Adhera Therapeutics, Inc. - Quarter Report: 2007 March (Form 10-Q)

e10vq

UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

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

For the Quarter Ended March 31, 2007

Commission File Number 000-13789

NASTECH PHARMACEUTICAL COMPANY INC.

(Exact name of registrant as specified in its charter)


Delaware		11-2658569
(State or other jurisdiction of		(I.R.S. Employer Identification No.)
incorporation or organization)

3830 Monte Villa Parkway, Bothell, WA		98021
(Address of principal executive offices)		(Zip Code)

Registrant’s telephone number, including area code: (425) 908-3600

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, as of the latest practicable date:


Date	Class	Shares Outstanding
April 30, 2007	Common stock — $0.006 par value	25,479,735

NASTECH PHARMACEUTICAL COMPANY INC. AND SUBSIDIARIES

TABLE OF CONTENTS


PART I — FINANCIAL INFORMATION
ITEM 1 — FINANCIAL STATEMENTS (unaudited)
Condensed Consolidated Balance Sheets as of December 31, 2006 and March 31, 2007			3
Condensed Consolidated Statements of Operations for the three months ended March 31, 2006 and March 31, 2007			4
Condensed Consolidated Statement of Stockholders’ Equity and Comprehensive Loss for the three months ended March 31, 2007			5
Condensed Consolidated Statements of Cash Flows for the three months ended March 31, 2006 and March 31, 2007			6
Notes to Condensed Consolidated Financial Statements			7
ITEM 2 — MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS			14
ITEM 3 — QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK			26
ITEM 4 — CONTROLS AND PROCEDURES			27
PART II — OTHER INFORMATION			27
ITEM 5 — OTHER INFORMATION			27
ITEM 6 — EXHIBITS			27
SIGNATURES			27
EXHIBIT INDEX			28
EXHIBIT 10.42
EXHIBIT 31.1
EXHIBIT 31.2
EXHIBIT 32.1
EXHIBIT 32.2

Items 1, 1A, 2, 3 and 4 of PART II have not been included as they are not applicable.

PART I — FINANCIAL INFORMATION

ITEM 1 — FINANCIAL STATEMENTS

NASTECH PHARMACEUTICAL COMPANY INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED BALANCE SHEETS

(Unaudited)


	December 31,			March 31,
	2006			2007
	(In thousands, except share and per share data)
ASSETS
Current assets:
Cash and cash equivalents	$	28,481		$	50,048
Restricted cash		2,155			2,150
Short-term investments		20,357			29,236
Accounts receivable		2,798			816
Inventories		2,203			2,211
Prepaid expenses and other current assets		1,564			1,688

Total current assets		57,558			86,149
Property and equipment, net		15,444			16,151
Other assets		830			854

Total assets	$	73,832		$	103,154

LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities:
Accounts payable	$	4,437		$	3,908
Accrued payroll and employee benefits		2,652			1,616
Accrued expenses		882			561
Capital lease obligations — current portion		4,226			4,490
Deferred revenue — current portion		2,528			3,046

Total current liabilities		14,725			13,621
Capital lease obligations, net of current portion		7,457			7,375
Deferred revenue, net of current portion		6,138			5,542
Other liabilities		2,176			2,239

Total liabilities		30,496			28,777

Commitments and contingencies
Stockholders’ equity:
Preferred stock, $0.01 par value; 100,000 authorized: no shares issued and outstanding:		—			—
Common stock and additional paid-in capital, $0.006 par value; 50,000,000 authorized:
22,117,124 shares issued and outstanding as of December 31, 2006 and 25,467,625 issued and outstanding as of March 31, 2007		185,849			228,438
Accumulated deficit		(142,493	)		(154,033	)
Accumulated other comprehensive loss		(20	)		(28	)

Total stockholders’ equity		43,336			74,377

Total liabilities and stockholders’ equity	$	73,832		$	103,154

See notes to condensed consolidated financial statements

NASTECH PHARMACEUTICAL COMPANY INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(Unaudited)


	Three Months Ended
	March 31,
	2006			2007
	(In thousands, except per share data)
Revenue
License and research fees	$	6,299		$	4,672
Government grants		—			100
Product revenue		419			220

Total revenue		6,718			4,992

Operating expenses:
Cost of product revenue		239			59
Research and development		11,801			12,874
Sales and marketing		395			581
General and administrative		2,951			3,704

Total operating expenses		15,386			17,218

Loss from operations		(8,668	)		(12,226	)
Other income (expense):
Interest income		638			957
Interest and other expense		(108	)		(271	)

Total other income (expense)		530			686

Loss before cumulative effect of change in accounting principle		(8,138	)		(11,540	)
Cumulative effect of change in accounting principle		291			—

Net Loss	$	(7,847	)	$	(11,540	)

Loss per common share — basic and diluted:
Loss before cumulative effect of change in accounting principle	$	(0.39	)	$	(0.47	)
Cumulative effect of change in accounting principle		.01			—

Net loss per common share — basic and diluted	$	(0.38	)	$	(0.47	)

Shares used in computing net loss per share — basic and diluted		20,689			24,549

See notes to condensed consolidated financial statements

NASTECH PHARMACEUTICAL COMPANY INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENT OF STOCKHOLDERS’ EQUITY AND COMPREHENSIVE LOSS

For the Three Months Ended March 31, 2007

(Unaudited)


								Accumulated
	Common Stock and Additional							Other			Total
	Paid-In Capital				Accumulated			Comprehensive			Stockholders’
	Shares		Amount		Deficit			Loss			Equity
	(In thousands, except share data)
Balance December 31, 2006		22,117,124	$	185,849	$	(142,493	)	$	(20	)	$	43,336
Proceeds from the exercise of options		14,500		105		—			—			105
Proceeds from the issuance of common shares, net		3,250,000		40,928		—			—			40,928
Compensation related to restricted stock		86,001		834		—			—			834
Compensation related to stock options		—		722		—			—			722
Net loss		—		—		(11,540	)		—			(11,540	)
Unrealized loss on securities available for sale		—		—		—			(8	)		(8	)

Comprehensive loss		—		—		—			—			(11,548	)


Balance March 31, 2007		25,467,625	$	228,438	$	(154,033	)	$	(28	)	$	74,377

See notes to condensed consolidated financial statements

NASTECH PHARMACEUTICAL COMPANY INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(Unaudited)


	Three Months Ended
	March 31,
	2006			2007
	(In thousands)
Operating activities:
Net loss	$	(7,847	)	$	(11,540	)
Adjustments to reconcile net loss to net cash used in operating activities:
Non-cash compensation related to stock options		652			722
Non-cash compensation related to restricted stock		548			834
Depreciation and amortization		583			1,007
Gain on sale of property and equipment		1			—
Cumulative effect of change in accounting principle		(291	)		—
Changes in assets and liabilities:
Accounts receivable		(1,359	)		1,982
Inventories		(44	)		(8	)
Prepaid expenses and other assets		(128	)		(148	)
Accounts payable		(847	)		(529	)
Deferred revenue		5,516			(78	)
Accrued expenses and other liabilities		(407	)		(1,294	)

Net cash used in operating activities		(3,623	)		(9,052	)

Investing activities:
Change in restricted cash		(500	)		5
Purchases of property and equipment		(1,360	)		(1,714	)
Purchases of investments		(15,642	)		(19,525	)
Sales and maturities of investments		7,600			10,638

Net cash used in investing activities		(9,902	)		(10,596	)

Financing activities:
Borrowings under capital lease obligations		953			1,301
Payments on capital lease obligations		(734	)		(1,119	)
Proceeds from exercise of stock options		2,466			105
Proceeds from exercise of warrants		5,325			—
Proceeds from the issuance of common shares, net		—			40,928

Net cash provided by financing activities		8,010			41,215

Net decrease in cash and cash equivalents		(5,515	)		21,567
Cash and cash equivalents — beginning of period		26,769			28,481

Cash and cash equivalents — end of period	$	21,254		$	50,048

Supplemental disclosure:
Cash paid for interest	$	118		$	270

See notes to condensed consolidated financial statements

NASTECH PHARMACEUTICAL COMPANY INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

For the three months ended March 31, 2007 and March 31, 2006 (Unaudited)

Note 1 — Summary of Significant Accounting Policies

Basis of Preparation —The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with U.S. generally accepted accounting principles for interim financial information and in accordance with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and note disclosures required by U.S. generally accepted accounting principles for complete financial statements. The accompanying unaudited financial information should be read in conjunction with the audited financial statements, including the notes thereto, as of and for the year ended December 31, 2006, included in our 2006 Annual Report on Form 10-K filed with the Securities and Exchange Commission (the “SEC”). The information furnished in this report reflects all adjustments (consisting of normal recurring adjustments), which are, in the opinion of management, necessary for a fair presentation of our financial position, results of operations and cash flows for each period presented. The results of operations for the interim period ended March 31, 2007 are not necessarily indicative of the results for the year ending December 31, 2007 or for any future period.

Principles of Consolidation — The financial statements include the accounts of Nastech Pharmaceutical Company Inc. and our wholly-owned subsidiaries, Atossa HealthCare, Inc., Nastech Holdings I, LLC, Nastech Holdings II, LLC and MD-RNA, Inc. All inter-company balances and transactions have been eliminated in consolidation.

Use of Estimates — The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires our management to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements, and reported amounts of revenues and expenses during the reporting periods. Estimates having relatively higher significance include revenue recognition, research and development costs, stock-based compensation and income taxes. Actual results could differ from those estimates.

Reclassifications — Certain reclassifications have been made to prior years’ financial statements to conform with current year presentations. Such reclassifications had no effect on stockholders’ equity, net loss, or net increase in cash and cash equivalents.

Recent Accounting Pronouncements — In July 2006, the FASB issued FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes-an interpretation of FASB Statement No. 109” (“FIN 48”), which prescribes a recognition threshold and measurement process for recording in the financial statements uncertain tax positions taken or expected to be taken in a tax return. Additionally, FIN 48 provides guidance on the recognition, classification, accounting in interim periods and disclosure requirements for uncertain tax positions. The accounting provisions of FIN 48 became effective on January 1, 2007. We have identified our federal tax return and our state tax return in New York as “major” tax jurisdictions, as defined. The periods subject to examination for our federal and New York state income tax returns are the tax years ended in 1992 and thereafter, since we have net operating loss carryforwards for tax years starting in 1992. We believe our income tax filing positions and deductions will be sustained on audit and we do not anticipate any adjustments that would result in a material change to our financial position. Therefore, no reserves for uncertain income tax positions have been recorded pursuant to FIN 48, nor we did record a cumulative effect adjustment related to the adoption of FIN 48. Our policy for recording interest and penalties associated with audits is to record such items as a component of income (loss) before taxes. Penalties and interest paid are recorded in interest and other expense and interest received is recorded in interest income in the statement of operations.

