GLUMETZA obtain approval in the United States.



We received a $0.6 million upfront license fee from LG in August 2004 and a $0.5 million milestone payment received in November 2006 with respect to LG’s approval to market Novamet GR in the Republic of Korea. These payments were originally deferred and amortized as license revenue over the estimated length of time we were obligated to provide assistance in development and manufacturing. In January 2007, we amended our agreement with LG, granted LG a license to certain of the Company’s intellectual property rights to manufacture the 500mg Novamet GR in exchange for royalties on net sales of Novamet GR in Korea, and removed the provisions of the original agreement providing for the supply of 500mg Novamet GR tablets by us to LG. Under the amended agreement, we no longer have continuing performance obligations that are other than inconsequential or perfunctory to LG. Accordingly, the remaining $0.9 million of previously deferred revenue was recognized as license revenue in the first quarter of 2007.



In February 2007, we received $0.5 million from Biovail upon entering into a license and development agreement with Biovail granting Biovail an option to license our AcuForm drug delivery technology to develop and commercialize up to two pharmaceutical products. We have no continuing performance obligations that are other than inconsequential or perfunctory under the agreement. Accordingly, we have recognized the entire upfront license fee as revenue in the first quarter of 2007.

Cost of Sales



Cost of sales consists of costs of the active pharmaceutical ingredient, contract manufacturing and packaging costs, product quality testing, internal employee costs related to the manufacturing process, distribution costs and shipping costs related to our product sales.

Cost of sales for the three and nine months ended September 30, 2007 relates primarily to costs associated with the sale of GLUMETZA. Costs of sales for the three and nine months ended September 30, 2006 relates primarily to costs associated with the supply of ProQuin XR to Esprit. The costs of manufacturing associated with deferred revenue on GLUMETZA product shipments are recorded as deferred costs, which are included in inventory, until such time the deferred revenue is recognized.



Research and Development Expense



Our research and development expenses currently include costs for scientific personnel, supplies, equipment, outsourced clinical and other research activities, consultants, depreciation, facilities and utilities. The scope and magnitude of future research and development expenses cannot be predicted at this time for our product candidates in the early phases of research and development, as it is not possible to determine the nature, timing and extent of clinical trials and studies, the FDA’s requirements for a particular drug and the requirements and level of participation, if any, by potential partners. As potential products proceed through the development process, each step is typically more extensive, and therefore more expensive, than the previous step. Success in development therefore, generally results in increasing expenditures until actual product launch.

The decrease in research and development expense for the three months ended September 30, 2007 as compared to the three months ended September 30, 2006 was primarily due to lower outside contract service expenses related to the completion of the Phase 3 clinical trial for Gabapentin GR for the treatment of postherpetic neuralgia which was completed in the first half of 2007.



The increase in research and development expense for the nine months ended September 30, 2007 as compared to the nine months ended September 30, 2006 was primarily due to higher outside contract service expenses for our clinical trial expenses related to our Phase 2 clinical trial for Gabapentin GR for the treatment of menopausal hot flashes and costs associated with our Phase 2a proof-of-concept GERD formulation studies.



We may decide to commence one or more additional Phase 3 trials for Gabapentin GR for the treatment of postherpetic neuralgia or menopausal hot flashes either alone or with a collaborative partner, which may result in increased research and development expense in future periods.

Selling, General and Administrative Expense



Selling, general and administrative expenses primarily consist of personnel expenses to support our operating activities, marketing and promotion expenses associated with GLUMETZA, facility costs and professional expenses, such as legal and accounting fees.

The increase in selling, general and administrative expense for the three months ended September 30, 2007 as compared to the three months ended September 30, 2006 was primarily due to $2.1 million in promotion fees due to King under the promotion agreement for GLUMETZA, which was launched in September 2006, offset by decreases of $0.6 million in marketing expenses related to GLUMETZA and $0.2 million related to stock-based compensation.



The increase in selling, general and administrative expense for the nine months ended September 30, 2007 as compared to the nine months ended September 30, 2006 was primarily due to an increase of $3.0 million in promotion fees due to King under the promotion agreement for GLUMETZA, $0.7 million in marketing costs associated with GLUMETZA, and $1.4 million increase in legal fees resulting from our patent infringement case against IVAX, offset by a decrease of $0.3 million related to stock-based compensation.