Note 2 — Inventories

Inventories, substantially all of which are raw materials, consisting primarily of bottles, actuators and the calcitonin-salmon active pharmaceutical ingredient for our calcitonin-salmon nasal spray which were acquired by us in furtherance of satisfying our supply obligations under our agreement with Par Pharmaceutical Companies, Inc. (“Par Pharmaceutical”), are stated at the lower of cost or market (first-in, first-out basis). For a discussion of the status of our collaboration with Par Pharmaceutical, see Note 7: Contractual Agreements — Par Pharmaceutical. Balances on hand in excess of estimated usage within one year are classified as non-current and are included in other assets in the accompanying consolidated balance sheets. At both December 31, 2006 and March 31, 2007, inventories classified as non-current were $515,000.

Note 3 — Concentration of Credit Risk and Significant Customers

We operate in an industry that is highly regulated, competitive and rapidly changing and involves numerous risks and uncertainties. Significant technological and/or regulatory changes, the emergence of competitive products and other factors could negatively impact our consolidated financial position or results of operations.

We are dependent on our collaborative agreements with a limited number of third parties for a substantial portion of our revenue, and our development and commercialization activities may be delayed or reduced if we do not maintain successful collaborative arrangements. Our agreement with Merck & Co., Inc. (“Merck”) was terminated in March 2006. Merck accounted for approximately 56% of total revenue and Procter & Gamble Pharmaceuticals, Inc. (“P&G”) accounted for approximately 31% of total revenue for the three months ended March 31, 2006. P&G accounted for 71% of total revenue and Novo Nordisk A/S (“Novo Nordisk”) accounted for approximately 19% of total revenue for the three months ended March 31, 2007.

At March 31, 2007, one customer accounted for 64% of our accounts receivable balance.

Note 4 — Net Loss Per Common Share

Basic and diluted net loss per common share is computed by dividing the net loss by the weighted average number of common shares outstanding during the period. Diluted loss per share excludes the effect of common stock equivalents (stock options, unvested restricted stock and warrants) since such inclusion in the computation would be anti-dilutive. The following numbers of shares have been excluded (in thousands):


	Three Months Ended March 31,
	2006		2007
Stock options outstanding under our various stock option plans		2,523		2,486
Unvested restricted stock		496		598
Warrants		733		661

Total		3,752		3,745

Note 5— Stockholders’ equity and comprehensive loss

Common Stock Offerings —In January 2007, we completed a public offering of 3,250,000 shares of our common stock at an offering price of $13.00 per share pursuant to our $125.0 million effective shelf registration statement. The offering resulted in gross proceeds of approximately $42.2 million, prior to the deduction of fees and commissions of approximately $1.3 million. As of March 31, 2007, we had approximately $84.1 million remaining on our effective shelf registration statement.

Comprehensive Loss —Comprehensive loss was $7.8 million and $11.5 million for the first quarter of 2006 and the first quarter of 2007. The difference between net loss as reported and comprehensive loss is the change in unrealized gains and losses on available-for-sale securities.

Stockholder Rights Plan — In February 2000, our Board adopted a stockholder rights plan and declared a dividend of one preferred stock purchase right for each outstanding share of common stock. Each right entitles the holder, once the right becomes exercisable, to purchase from us one one-thousandth of a share of our Series A Junior Participating Preferred Stock, par value $.01 per share. We issued these rights in March 2000 to each stockholder of record on such date, and these rights attach to shares of common stock subsequently issued. The rights will cause substantial dilution to a person or group that attempts to acquire us on terms not approved by our Board and could, therefore, have the effect of delaying or preventing someone from taking control of us, even if a change of control were in the best interest of our stockholders.

Holders of our preferred share purchase rights are generally entitled to purchase from us one one-thousandth of a share of Series A preferred stock at a price of $50.00, subject to adjustment as provided in the Stockholder Rights Agreement. These preferred share purchase rights will generally be exercisable only if a person or group becomes the beneficial owner of 15 percent or more of our outstanding common stock or announces a tender offer for 15 percent or more of our outstanding common stock. Each holder of a preferred share purchase right, excluding an acquiring entity or any of its affiliates, will have the right to receive, upon exercise, shares of our common stock, or shares of stock of the acquiring entity, having a market value equal to two times the purchase price paid for one one-thousandth of a share of Series A preferred stock. The preferred share purchase rights expire on March 17, 2010, unless we extend the expiration date or in certain limited circumstances, we redeem or exchange such rights prior to such date. Initially, 10,000 Series A Junior Participating Preferred shares were authorized. In January 2007, this was increased to 50,000 shares so that a

sufficient number of Series A Junior Participating Preferred shares would be available to the holders of shares of common stock for issuance in satisfaction of such rights, given increases in the number of shares of common stock outstanding.

Note 6 — Stock-based compensation

On January 1, 2006, we adopted SFAS No. 123 (Revised 2004) “Share-Based Payment” (“SFAS 123R”) using the modified prospective transition method. The adoption of SFAS 123R resulted in a cumulative benefit from accounting change of $291,000 as of January 1, 2006, which reflected the net cumulative impact of estimating future forfeitures in the determination of period expense for restricted stock awards, rather than recording forfeitures when they occur as previously permitted.

The following table summarizes stock-based compensation expense recorded related to stock-based awards (in thousands):


	Three Months ended March 31,
	2006		2007
Stock-based compensation:
Research and development	$	480	$	725
Sales and marketing		45		117
General and administrative		675		714

Total stock-based compensation	$	1,200	$	1,556

Restricted Stock Awards — Pursuant to restricted stock awards granted under our existing stock-based incentive plans, we have issued shares of restricted stock to certain employees and members of our Board. Non-cash compensation expense is being recognized on a straight-line basis over the applicable vesting periods of one to four years of the restricted shares based on the fair value of such restricted stock on the grant date. We granted restricted stock awards representing 71,311 and 91,762 shares of common stock with a per share weighted average fair value of $16.81 and $13.16 in each of the first quarters of 2006 and of 2007. Additional information on restricted shares is as follows (in thousands, except per share amount):


Unvested restricted shares outstanding, January 1, 2007		544
Restricted shares issued		92
Restricted shares forfeited		(3	)
Restricted shares vested		(35	)

Unvested restricted shares outstanding, March 31, 2007		598

Weighted average grant date fair value per share	$	13.89

The 598,414 unvested restricted shares outstanding at March 31, 2007 are scheduled to vest as follows: 179,450 shares in 2007, 219,367 shares in 2008, 169,014 shares in 2009 and 30,583 shares in 2010. The fair value of restricted stock vested during the three month periods ended March 31, 2006 and 2007 was approximately $136,000 and $518,000.

Our total unrecognized compensation cost related to unvested restricted stock awards granted under our 2004 Stock Incentive Plan was approximately $6.7 million at March 31, 2007. Total unrecognized compensation cost will be adjusted for future changes in estimated forfeitures. We expect to recognize this cost over a weighted average period of approximately 1.3 years.

Stock Options — Stock options to purchase shares of our common stock are granted to certain employees, at prices at or above the fair market value on the date of grant. Non-cash compensation expense is being recognized on a straight-line basis over the applicable vesting periods of one to four years of the options based on the fair value on the grant date. The following summarizes stock option activity during the three month period ended March 31, 2007:


						Weighted
				Weighted		Average
				Average		Remaining	Aggregate
				Exercise		Contractual	Intrinsic
	Options			Price		Life	Value
	(in thousands)						(in thousands)
Outstanding December 31, 2006		2,412		$	13.18
Options granted		88			13.16
Options exercised		(15	)		9.72
Options canceled		—			—
Options expired		—			—

Outstanding at March 31, 2007		2,486		$	13.20	6.0 years	$	869

Exercisable at March 31, 2007		1,792		$	12.79	5.1 years	$	860

The fair value of stock-based awards was estimated at the date of grant using the Black-Scholes option valuation model with the following weighted average assumptions for the three month periods ended March 31:


	2006			2007
Expected dividend yield		0	%		0	%
Risk free interest rate		4.1	%		4.8	%
Expected stock volatility		74	%		66	%
Expected option life	6 years			6 years
Weighted average fair value granted	$	10.39		$	8.36

As of March 31, 2007, we had approximately $4.8 million of total unrecognized compensation cost related to unvested stock options granted under all equity compensation plans. Total unrecognized compensation cost will be adjusted for future changes in estimated forfeitures. We expect to recognize this cost over a weighted average period of approximately 1.2 years.

The intrinsic value of stock options outstanding and exercisable at March 31, 2007 is based on the $10.79 closing market price of our common stock on that date, and is calculated by aggregating the difference between $10.79 and the exercise price of each of the approximately 2.4 million outstanding vested and unvested stock options which have an exercise price less than $10.79. The total intrinsic value of options exercised during the three month periods ended March 31, 2006 and 2007 was approximately $1.0 million and $57,000, respectively, determined as of the date of exercise. The total fair value of options that vested during the three month periods ended March 31, 2006 and March 31, 2007 was approximately $1.0 million and $271,000. The total fair value of options that were forfeited during the three month period ended March 31, 2006 was approximately $101,000. No options were forfeited during the three month period ended March 31, 2007.

At March 31, 2007, options to purchase up to 2,486,185 shares of our common stock were outstanding under our various stock incentive plans, unvested restricted stock awards for an aggregate of 598,414 shares of our common stock were outstanding under our 2004 Plan and 797,218 shares were available for future grants or awards under our various stock incentive plans.

We generally issue new shares for option exercises unless treasury shares are available for issuance. We have no treasury shares as of March 31, 2007 and have no plans to purchase any in the next year, however, we may accept the surrender of vested restricted shares from employees to cover tax requirements at our discretion.

Warrants — In connection with offerings of our common stock, we have issued warrants to purchase shares of our common stock. At March 31, 2007, there were warrants outstanding for the purchase of 660,814 shares of our common stock with exercise prices ranging from $11.09 to $14.26, which will expire in September 2008 and June 2009, respectively, with a weighted average exercise price of $13.57 per share.

Note 7 — Contractual Agreements

Procter & Gamble (“P&G”) — In January 2006, we entered into a License Agreement (the “License Agreement”) with P&G to develop and commercialize our PTH(1-34) nasal spray for the treatment of osteoporosis. Under terms of the License Agreement, we granted P&G rights to the worldwide development and commercialization of our PTH(1-34) nasal spray in exchange for an upfront fee, research and development expense reimbursements and potential for future milestone payments and royalties on product sales. Payments we have already received under the License Agreement include a $10.0 million initial payment upon execution of the License Agreement, which has been recorded as deferred revenue and is being amortized into revenue over the estimated development period, and a $7.0 million milestone payment received in the second quarter of 2006 and recognized in full as revenue in the year ended December 31, 2006. In total, milestone payments could reach $577 million over the life of the partnership depending upon the successful completion of specified development, regulatory and commercialization goals, although there can be no assurance that any such milestones will be achieved. Under the License Agreement, we are eligible to receive double-digit patent-based royalties, with the rate escalating upon the achievement of certain sales levels.

We will jointly develop our PTH(1-34) nasal spray and P&G will reimburse us for development activities performed by us under the License Agreement. P&G will assume responsibility for clinical and non-clinical studies and will direct regulatory approval and worldwide sales, marketing and promotion of our PTH(1-34) nasal spray while we will be responsible for the chemistry, manufacturing and controls (“CMC”) sections of the FDA regulatory submission. In June 2006, we entered into an agreement with P&G to manufacture and supply PTH(1-34) nasal spray for the potential commercialization of this investigational product for the

treatment of osteoporosis. Under terms of the supply agreement, we will be the exclusive manufacturer of the PTH(1-34) nasal spray and will manufacture the product and supply it to P&G at a transfer price that includes a manufacturing profit if the product is approved.

On December 4, 2006, we entered into the First Amendment (the “Amendment”) to the License Agreement with P&G relating to PTH(1-34). Under the terms of the Amendment, an additional Phase 2 dose ranging study relating to PTH(1-34) has been added to the clinical development program under the License Agreement and is planned to begin in 2007. In addition, the Amendment modifies contractual milestone payment terms under the License Agreement relating to a $15.0 million milestone payment which we had previously anticipated receiving in 2006. The amended milestone payment terms now require a $5.0 million payment on the initiation of an additional Phase 2 dose ranging study and a $10.0 million payment on the initiation of a Phase 3 clinical study.

Galenea — In February 2006, we acquired RNAi intellectual property (“IP”) and other RNAi technologies from Galenea Corporation (“Galenea”). The IP acquired from Galenea includes patent applications licensed from the Massachusetts Institute of Technology that have early priority dates in the antiviral RNAi field focused on viral respiratory infections, including influenza, rhinovirus, and other respiratory diseases. We also acquired Galenea’s research and IP relating to pulmonary drug delivery technologies for RNAi. Additionally, we assumed Galenea’s awarded and pending grant applications from the National Institute of Allergy and Infectious Diseases, a division of the National Institutes of Health (“NIH”), and the Department of Defense to support the development of RNAi-based antiviral drugs.

RNAi-based therapeutics offers a potentially effective treatment for a future influenza pandemic, which we believe is an urgent global concern. This program complements our current TNF-alpha RNAi program targeting inflammation, since a consequence of influenza infection can be life-threatening respiratory and systemic inflammation.

Consideration for the acquisition consisted of an upfront payment and may include contingent payments based upon certain regulatory filings and approvals, and the sale of products. In connection with the transaction, we recorded a charge of approximately $4.1 million for acquired research associated with products in development for which, at the acquisition date, technological feasibility had not been established and there was no alternative future use as set forth in SFAS No. 2, “Accounting for Research and Development Costs.” This charge was included in research and development expense in the first quarter of 2006.

Amylin Pharmaceuticals, Inc. — In June 2006, we entered into an agreement with Amylin Pharmaceuticals, Inc. (“Amylin”) to develop a nasal spray formulation of exenatide for the treatment of type 2 diabetes. Preclinical studies of the formulation have been completed in preparation for initiating studies in human subjects. Amylin filed an Investigational New Drug application (“IND”) with the FDA in July 2006 to allow clinical trials to begin, and began clinical trials in the third quarter of 2006.

Under terms of the agreement, we will receive milestone payments and royalties on product sales. If the development program is successful and the product continues to move forward, milestone payments could reach up to $89.0 million in total, based on specific development, regulatory, and commercialization goals. Royalty rates escalate with product success.

Under the terms of our agreement with Amylin, we will jointly develop the nasal spray formulation with Amylin utilizing our proprietary nasal delivery technology, and Amylin will reimburse us for any development activities we perform under the agreement. Amylin has overall responsibility for the development program including clinical, non-clinical and regulatory activities, and our efforts will focus on drug delivery and CMC activities. If a supply agreement is reached between the companies, we may supply commercial product to Amylin and their exenatide collaboration partner, Eli Lilly and Company, however, there can be no assurance that such a supply agreement will be executed.

Par Pharmaceutical — In October 2004, we entered into a license and supply agreement with Par Pharmaceutical for the exclusive U.S. distribution and marketing rights to a generic calcitonin-salmon nasal spray for the treatment of osteoporosis. Under the terms of the agreement with Par Pharmaceutical, we will manufacture and supply finished calcitonin-salmon nasal spray product to Par Pharmaceutical, while Par Pharmaceutical will distribute the product in the U.S. The financial terms of the agreement include milestone payments, product transfer payments for manufactured product and a profit sharing following commercialization.

information is not required under applicable law. In March 2006, the petitioner submitted an additional request to the FDA in response to our assertions in our October 2005 submission to the FDA. In May 2006, we filed an additional response requesting that the FDA deny the citizen’s petition.

Apotex Inc. (“Apotex”) has filed a generic application for its nasal calcitonin-salmon product with a filing date that has priority over our ANDA for calcitonin-salmon nasal spray. In November 2002, Novartis AG (“Novartis”) brought a patent infringement action against Apotex claiming that Apotex’s nasal calcitonin-salmon product infringes on Novartis’ patents, seeking damages and requesting injunctive relief. That action is still pending. We are unable to predict what, if any, effect the Novartis action will have on Apotex’s ability or plans to commence marketing its product.

In July 2006, we received written notification from the FDA stating that our ANDA for nasal calcitonin-salmon was not approvable at that time. The FDA expressed a concern relating to the potential for immunogenicity that might result from a possible interaction between calcitonin-salmon and chlorobutanol, the preservative in the formulation. In September 2006, we announced that we had submitted a response to the FDA’s Office of Generic Drugs regarding the potential for such immunogenicity. The FDA has accepted our submission for review, indicating that the generic division of the FDA has maintained jurisdiction of our filing. The FDA is actively reviewing this amendment, and has requested additional information. We expect to submit this additional information in the first half of 2007, but we do not know the timeline over which the FDA will review this information, nor can we be sure that our additional information will fully satisfy the FDA’s request. To date, the FDA has informally communicated to us that it has determined that our nasal calcitonin product is bioequivalent to the reference listed drug, Miacalcin^®. The FDA has also completed Pre-Approval Inspections of both of our nasal spray manufacturing facilities. If we are not successful at keeping our application as an ANDA, a 505(b)(2) NDA may be pursued or the application may be withdrawn. At this time, we are not able to determine whether the citizen’s petition will delay the FDA’s approval of our ANDA, nor can we determine how the Apotex filing priority will be resolved, or when, if at all, our calcitonin product will receive marketing approval from the FDA.

Our formulation of calcitonin-salmon nasal spray was specifically developed to be similar to Novartis’ currently marketed calcitonin-salmon nasal spray, Miacalcin^®, in order to submit the application as an ANDA. Thus, our formulation does not utilize our advanced tight junction drug delivery technology, which is currently being used in development of our proprietary pipeline of peptide and protein therapeutics.

Questcor/QOL Medical, LLC — In connection with the 2003 sale of certain assets relating to our Nascobal^® brand products, including the Nascobal^® (Cyanocobalamin USP) nasal gel and nasal spray, to Questcor, Questcor agreed to make payments of: (i) $2.0 million contingent upon FDA approval of a New Drug Application for the Nascobal^® nasal spray product; and (ii) $2.0 million contingent upon issuance of a U.S. patent for the Nascobal^® nasal spray product. FDA approval for the Nascobal^® nasal spray product was granted in January 2005, and the $2.0 million payment due upon this milestone was received from Questcor in February 2005.

Under the terms of a supply agreement between the parties, subject to certain limitations, we were obligated to manufacture and supply, and Questcor was obligated to purchase from us, all of Questcor’s requirements for Nascobal^® nasal gel and spray.

In October 2005, with our consent, Questcor assigned all of its rights and obligations under the Questcor Asset Purchase and Supply Agreements dated June 2003 (the “Questcor Agreements”) to QOL Medical, LLC (“QOL”). We received $2.0 million from Questcor in October 2005 in consideration for our consent to the assignment and in connection with our entering into an agreement with QOL which modified certain terms of the Questcor Agreements. The $2.0 million is being recognized ratably over the five-year life of the QOL agreement. QOL has also assumed Questcor’s obligation to pay us $2.0 million on the issuance by the U.S. Patent and Trademark Office of a patent covering any formulation that treats any indication identified in our NDA for Nascobal^® nasal spray. Pursuant to the terms of our agreement with Questcor, we will continue to prosecute the pending U.S. patents for the Nascobal^® nasal spray product on behalf of QOL. We recognized product revenue relating to the supply agreement of approximately $419,000 in the first quarter of 2006 and approximately $220,000 in the first quarter of 2007.

Alnylam Pharmaceuticals, Inc. — In July 2005, we announced that we had acquired an exclusive InterfeRx^™ license from Alnylam Pharmaceuticals, Inc. (“Alnylam”) to discover, develop, and commercialize RNAi therapeutics directed against TNF-alpha, a protein associated with inflammatory diseases including rheumatoid arthritis and certain chronic respiratory diseases. Under the agreement, Alnylam received an initial license fee from us and is entitled to receive annual and milestone fees and royalties on sales of any products covered by the licensing agreement. We expensed the initial license fee as research and development expense in 2005.

Merck — In September 2004, we entered into an Exclusive Development, Commercialization and License Agreement and a separate Supply Agreement (collectively, the “Merck Agreements”) with Merck, for the global development and commercialization of PYY(3-36) nasal spray, our product for the treatment of obesity. The Merck Agreements provide that Merck would assume primary responsibility for conducting and funding clinical and non-clinical studies and regulatory approval, while we would be responsible for all manufacturing of PYY-related product. Merck would lead and fund commercialization, subject to our exercise of an option to co-promote the product in the U.S. Under the Merck Agreements, we received an initial cash payment of $5.0 million in 2004. The $5.0 million initial payment was being amortized over the estimated development period, and was initially recorded as deferred revenue in our accompanying consolidated balance sheets.

The Merck Agreements were terminated in March 2006, at which time we reacquired our rights in the PYY program. The unamortized balance of Merck’s $5.0 million initial payment, approximately $3.7 million, was recognized as revenue in the first quarter of 2006. We have continued PYY product development on our own, and in December 2006, we announced the completion of a dose ranging study designed to evaluate the pharmacokinetic parameters, appetite, food intake and safety of various doses of our PYY(3-36) nasal spray in obese subjects.

Government Grants — In September 2006, the National Institute of Health awarded us a $1.9 million grant to prevent and treat influenza. In the first quarter of 2007, we recognized approximately $100,000 in revenue related to this grant.