We are no longer obligated to pay King promotion fees related to sales of GLUMETZA. Accordingly, selling, general and administrative expenses may decrease in the fourth quarter of 2007.



Gain on Termination of Esprit Pharma Agreement



In conjunction with the termination and assignment agreement entered into with Esprit in July 2007, we received a $5.0 million termination payment from Esprit, which has been classified as a gain within operating income for the three months ended September 30, 2007.

Interest and other income increased during the three months ended September 30, 2007 as compared to the corresponding period in 2006 due to higher investment balances in the three months ended September 30, 2007 as a result of receipt of $17.5 million from Esprit in July 2007. Interest and other income decreased during the nine months ended September 30, 2007 as compared to the corresponding periods in 2006 as a result of lower investment balances in 2007.

LIQUIDITY AND CAPITAL RESOURCES

Since inception through September 30, 2007, we have financed our product development efforts and operations primarily from private and public sales of equity securities and receipts of upfront license and termination fees from collaborative and license partners.

In December 2006, we entered into a common stock purchase agreement with Azimuth Opportunity, Ltd., pursuant to which Azimuth is committed to purchase, from time to time and at our sole discretion, up to the lesser of (a) $30.0 million of our common stock, or (b) 8,399,654 shares of common stock. Sales to Azimuth under the agreement, if any, will occur over a 24-month term and will be made at a price equal to the average closing price of our common stock over a given pricing period, minus a discount ranging from approximately 3.8% to 6.4%, which varies based on a threshold price set by us. Upon each sale of the our common stock to Azimuth under the agreement, we have also agreed to pay Reedland Capital Partners a placement fee equal to approximately 1.1% of the aggregate dollar amount of common stock purchased by Azimuth. Azimuth is not required to purchase our common stock when the price of our common stock is below $2 per share. As of September 30, 2007, we have not sold any common stock to Azimuth under this common stock purchase agreement.



In April 2007, we completed a registered direct offering of 5,300,000 shares of common stock with institutional investors. The shares were sold at a price of approximately $3.78 per share, with net proceeds totaling approximately $20.0 million.



In July 2007, Esprit paid us $17.5 million in connection with the termination of the license and supply agreement.



In October 2007, King paid us $29.9 million in connection with the termination of our GLUMETZA promotion agreement with King.



As of September 30, 2007, we have accumulated net losses of $159.6 million. We expect to continue to incur operating losses in 2008. We anticipate that our existing capital resources will permit us to meet our capital and operational requirements through at least the end of 2008. We base this expectation on our current operating plan, which may change as a result of many factors.



Our cash needs may also vary materially from our current expectations because of numerous factors, including:

• sales of our marketed products;

• expenditures related to our commercialization and development efforts;

• financial terms of definitive license agreements or other commercial agreements we enter into, if any;

• results of research and development efforts;

• results of our litigation against IVAX;

• changes in the focus and direction of our research and development programs;

• technological advances;

• results of clinical testing, requirements of the FDA and comparable foreign regulatory agencies; and

• acquisitions or investment in complimentary businesses, products or technologies.

We will need substantial funds of our own or from third parties to.

• conduct research and development programs;

• conduct preclinical and clinical testing; and

• manufacture (or have manufactured) and market (or have marketed) our marketed products and product candidates.

Our existing capital resources may not be sufficient to fund our operations until such time as we may be able to generate sufficient revenues to support our operations. We have limited credit facilities and, except for the common stock purchase agreement with Azimuth, we have no other committed sources of capital. To the extent that our capital resources are insufficient to meet our future capital requirements, we will have to raise additional funds through the sale of our equity securities or from development and licensing arrangements to continue our development programs. We may be unable to raise such additional capital on favorable terms, or at all. If we raise additional capital by selling our equity or convertible debt securities, the issuance of such securities could result in dilution of our shareholders’ equity positions. If adequate funds are not available we may have to:



• delay, postpone or terminate clinical trials;

• significantly curtail commercialization of our marketed products or other operations; and/or

• obtain funds through entering into collaboration agreements on unattractive terms.



The inability to raise additional capital would have a material adverse effect on our company.

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