Thiakis Limited — In September 2004, we acquired exclusive worldwide rights to the Imperial College Innovations and Oregon Health & Science University PYY patent applications in the field of nasal delivery of PYY and the use of glucagon-like peptide-1 (GLP-1) used in conjunction with PYY for the treatment of obesity, diabetes and other metabolic conditions. Under the agreement, we made an equity investment in and paid an initial license fee to Thiakis, Ltd. (“Thiakis”). We expensed the equity investment and initial license fee as research and development expense in 2004. Under the agreement, Thiakis is entitled to receive an annual fee, additional milestone fees, patent-based royalties, and additional equity investments based upon future progress of the IP and product development processes.

Cytyc Corporation — In July 2003, we entered into an agreement with Cytyc Corporation (“Cytyc”) pursuant to which Cytyc acquired patent rights to our Mammary Aspirate Specimen Cytology Test device. Under the terms of the agreement, we received a license fee from Cytyc in 2003 and reimbursement for the cost of patent maintenance and further patent prosecution if incurred during the term of the agreement. We had the potential to receive additional milestone payments and royalties based on certain conditions; however, as of February 6, 2007, Cytyc notified us that it intends to terminate the license agreement in the near future. Accordingly, no further payments currently are anticipated to be received related to this license agreement. We will evaluate further commercial prospects for this device if such rights are returned.

City of Hope — In November 2006, we entered into a license with the Beckman Research Institute/City of Hope for exclusive and non-exclusive licenses to the Dicer-substrate RNAi IP developed there. We obtained exclusive rights to five undisclosed targets selected by us, as well as broad non-exclusive rights to siRNAs directed against all mammalian targets subject to certain City of Hope limitations that will have no impact on our programs. We believe this IP and technology could provide significant commercial and therapeutic advantages for us in this field, by enabling the use of 25 to 30 base pair RNA duplexes designed to act as substrates for processing by the cells’ natural activities.

Feasibility Agreements — We have entered into various feasibility agreements with partners, including Novo Nordisk and other undisclosed partners. Under the feasibility agreements, which are generally for terms of one year or less, we are typically reimbursed for the cost of work performed.

Note 8 — Commitments and Contingencies

Leases — We lease space for our manufacturing, research and development and corporate offices in Bothell, Washington under operating leases expiring in 2016 and for manufacturing, warehousing and research and development activities in Hauppauge, New York under operating leases expiring in June 2010. In connection with the terms of the leases of our Bothell, Washington facilities, we provide our landlords with stand-by letters of credit that total approximately $2.2 million.

We have entered into a capital lease agreement with GE Capital Corporation, which allows us to finance certain property and equipment purchases over three-or four-year terms depending on the type of equipment. Under this agreement, we purchase assets approved by GE Capital Corporation, at which date GE Capital Corporation assumes ownership of the assets and we are reimbursed. The equipment is then leased to us. We borrowed approximately $1.0 million and $1.3 million in the three months ended March 31,

2006 and 2007. Our annual borrowing limit for new purchases in 2007 is $5.5 million. Interest rates on capital lease borrowings ranged from approximately 8.3% to 10.3% during the three months ended March 31, 2006 and from approximately 8.3% to 10.6% during the three months ended March 31, 2007.

Contingencies — We are subject to various legal proceedings and claims that arise in the ordinary course of business. Our management currently believes that resolution of such legal matters will not have a material adverse impact on our consolidated financial position, results of operations or cash flows.

ITEM 2 — MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

Overview

Statements contained herein that are not historical fact may be forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended, that are subject to a variety of risks and uncertainties. There are a number of important factors that could cause actual results to differ materially from those projected or suggested in any forward-looking statement made by us. These factors include, but are not limited to: (i) our ability to obtain additional funding; (ii) our ability to attract and/or maintain manufacturing, research, development and commercialization partners; (iii) our and/or a partner’s ability to successfully complete product research and development, including pre-clinical and clinical studies and commercialization; (iv) our and/or a partner’s ability to obtain required governmental approvals, including product and patent approvals; and (v) our and/or a partner’s ability to develop and commercialize products that can compete favorably with those of competitors. In addition, significant fluctuations in quarterly results may occur as a result of the timing of milestone payments, the recognition of revenue from milestone payments and other sources not related to product sales to third parties, and the timing of costs and expenses related to our research and development programs. Additional factors that would cause actual results to differ materially from those projected or suggested in any forward-looking statements are contained in our filings with the Securities and Exchange Commission, including those factors discussed under the captions “Forward-Looking Information” and “Risk Factors” in our most recent Annual Report on Form 10-K, as may be supplemented or amended by our Quarterly Reports on Form 10-Q, which we urge investors to consider. We undertake no obligation to publicly release revisions in such forward-looking statements that may be made to reflect events or circumstances after the date hereof or to reflect the occurrences of unanticipated events or circumstances, except as otherwise required by securities and other applicable laws.

We are a biopharmaceutical company focusing on the development and commercialization of innovative therapeutic products based on our proprietary molecular biology-based drug delivery technology. Using our technology, we create or utilize novel formulation components or excipients that can reversibly open the “tight junctions” between cells in various tissues and thereby deliver therapeutic drugs to the blood stream. Tight junctions are cell-to-cell connections in various tissues of the body, including the epithelial layer of the nasal mucosa, the gastrointestinal tract and the blood brain barrier, which function to provide barrier integrity and to regulate the transport and passage of molecules across these natural boundaries.

We believe our nasal drug delivery technology offers advantages over injectable routes of administration for large molecules, such as peptides and proteins. These advantages may include improved safety, clinical efficacy and increased patient compliance, due to the elimination of injection site pain and avoidance of injection site irritation. In addition, we believe our nasal drug delivery technology can potentially offer advantages over oral administration by providing for faster absorption into the bloodstream, reduced side effects and improved effectiveness by avoiding problems relating to gastrointestinal side effects and first-pass liver metabolism. Although some of our product candidates use our expertise outside this area, this technology is the foundation of our nasal drug delivery platform and we use it to develop commercial products with our collaboration partners or, in select cases, to develop products that we manufacture and commercialize on our own.

We believe we are also at the forefront of small interfering RNA (“siRNA”) therapeutic research and development. Our RNA interference (“RNAi”) therapeutic programs are targeted at both developing and delivering novel therapeutics using siRNA to down-regulate the expression of certain disease causing proteins that are over-expressed in inflammation, viral respiratory infections and other diseases.

Our goal is to become a leader in both the development and commercialization of innovative, nasal drug delivery products and technologies, as well as in RNAi therapeutics. Key elements of our strategy include:

	•		Applying Our Tight Junction Technology and Other Drug Delivery Methods to Product Candidates. We focus our research and development efforts on product candidates, including peptides, large and small molecules and therapeutic siRNA, for which our proprietary technologies may offer clinical advantages, such as improved safety and clinical efficacy, or increased patient compliance. We also will continue to search for applications of our tight junction technology to improve other forms of drug delivery, including oral, pulmonary and intravenous delivery.

	•		Collaborations with Pharmaceutical and Biotechnology Companies. We will continue to establish strategic collaborations with pharmaceutical and biotechnology companies. Typically, we collaborate with partners to commercialize our internal product candidates by utilizing their late stage clinical development, regulatory, marketing and sales capabilities. We also assist our collaboration partners in developing more effective drug delivery methods for their product candidates that have already completed early stage clinical trials, or are even currently marketed. We generally structure our collaborative arrangements to receive research and development funding and milestone payments during the development phase, revenue from manufacturing upon commercialization and patent-based royalties on future sales of products.

	•		Developing and Commercializing Our Own Product Candidates. In select cases in which we deem it to be strategically advantageous to us, we plan to internally develop, manufacture and commercialize our products.

	•		Leveraging Our Manufacturing Expertise and Capabilities. We have invested substantial time, money and intellectual capital in developing our manufacturing facilities and know-how, which we believe would be difficult for our competitors to replicate in the near term. These capabilities give us competitive advantages, including the ability to prepare the chemistry, manufacturing and controls (“CMC”) section of new drug application (“NDA”) filings with the U.S. Food and Drug Administration (“FDA”) and to maintain a high-level of quality control in manufacturing product candidates for clinical trials and FDA-approved products for commercialization. We believe our manufacturing capabilities will meet our projected capacity needs for the foreseeable future.

We are engaged in a variety of preclinical and clinical research and development activities to identify and develop viable product candidates. We and our collaboration partners have been developing a diverse portfolio of clinical-stage product candidates for multiple therapeutic areas utilizing our molecular biology-based drug delivery technology. In addition, we have been expanding our RNAi research and development efforts. As of March 31, 2007, we had 41 patents issued and 314 patent applications filed to protect our proprietary technologies.

Procter & Gamble Partnership

PTH(1-34), a part of the naturally occurring human parathyroid hormone that helps regulate calcium and phosphorus metabolism and causes bone growth, is the same active ingredient that is being marketed as an injectable product by Eli Lilly & Company (“Lilly”) under the trade name Forteo^®. We have developed a proprietary nasal formulation of PTH(1-34) and we are currently in Phase 2 clinical trials in this program. We view a potentially non-invasive, nasally delivered alternative to Forteo^® as a significant market opportunity.

On January 27, 2006, we entered into a Product Development and License Agreement (the “License Agreement”) with P&G to develop and commercialize our PTH(1-34) nasal spray for the treatment of osteoporosis. Under the terms of the License Agreement, we have granted P&G rights to the worldwide development and commercialization of our PTH(1-34) nasal spray in exchange for an upfront fee, research and development expense reimbursements and the potential for future milestone payments and royalties on product sales. Payments we have already received under the License Agreement include a $10.0 million initial payment upon execution of the License Agreement, which has been recorded as deferred revenue and is being amortized into revenue over the estimated development period, and a $7.0 million milestone payment received in the second quarter of 2006 and recognized in full as revenue in 2006. In total, milestone payments could reach $577 million over the life of the partnership depending upon the successful completion of specified development, regulatory and commercialization goals, although there can be no assurance that any such milestones will be achieved. Under the License Agreement, we are eligible to receive double-digit patent-based royalties, with the rate escalating upon the achievement of certain sales levels.

We will jointly develop our PTH(1-34) nasal spray with P&G and P&G will reimburse us for development activities performed by us under the License Agreement. P&G will assume responsibility for clinical and non-clinical studies and will direct regulatory approval and worldwide sales, marketing and promotion of our PTH(1-34) nasal spray, while we will be responsible for the CMC sections of the FDA regulatory submission. In June 2006, we entered into an agreement with P&G to manufacture and supply PTH(1-34) nasal spray for the potential commercialization of this investigational product for the treatment of osteoporosis. Under terms of the

supply agreement, we will be the exclusive manufacturer of the PTH(1-34) nasal spray and will manufacture the product and supply it to P&G at a transfer price that includes a manufacturing profit if the product is approved.

On December 4, 2006, we entered into the First Amendment to the License Agreement (“the Amendment”) with P&G relating to PTH (1-34). Under the terms of the Amendment, an additional Phase 2 dose ranging study relating to PTH(1-34) has been added to the clinical development program under the License Agreement and is planned to begin in 2007. In addition, the Amendment modifies contractual milestone payment terms under the License Agreement relating to a $15.0 million milestone payment which we had previously anticipated receiving in 2006. The amended milestone payment terms now require a $5.0 million payment on the initiation of an additional Phase 2 dose ranging study and a $10.0 million payment on the initiation of a Phase 3 clinical study.

Par Pharmaceutical Partnership

In October 2004, we entered into a license and supply agreement with Par Pharmaceutical Companies, Inc. (“Par Pharmaceutical”) for the exclusive U.S. distribution and marketing rights to a generic calcitonin-salmon nasal spray for the treatment of osteoporosis. Under the terms of the agreement with Par Pharmaceutical, we will manufacture and supply finished calcitonin-salmon nasal spray product to Par Pharmaceutical, while Par Pharmaceutical will distribute the product in the U.S. The financial terms of the agreement include milestone payments, product transfer payments for manufactured product and profit sharing following commercialization.

In December 2003, we submitted to the FDA an Abbreviated New Drug Application (“ANDA”) for a calcitonin-salmon nasal spray for the treatment of osteoporosis, and in February 2004, the FDA accepted the submission of our ANDA for the product. In September 2005, a citizen’s petition was filed with the FDA requesting that the FDA not approve our ANDA as filed prior to additional studies for safety and bioequivalence. In October 2005, we filed a response requesting that the FDA deny this citizen’s petition on the grounds that no additional information is necessary from a scientific or medical basis and that such additional information is not required under applicable law. In March 2006, the petitioner submitted an additional request to the FDA in response to our assertions in our October 2005 submission to the FDA. In May 2006, we filed an additional response requesting that the FDA deny the citizen’s petition.

Merck Partnership

In September 2004, we entered into an Exclusive Development, Commercialization and License Agreement and a separate Supply Agreement (collectively, the “Merck Agreements”) with Merck & Co., Inc. (“Merck”), for the global development and commercialization of PYY(3-36) nasal spray, our product for the treatment of obesity. The Merck Agreements provide that Merck would assume primary responsibility for conducting and funding clinical and non-clinical studies and regulatory approval, while we would be responsible for all manufacturing of PYY-related product. Merck would lead and fund commercialization, subject to our exercise of an option to co-promote the product in the U.S. Under the Merck Agreements, we received an initial cash payment of $5.0 million in 2004. The $5.0 million initial payment was being amortized over the estimated development period, and was initially recorded as deferred revenue in our accompanying condensed consolidated balance sheets.

Amylin Pharmaceuticals, Inc.

In June 2006, we entered into an agreement with Amylin Pharmaceuticals, Inc. (“Amylin”) to develop a nasal spray formulation of exenatide for the treatment of diabetes. Preclinical studies of the formulation have been completed in preparation for the initiation of studies in human subjects. Amylin began clinical trials in the third quarter of 2006.

Under terms of the agreement, we will receive both milestone payments and royalties on product sales. If the development program is successful and the development of this product continues to move forward, milestone payments could reach up to $89.0 million in total, based on specific development, regulatory and commercialization goals. Royalty rates escalate with the success of this product.

Under the terms of our agreement with Amylin, we will jointly develop the nasal spray formulation with Amylin utilizing our proprietary nasal delivery technology, and Amylin will reimburse us for any development activities performed under the agreement. Amylin has overall responsibility for the development program, including clinical, non-clinical and regulatory activities and our efforts will focus on drug delivery and CMC activities. If we reach a supply agreement with Amylin, we may supply commercial product to Amylin and its exenatide collaboration partner, Lilly. However, there can be no assurance that such a supply agreement will be executed.

RNAi Technology and Intellectual Property Acquisitions

We also are applying our drug delivery technology to a promising new class of therapeutics based on RNAi. siRNAs are double-stranded RNA molecules that are able to silence specific genes and reduce the amount of protein these genes produce. Specific proteins may be involved in causing a disease or be necessary for the replication of a pathogenic virus. The therapeutic use of RNAi in this manner requires the ability to deliver siRNA-based drugs inside the cells where the target proteins are produced. We have continued our research and development program to enhance the delivery of this potential new class of therapeutic drugs and have strengthened our RNAi development strategy through the acquisition of key technologies, intellectual property (“IP”) and licensing agreements.

Alnylam. We entered into a license agreement in July 2005 with Alnylam Pharmaceuticals, Inc. (“Alnylam”), a biopharmaceutical company focused on developing RNAi-based drugs, pursuant to Alnylam’s InterfeRx™ licensing program. Under the license, we acquired the exclusive rights to discover, develop and commercialize RNAi therapeutics directed against TNF-alpha, a protein associated with inflammatory diseases, including rheumatoid arthritis and certain chronic diseases. Under our agreement with Alnylam, we paid an initial license fee to Alnylam, and we are obligated to pay annual and milestone fees and royalties on sales of any products covered by the license agreement.

Galenea. We expanded our RNAi pipeline by initiating an RNAi therapeutics program targeting influenza and other respiratory diseases. In connection with this new program, in February 2006, we acquired RNAi IP and other RNAi technologies from Galenea Corp. (“Galenea”). The IP acquired from Galenea includes patent applications licensed from the Massachusetts Institute of Technology (“MIT”) that have early priority dates in the antiviral RNAi field focused on viral respiratory infections, including influenza, rhinovirus and other respiratory diseases. We also acquired Galenea’s research and IP relating to pulmonary drug delivery technologies for siRNA. Additionally, we have assumed Galenea’s awarded and pending grant applications from the National Institute of Allergy and Infectious Diseases (“NIAID”), a division of the National Institutes of Health (“NIH”), and the Department of Defense to support the development of RNAi-based antiviral drugs. RNAi-based therapeutics offer potentially effective treatments for a future influenza pandemic, which is an urgent global concern. This program complements our current TNF-alpha RNAi program targeting inflammation, as life-threatening respiratory and systemic inflammation caused by excess TNF-alpha production can be a consequence of influenza infection.

had not been established and there was no alternative future use. This charge was included in research and development expense in the first quarter of 2006.

Our lead siRNA product candidate, G00101, has demonstrated efficacy against multiple influenza strains, including avian flu strains (H5N1) in animals. The development of siRNA targeting sequences that are highly conserved across all flu genomes, including avian and others having pandemic potential, may reduce the potential for development of drug resistance and is a novel approach to therapies against influenza viruses. We believe G00101 represents a first-in-class approach to fight influenza and is one of the most advanced anti-influenza compounds based on RNAi. G00101 can be administered by inhalation to maximize delivery to the lung tissue and has the potential to be delivered to the nasal cavity to prevent or abate early viral infections. The product is being designed for ease of use by patients and for long-term stability, both essential for stockpiling the product for rapid mobilization during a flu epidemic.

City of Hope. In November 2006, we entered into a license with the Beckman Research Institute/City of Hope for exclusive and non-exclusive licenses to the Dicer-substrate RNAi IP developed there. We obtained exclusive rights to five undisclosed targets selected by us, as well as broad non-exclusive rights to siRNAs directed against all mammalian targets subject to certain City of Hope limitations that will have no impact on our programs. We believe this IP and technology could provide significant commercial and therapeutic advantages for us in this field, by enabling the use of 25 to 30 base pair RNA duplexes designed to act as substrates for processing by the cells’ natural activities.

Independent Product Development

While we seek development and commercialization partnerships, such as our PTH(1-34) program with P&G, to maximize program value to our stockholders, we are also applying our technology and experience to develop other product candidates on our own (i.e., without a partner). Independent product development candidates include PYY, insulin and carbetocin. As these programs progress, we will evaluate the appropriateness of continued investment in them and whether bringing on a development and commercialization partner would increase the value of the program to our stockholders.

Other Collaborations

Questcor Pharmaceuticals, Inc./QOL Medical LLC. In February 2005, the FDA approved our Nascobal^® nasal spray 505(b)(2) application for vitamin B12 (cyanocobalamin) deficiency in patients with pernicious anemia, Crohn’s Disease, HIV/ AIDS and multiple sclerosis. We developed the Nascobal^® nasal spray as an alternative to Nascobal^® (Cyanocobalamin, USP) gel, an FDA-approved product launched in 1997.

Under the terms of the Questcor Asset Purchase and Supply Agreement, dated June 2003 (the “Questcor Agreements”), we entered into with Questcor Pharmaceuticals Inc. (“Questcor”), subject to certain limitations, we were obligated to manufacture and supply, and Questcor is obligated to purchase from us, all of Questcor’s requirements for the Nascobal^® nasal gel and the Nascobal^® nasal spray. In February 2005, Questcor paid us a milestone fee of $2.0 million upon receipt of FDA approval of the NDA for Nascobal^® nasal spray.

In October 2005, with our consent, Questcor assigned all of its rights and obligations under the Questcor Agreements to QOL Medical LLC (“QOL”). We received $2.0 million from Questcor in October 2005 as consideration for our consent to the assignment and in connection with our entering into an agreement with QOL that modified certain terms of the Questcor Agreements. The $2.0 million is being recognized ratably over the five-year life of the QOL agreement. QOL has also assumed Questcor’s obligation to pay us $2.0 million on the issuance by the U.S. Patent and Trademark Office (“PTO”) of a patent covering any formulation that treats any indication identified in our NDA for Nascobal^® nasal spray. Pursuant to the terms of our agreement with Questcor, we will continue to prosecute the pending U.S. patents for the Nascobal^® nasal spray product on behalf of QOL.

Novo Nordisk A/S feasibility agreement. In March 2006, we entered into a multi-compound feasibility study agreement with Novo Nordisk A/S (“Novo Nordisk”) with respect to certain Novo Nordisk therapeutic compounds.

Cytyc Corporation. In July 2003, we entered into an agreement with Cytyc Corporation (“Cytyc”) pursuant to which Cytyc acquired patent rights to our Mammary Aspirate Specimen Cytology Test (“MASCT”) device. Under the terms of the agreement, we received a license fee from Cytyc in 2003 and reimbursement for the cost of patent maintenance and further patent prosecution if incurred during the term of the agreement. We had the potential to receive additional milestone payments and royalties based on certain conditions; however, as of February 6, 2007, Cytyc notified us that it intends to terminate the license agreement in the near

future. Accordingly, no further payments currently are anticipated to be received related to this license agreement. We will evaluate further commercial prospects for this device if such rights are returned.

Cash Position and Recent Financings

As of March 31, 2007, we had approximately $81.4 million in cash, cash equivalents and short-term investments, including approximately $2.2 million in restricted cash. As of March 31, 2007, we had an accumulated deficit of $154.0 million and expect additional operating losses in the future as we continue our research and development activities. Our development efforts and the future revenues from sales of these products are expected to generate contract research revenues, milestone payments, license fees, patent-based royalties and manufactured product sales for us. We believe, although there can be no assurance, that our current cash position provides us with adequate working capital for at least the next 12 months, or longer depending upon the degree to which we exploit our various current opportunities that are in the pipeline and the success of our collaborative arrangements. This belief is based, in part, on the assumption that we have completed and are planning to enter into various collaborations to accelerate our research and development programs which will provide us with additional financing. To the extent these collaborations do not proceed as planned, we may be required to reduce our research and development activities or, if necessary and possible, raise additional capital from new investors or in the public markets.

Critical Accounting Policies and Estimates

We prepare our consolidated financial statements in conformity with accounting principles generally accepted in the U.S. As such, we are required to make certain estimates, judgments and assumptions that we believe are reasonable based upon the information available. These estimates and assumptions affect the reported amounts of assets and liabilities at the date of the consolidated financial statements and the reported amounts of revenue and expenses during the periods presented. Actual results could differ significantly from those estimates under different assumptions and conditions. We believe that the following discussion addresses our most critical accounting estimates, which are those that we believe are most important to the portrayal of our financial condition and results of operations and which require our most difficult and subjective judgments, often as a result of the need to make estimates about the effect of matters that are inherently uncertain. Other key estimates and assumptions that affect reported amounts and disclosures include depreciation and amortization, inventory reserves, asset impairments, requirements for and computation of allowances for doubtful accounts, allowances for product returns, expense accruals, stock-based award valuations, including expected term, volatility and forfeiture rates and income tax valuation allowances. We also have other policies that we consider key accounting policies; however, these policies do not meet the definition of critical accounting estimates because they do not generally require us to make estimates or judgments that are difficult or subjective.

Revenue Recognition

Our revenue recognition policies are based on the requirements of Securities and Exchange Commission (“SEC”) Staff Accounting Bulletin (SAB) No. 104 “Revenue Recognition,” the provisions of Emerging Issues Task Force (“EITF”) Issue 00-21, “Revenue Arrangements with Multiple Deliverables,” and the guidance set forth in EITF Issue 01-14, “Income Statement Characterization of Reimbursements Received for “Out-of-Pocket” Expenses Incurred”. Revenue is recognized when there is persuasive evidence that an arrangement exists, delivery has occurred, collectibility is reasonably assured, and fees are fixed or determinable. Deferred revenue expected to be realized within the next 12 months is classified as current.

Substantially all of our revenues are generated from research and licensing arrangements with partners that may involve multiple deliverables. For multiple-deliverable arrangements, judgment is required to evaluate, using the framework outlined in EITF 00-21, whether (a) an arrangement involving multiple deliverables contains more than one unit of accounting, and (b) how the arrangement consideration should be measured and allocated to the separate units of accounting in the arrangement. Our research and licensing arrangements may include upfront non-refundable payments, development milestone payments, payments for contract research and development services performed, patent-based or product sale royalties, government grants, and product sales. For each separate unit of accounting, we have objective and reliable evidence of fair value using available internal evidence for the undelivered item(s) and our arrangements generally do not contain a general right of return relative to the delivered item. In accordance with the guidance in EITF 00-21, we use the residual method to allocate the arrangement consideration when we do not have an objective fair value for a

delivered item. Under the residual method, the amount of consideration allocated to the delivered item equals the total arrangement consideration less the aggregate fair value of the undelivered items.

Revenue from research and licensing arrangements is recorded when earned based on the performance requirements of the contract. Nonrefundable upfront technology license fees, for product candidates where we are providing continuing services related to product development, are deferred and recognized as revenue over the development period or as we provide the services required under the agreement. The ability to estimate total development effort and costs can vary significantly for each product candidate due to the inherent complexities and uncertainties of drug development. The timing and amount of revenue that we recognize from licenses of technology, either from upfront fees or milestones where the we are providing continuing services related to product development, is dependent upon on our estimates of filing dates or development costs. As product candidates move through the development process, it is necessary to revise these estimates to consider changes to the product development cycle, such as changes in the clinical development plan, regulatory requirements, or various other factors, many of which may be outside of our control. The impact on revenue of changes in our estimates and the timing thereof, is recognized prospectively over the remaining estimated product development period.

Milestone payments typically represent nonrefundable payments to be received in conjunction with the achievement of a specific event identified in the contract, such as initiation or completion of specified clinical development activities. We believe a milestone payment represents the culmination of a distinct earnings process when it is not associated with ongoing research, development or other performance on our part and it is substantive in nature. We recognize such milestone payments as revenue when they become due and collection is reasonably assured. When a milestone payment does not represent the culmination of a distinct earnings process, revenue is either recognized when the earnings process is deemed to be complete or in a manner similar to that of an upfront technology license fee.

Revenue from contract research and development services performed is generally received for services performed under collaboration agreements and is recognized as services are performed. Payments received in excess of amounts earned are recorded as deferred revenue. Under the guidance of EITF 01-14, reimbursements received for direct out-of-pocket expenses related to contract research and development costs are recorded as revenue in the consolidated statements of operations rather than as a reduction in expenses.

Royalty revenue is generally recognized at the time of product sale by the licensee.

Government grant revenue is recognized during the period qualifying expenses are incurred for the research that is performed as set forth under the terms of the grant award agreements, and when there is reasonable assurance that we will comply with the terms of the grant and that the grant will be received.

Product sales revenue is recognized when the manufactured goods are shipped to the purchaser and title has transferred under our contracts where there is no right of return. Provision for potential product returns has been made on a historical trends basis. To date, we have not experienced any significant returns from our customers.

Research and Development Costs

All research and development (“R&D”) costs are charged to operations as incurred. Our R&D expenses consist of costs incurred for internal and external R&D. These costs include direct and research-related overhead expenses. We recognize clinical trial expenses, which are included in R&D expenses, based on a variety of factors, including actual and estimated labor hours, clinical site initiation activities, patient enrollment rates, estimates of external costs and other activity-based factors. We believe this method best approximates the efforts expended on a clinical trial with the expenses recorded. We adjust our rate of clinical expense recognition if actual results differ from our estimates. As product candidates move through the development process, it is necessary to revise these estimates to consider changes to the product development cycle, such as changes in the clinical development plan, regulatory requirements or various other factors, many of which may be outside of our control. The impact on revenue and R&D expenses of changes in our estimates and the timing thereof is recognized prospectively over the remaining estimated product development period.

The ability to estimate total development effort and costs can vary significantly for each product candidate due to the inherent complexities and uncertainties of drug development.

When we acquire intellectual properties from others, the purchase price is allocated, as applicable, between in-process research and development (“IPR&D”), other identifiable intangible assets and net tangible assets. Our policy defines IPR&D as the value assigned

to those projects for which the related products have not yet reached technological feasibility and have no alternative future use. Determining the portion of the purchase price allocated to IPR&D requires us to make significant estimates. The amount of the purchase price allocated to IPR&D is determined by estimating the future cash flows of each project of technology and discounting the net cash flows back to their present values. The discount rate used is determined at the acquisition date, in accordance with accepted valuation methods, and includes consideration of the assessed risk of the project not being developed to a stage of commercial feasibility. Amounts recorded as IPR&D are charged to R&D expense upon acquisition.

Stock-Based Compensation

On January 1, 2006, we adopted Statement of Financial Accounting Standards (“SFAS”) No. 123 (revised 2004) “Share-Based Payment,” (“SFAS 123R”) using the modified prospective transition method. SFAS 123R requires the measurement and recognition of compensation for all stock-based awards made to employees and directors, including stock options and restricted stock, based on estimated fair values and supersedes our previous accounting under Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees.” In 2005, the SEC issued SAB No. 107 relating to application of SFAS 123R. We have applied the provisions of SAB 107 in our adoption of SFAS 123R.

Upon adoption of SFAS 123R, we continued to use the Black-Scholes option pricing model as our method of valuation for stock-based awards. Stock-based compensation expense is based on the value of the portion of the stock-based award that will vest during the period, adjusted for expected forfeitures. Our determination of the fair value of stock-based awards on the date of grant using an option pricing model is affected by our stock price as well as assumptions regarding a number of highly complex and subjective variables. These variables include, but are not limited to, the expected life of the award, expected stock price volatility over the term of the award and historical and projected exercise behaviors. The estimation of stock-based awards that will ultimately vest requires judgment, and to the extent actual or updated results differ from our current estimates, such amounts will be recorded as a cumulative adjustment in the period estimates are revised. Although the fair value of stock-based awards is determined in accordance with SFAS 123R and SAB 107, the Black-Scholes option pricing model requires the input of highly subjective assumptions, and other reasonable assumptions could provide differing results.

The adoption of SFAS 123R resulted in a cumulative benefit from accounting change of $291,000 as of January 1, 2006, which reflected the net cumulative impact of estimating future forfeitures in the determination of period expense for restricted stock awards, rather than recording forfeitures when they occur as previously permitted.

Income Taxes

Income taxes are accounted for under the asset and liability method. Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases and operating loss and tax credit carry-forwards. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. We continue to record a valuation allowance for the full amount of deferred tax assets since realization of such tax benefits is not considered to be more likely than not.

Recently Issued Accounting Standards

In July 2006, the FASB issued FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes-an interpretation of FASB Statement No. 109” (“FIN 48”), which prescribes a recognition threshold and measurement process for recording in the financial statements uncertain tax positions taken or expected to be taken in a tax return. Additionally, FIN 48 provides guidance on the recognition, classification, accounting in interim periods and disclosure requirements for uncertain tax positions. The accounting provisions of FIN 48 became effective on January 1, 2007. We have identified our federal tax return and our state tax return in New York as “major” tax jurisdictions, as defined. The periods subject to examination for our federal and New York state income tax returns are the tax years ended in 1992 and thereafter, since we have net operating loss carryforwards for tax years ended in 1992. We believe our income tax filing positions and deductions will be sustained on audit and we do not anticipate any adjustments that will result in a material change to our financial position. Therefore, no reserves for uncertain income tax positions have been recorded pursuant to FIN 48, nor we did record a cumulative effect adjustment related to the adoption of FIN 48. Our policy for recording interest and penalties associated with audits is to record such items as a component of income (loss) before taxes. Penalties and interest paid are recorded in interest and other expense and interest received is recorded in interest income in the statement of operations.

Consolidated Results of Operations

Comparison of Quarterly Results of Operations

Percentage comparisons have been omitted within the following table where they are not considered meaningful. All amounts, except amounts expressed as a percentage, are presented in thousands in the following table.


	Three Months Ended
	March 31,						Change
	2006			2007			$			%
Revenue
License and research fees	$	6,299		$	4,672		$	(1,627	)		(26	)%
Government grants		—			100			100
Product revenue		419			220			(199	)		(47	)%

Total revenue		6,718			4,992			(1,726	)		(26	)%

Operating expenses
Cost of product revenue		239			59			(180	)		(75	)%
Research and development		11,801			12,874			1,073			9	%
Sales and marketing		395			581			186			47	%
General and administrative		2,951			3,704			753			26	%

Total operating expenses		15,386			17,218			1,832			12	%
Interest income		638			957			319			50	%
Interest and other expense		(108	)		(271	)		(163	)		151	%

Loss before cumulative effect of change in accounting principle		(8,138	)		(11,540	)		(3,402	)		42	%
Cumulative effect of change in accounting principle		291			—			(291	)		(100	)%

Net loss	$	(7,847	)	$	(11,540	)	$	(3,693	)		47	%

Comparison of the Three Months Ended March 31, 2006 to the Three Months Ended March 31, 2007

Revenue. Our agreement with Merck was terminated in March 2006. Merck accounted for approximately 56% of total revenue and P&G accounted for approximately 31% of total revenue for the three months ended March 31, 2006. P&G accounted for 71% of total revenue and Novo Nordisk accounted for approximately 19% of total revenue for the three months ended March 31, 2007.

License and research fees revenue. Revenue from license and research fees decreased in the first quarter of 2007 compared to the first quarter of 2006.

Our license and research fee revenue recognized in the first quarter of 2006 was primarily composed of approximately $3.7 million in previously deferred license fees as a result of the termination of our collaboration with Merck and recognition of other fees received from other collaborative partners over the estimated remaining development periods, including a portion of the $10.0 million received as a result of our collaboration agreement with P&G. In the first quarter of 2007, license and research fee revenue was primarily composed of the recognition of current period research and development fees related to our collaboration with P&G, including a portion of the $10.0 million discussed above, as well as recognition of other revenue from other collaboration agreements. The estimated development periods may be revised over time based upon changes in clinical development plans, regulatory requirements or other factors, many of which may be out of our control.

Government grants revenue. In September 2006, the NIH awarded us a $1.9 million grant to prevent and treat influenza. Revenue recognized under this grant during the first quarter of 2007 totaled approximately $100,000.

Product Revenue. During the first quarters of 2006 and 2007, product revenue consists of sales of our Nascobal^® brand products. Since the sale of the assets relating to our Nascobal^® brand products to Questcor in June 2003, we have earned product sales revenue under the supply agreement. The Questcor Agreements were subsequently assigned to QOL in October 2005. We expect to continue to receive product sales revenue from QOL in the future.

Cost of product revenue. Cost of product revenue consists of raw materials, labor and overhead expenses. Cost of product revenue decreased to $59,000 in the first quarter of 2007 compared to $239,000 in the first quarter of 2006 due primarily to decreased orders and, accordingly, shipments of Nascobal^® products. We produced two production lots of Nascobal^® nasal spray in the first quarter of

2007, compared to two production lots of Nascobal^® nasal spray, one production lot of Nascobal^® nasal gel and a bulk inventory sale of production vials under the supply agreement with QOL in the first quarter of 2006.

Research and Development. R&D expense consists primarily of salaries and other personnel-related expenses, costs of clinical trials, consulting and other outside services, laboratory supplies, facilities costs, FDA filing fees, patent filing fees, purchased IPR&D and other costs. We expense all R&D costs as incurred. R&D expense for the first quarter of 2007 continued to increase as compared to the 2006 period, due to the following:

	•		Personnel-related expenses increased by 36% to $5.3 million in the first quarter of 2007 compared to $3.9 million in the first quarter of 2006 due to an increase in headcount in support of our R&D programs.

	•		Costs of clinical trials, consulting, outside services and laboratory supplies increased by 132% to approximately $4.0 million in the first quarter of 2007 compared to approximately $1.7 million in the first quarter of 2006 due primarily to our increased efforts related to pre-clinical and clinical programs for PTH(1-34), PYY, calcitonin and RNAi.

	•		Facilities and equipment costs increased by 76% to $2.4 million in the first quarter of 2007 compared to $1.4 million in the first quarter of 2006 due to rent and related expenses on additional space leased at the Bothell facility and an increase in depreciation of equipment resulting from capital expenditures to acquire needed technical capabilities and to support increased capacity. Depreciation expense included in R&D in the first quarter of 2007 was $0.7 million, compared with $0.5 million in the first quarter of 2006.

	•		Non-cash stock-based compensation included in R&D expense increased to $0.7 million in the first quarter of 2007 from approximately $0.5 million in the first quarter of 2006.

	•		In November 2006, we acquired a license from the Beckman Research Institute/City of Hope for exclusive and non-exclusive licenses to the Dicer-substrate RNAi IP developed there. We obtained exclusive rights to five undisclosed targets selected by us, as well as broad non-exclusive rights to Dicer-substrates directed against all mammalian targets subject to certain City of Hope limitations that will have no impact on our programs. We intend to further develop this IP and technology, which should cause a related increase in R&D expenses.

The increases in R&D expenses discussed above were partially offset by the decrease related to purchased in-process R&D (IPR&D). In February 2006 we acquired RNAi IP and other RNAi technologies from Galenea, including patent applications licensed from the Massachusetts Institute of Technology that have early priority dates in the antiviral RNAi field focused on viral respiratory infections, including influenza, rhinovirus and other respiratory diseases. We also acquired Galenea’s research and IP relating to pulmonary drug delivery technologies for RNAi. We also assumed Galenea’s awarded and pending grant applications from National Institutes of Allergy and Infectious Diseases and the Department of Defense to support the development of RNAi-based antiviral drugs. In connection with this transaction, we recorded a charge of approximately $4.1 million for acquired research associated with products in development for which, at the acquisition date, technological feasibility had not been established and there was no alternative future use. Purchased IPR&D expenses, which were zero in the current quarter, were included in R&D expense in the first quarter of 2006.

R&D expense by project, as a percentage of total R&D project expense, was as follows:


	Three Months Ended March 31,
	2006(2)			2007
PTH(1-34)		28	%		32	%
Tight Junctions and RNAi		32	%		17	%
Insulin		7	%		11	%
PYY		5	%		8	%
Influenza		4	%		7	%
Carbetocin		0	%		6	%
Calcitonin		11	%		3	%
Other research and development projects(1)		13	%		16	%

Total		100	%		100	%


(1)		Other research and development projects include our excipient projects, feasibility projects and other projects.

(2)		Excludes purchased IPR&D in the field of RNAi related to influenza from Galenea of approximately $4.1 million in 2006. We believe that presenting R&D expense by project as a percentage of total R&D project expense without the Galenea transaction allows for better comparability between periods given the significance of the amount relative to total R&D project expense.

We expect a continued increase in R&D expense in the foreseeable future as we continue to expand our R&D activities. These expenditures are subject to uncertainties in timing and cost to completion. We test compounds in numerous preclinical studies for safety, toxicology and efficacy. We then conduct early stage clinical trials for each drug candidate. If we are not able to engage a collaboration partner prior to the commencement of later stage clinical trials, or if we decide to pursue a strategy of maintaining commercialization rights to a program, we may fund these trials ourselves. As we obtain results from trials, we may elect to discontinue or delay clinical trials for certain products in order to focus our resources on more promising products. Completion of clinical trials by us and our collaboration partners may take several years or more, as the length of time varies substantially according to the type, complexity, novelty and intended use of a drug candidate. The cost of clinical trials may vary significantly over the life of a project as a result of differences arising during clinical development, including:

	•		the number of sites included in the clinical trials;

	•		the length of time required to enroll suitable patient subjects;

	•		the number of patients that participate in the trials;

	•		the duration of patient follow-up that seems appropriate in view of results; and

	•		the number and complexity of safety and efficacy parameters monitored during the study.

With the exception of our Nascobal^® gel and Nascobal^® spray, none of our current product candidates utilizing our nasal drug delivery technology has received FDA or foreign regulatory marketing approval. In order to achieve marketing approval, the FDA or foreign regulatory agencies must conclude that our and our collaboration partners’ clinical data establishes the safety and efficacy of our drug candidates. Furthermore, our strategy includes entering into collaborations with third parties to participate in the development and commercialization of our products. In the event that the collaboration partner has control over the development process for a product, the estimated completion date would largely be under control of such partner. We cannot forecast with a high degree of certainty how such collaboration arrangements will affect our development spending or capital requirements.

As a result of the uncertainties discussed above, we are often unable to determine the duration and completion costs of our R&D projects or when and to what extent we will receive cash inflows from the commercialization and sale of a product.

Sales and marketing. Sales and marketing expense consists primarily of salaries and other personnel-related expenses, consulting, sales materials, trade shows and advertising. The 47% increase in sales and marketing expense in the first quarter of 2007 compared to the first quarter of 2006 resulted primarily from increased staffing in support of our collaborative relationships and an increase in non-cash stock-based compensation expense resulting from the expensing of restricted stock, which we first began issuing in 2004. Stock-based compensation included in sales and marketing increased from approximately $45,000 in the first quarter of 2006 to $117,000 in the first quarter of 2007. As a percent of revenue, sales and marketing expense increased from 6% in the first quarter of 2006 to 12% in the first quarter of 2007 due to higher expenses and lower revenue in the 2007 period. We expect sales and marketing costs, which include business development staff and activities, to increase moderately in the foreseeable future to support activities associated with partnering our other drug candidates.

General and administrative. General and administrative expense consists primarily of salaries and other personnel-related expenses to support our R&D activities, non-cash stock-based compensation for general and administrative personnel and non-employee members of our Board, professional fees, such as accounting and legal, corporate insurance and facilities costs. The 26% increase in general and administrative expenses in first quarter of 2007 compared to the first quarter of 2006 resulted primarily from the following:

	•		Costs of legal and accounting fees, corporate insurance and other administrative costs increased by 17% to approximately $1.5 million in the first quarter of 2007 compared to approximately $1.3 million in the first quarter of 2006.

	•		Personnel-related expenses increased by 43% to $1.3 million in the first quarter of 2007 compared to $0.9 million in the first quarter of 2006 due primarily to increased headcount related to administrative activities.

We expect general and administrative expenses to increase in the foreseeable future, depending on the growth of our research and development and other corporate activities.

Interest Income. The 50% increase in interest income in the first quarter of 2007 compared to the first quarter of 2006 was primarily due to higher market interest rates earned on our invested funds, as well as higher average balances available for investment in the current year period. In January 2007 we raised net proceeds of approximately $41.0 million through issuance of our common stock.

Interest and Other Expense. We incurred interest expense on our capital leases. The increase in interest expense in the first quarter of 2007 compared to the first quarter of 2006 was due to an increase in the average borrowings as well as a higher weighted average interest rate.

Liquidity and Capital Resources

Cash Requirements

Our cash requirements consist primarily of the need for working capital, including funding R&D activities and capital expenditures for the purchase of equipment. From time to time, we also may require capital for investments involving acquisitions and strategic relationships. We had an accumulated deficit of approximately $154.0 million as of March 31, 2007 and expect additional losses in the future as we continue to expand our R&D activities. In addition, we are planning to enter into various collaborations in furtherance of our R&D programs, and we may be required to reduce our R&D activities or raise additional funds from new investors or in the public markets.

Sources and Uses of Cash

We have financed our operations primarily through the sale of common stock and warrants through private placements and in the public markets, revenue received from our collaboration partners and, to a lesser extent, equipment financing facilities and notes payable.

In January 2007, we completed a public offering of 3,250,000 shares of our common stock for net proceeds of approximately $41.0 million. As of March 31, 2007, we had approximately $84.0 million remaining on our effective shelf registration statement under the Securities Act of 1933, pursuant to which we may issue common stock or warrants in the amount of up to $125.0 million. Shelf registration statements enable us to raise capital in the public markets from the offering of securities covered by the shelf registration statements, from time to time and through one or more methods of distribution, subject to market conditions and our cash needs.

Our research and development efforts and collaborative arrangements with our partners enable us to generate contract research revenues, milestone payments, license fees, royalties and manufactured product sales.

	•		Under our collaborative arrangement with P&G, we received an initial cash payment of $10.0 million in February 2006, which has been recorded as deferred revenue and is being amortized into revenue over the estimated development period. A $7.0 million milestone payment received from P&G in second quarter 2006 was recognized in full as revenue in that period.

	•		Under our collaborative arrangement with Merck for PYY(3-36), we received an initial cash payment of $5.0 million in October 2004. The $5.0 million initial payment was being amortized over the estimated development period until the collaboration was terminated in March 2006, at which time the unamortized balance of the license payment of approximately $3.7 million was recognized as revenue and we reacquired our rights in the PYY program.

	•		Under our supply agreement with Questcor, in February 2005 we received and recognized a payment of $2.0 million from Questcor upon FDA approval of an NDA for our Nascobal^® nasal spray product. In October 2005, with our consent, Questcor assigned all of its rights and obligations under the Questcor Agreements dated June 2003 to QOL. We received $2.0 million from

Questcor in October 2005 in consideration for our consent to the assignment and in connection with our entering into an agreement with QOL that modified certain terms of the Questcor Agreements. The $2.0 million is being recognized ratably over the five-year life of the QOL agreement. QOL has assumed Questcor’s obligation to pay us an additional $2.0 million contingent upon issuance of a U.S. patent for the Nascobal^® nasal spray product.

We used cash of $9.1 million in our operating activities in the first quarter of 2007, compared to $3.6 million in the first quarter of 2006. Cash used in operating activities relates primarily to funding net losses and changes in deferred revenue from collaborators, accounts and other receivables, accounts payable and accrued expenses and other liabilities, partially offset by depreciation and amortization and non-cash compensation related to restricted stock and stock options. We expect to use cash for operating activities in the foreseeable future as we continue our R&D activities.

We used cash of $10.6 million in our investing activities in the first quarter of 2007, compared to $9.9 million in the first quarter of 2006. Changes in cash from investing activities are due primarily to changes in restricted cash, purchases of short-term investments net of maturities and purchases of property and equipment. We expect to continue to make significant investments in our R&D infrastructure, including purchases of property and equipment to support our R&D activities. We have pledged approximately $2.2 million of our cash as collateral for letters of credit for leased facilities and we report changes in our restricted cash as investing activities in the consolidated statements of cash flows.

Our financing activities provided cash of $41.2 million in the first quarter of 2007, compared to $8.0 million in the first quarter of 2006. Changes in cash from financing activities are primarily due to issuance of common stock and warrants, proceeds and repayment of equipment financing facilities and proceeds from exercises of stock options and warrants. We raised net proceeds of approximately $41.0 million in January 2007 through public placement of shares of common stock.

Liquidity

We had a working capital (current assets less current liabilities) surplus of $72.5 million as of March 31, 2007. As of March 31, 2007, we had approximately $81.4 million in cash, cash-equivalents and short-term investments, including $2.2 million in restricted cash. We believe, although there can be no assurance, that our current cash position will provide us with adequate working capital for at least the next 12 months, or longer, depending upon the degree to which we exploit our various current opportunities that are in the pipeline and the success of our collaborative arrangements. This belief is based, in part, on the assumption that we have completed and are planning to enter into various collaborations to accelerate our research and development programs which will provide us with additional financing. To the extent these collaborations do not proceed as planned, we may be required to reduce our research and development activities or, if necessary and possible, raise additional capital from new investors or in the public markets.

As of March 31, 2007, the unused portion of our 2007 capital lease credit line of $5.5 million for financing equipment and leasehold assets was approximately $4.2 million.

Contractual Obligations

Our contractual obligations have changed since December 31, 2006 to March 31, 2007 as follows:

•

Our purchase obligations decreased by approximately $3.0 million from approximately $3.6 million at December 31, 2006 to approximately $0.6 million at March 31, 2007 due to the timing of purchase order activity (primarily for PTH(1-34)) .

Off-Balance Sheet Arrangements

As of March 31, 2007, we did not have any off-balance sheet arrangements, as defined in Item 303(a)(4)(ii) of SEC Regulation S-K.

ITEM 3 – QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

We are exposed to financial market risk resulting from changes in interest rates. We do not engage in speculative or leveraged transactions, nor do we utilize derivative financial instruments. We invest in interest-bearing instruments that are classified as cash and cash equivalents, restricted cash and short-term investments. Our investment policy is to manage our total invested funds to preserve principal and liquidity while maximizing the return on the investment portfolio through the full investment of available funds. We invest in debt instruments of U.S. Government. Unrealized gains or losses related to fluctuations in interest rates are reflected in other

comprehensive income or loss. Based on our cash and cash equivalents, restricted cash and short-term investments balances at March 31, 2007, a 100 basis point increase or decrease in interest rates would result in an increase or decrease of approximately $0.8 million to interest income on an annual basis.

ITEM 4 – CONTROLS AND PROCEDURES

(a) Disclosure Controls and Procedures. As of the end of the period covered by this Quarterly Report on Form 10-Q, we carried out an evaluation, under the supervision and with the participation of our senior management, including our Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures. Based upon that evaluation, our Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures are effective for gathering, analyzing and disclosing the information that we are required to disclose in reports filed under the Securities Exchange Act of 1934, as amended.

(b) Internal Control Over Financial Reporting. There have been no changes in our internal controls over financial reporting or in other factors during the fiscal quarter ended March 31, 2007, that materially affected, or are reasonably likely to materially affect, our internal control over financial reporting subsequent to the date we carried out our most recent evaluation.

PART II – OTHER INFORMATION

ITEM 5 – OTHER INFORMATION

On May 4, 2007 the Company and Dr. Quay, Mr. Ranker, Dr. Brandt and Mr. Duffy entered into omnibus amendments to their respective outstanding grant awards dated February 6, 2007 to provide that the terms of their respective Employment Agreements shall supersede any conflicting terms contained in such grant awards.

ITEM 6 – EXHIBITS

The exhibits required by this item are set forth in the Exhibit Index attached hereto.

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, duly authorized, in Bothell, State of Washington, on May 7, 2007.


	NASTECH PHARMACEUTICAL COMPANY INC.
	By:	/s/ Steven C. Quay
		Steven C. Quay, M.D., Ph.D.
		Chairman of the Board, President and Chief Executive Officer


	By:	/s/ Philip C. Ranker
		Philip C. Ranker
		Chief Financial Officer

EXHIBIT INDEX


Exhibit
No.		Description

2.1		Agreement and Plan of Reorganization, dated August 8, 2000, among the Company, Atossa Acquisition Corporation, a Delaware corporation and wholly-owned subsidiary of the Company, and Atossa HealthCare, Inc. (filed as Exhibit 2.1 to our Current Report on Form 8-K dated August 8, 2000, and incorporated herein by reference).

2.2		Asset Purchase Agreement, dated September 30, 2002, with Schwarz Pharma, Inc. (filed as Exhibit 2.1 to our Current Report on Form 8-K dated September 30, 2002 and incorporated herein by reference).

3.1		Restated Certificate of Incorporation of the Company dated July 20, 2005 (filed as Exhibit 3.1 to our Current Report on Form 8-K dated July 20, 2005, and incorporated herein by reference).

3.2		Amended and Restated Bylaws of the Company dated August 11, 2004 (filed as Exhibit 3.10 to our Registration Statement on Form S-3, File No. 333-119429, and incorporated herein by reference).

4.1		Investment Agreement, dated as of February 1, 2002, by and between the Company and Pharmacia & Upjohn Company (filed as Exhibit 4.1 to the Company Current Report on Form 8-K dated February 1, 2002 and incorporated herein by reference).

4.2		Rights Agreement, dated February 22, 2000, between the Company and American Stock Transfer & Trust Company as Rights Agent (filed as Exhibit 1 to our Current Report on Form 8-K dated February 22, 2000 and incorporated herein by reference).

4.3		Amendment No. 1 to Rights Agreement dated as of January 17, 2007 by and between the Company and American Stock Transfer & Trust Company (filed as Exhibit 4.1 to our Current Report on Form 8-K dated January 19, 2007 and incorporated herein by reference).

4.4		Securities Purchase Agreement dated as of June 25, 2004 (filed as Exhibit 99.2 to our Current Report on Form 8-K dated June 25, 2004 and incorporated herein by reference).

4.5		Form of Warrant (filed as Exhibit 99.3 to our Current Report on Form 8-K dated June 25, 2004 and incorporated herein by reference).

4.6		Certificate of Designation, Rights and Preferences of Series A Junior Participating Preferred Stock dated January 17, 2007 (filed as Exhibit 3.1 to our Current Report on Form 8-K dated January 19, 2007 and incorporated herein by reference).

10.1		Lease Agreement for facilities at 45 Davids Drive, Hauppauge, NY, effective as of July 1, 2005 (filed as Exhibit 10.30 to our Quarterly Report on Form 10-Q for the quarter ended March 31, 2005 and incorporated herein by reference).

10.2		Lease Agreement, dated April 23, 2002, with Phase 3 Science Center LLC, Ahwatukee Hills Investors LLC and J. Alexander’s LLC (filed as Exhibit 10.26 to our Quarterly Report on Form 10-Q for the Quarter Ended March 31, 2002 and incorporated herein by reference).

10.3		First Amendment, dated June 17, 2003, to Lease Agreement dated April 23, 2002, with Phase 3 Science Center LLC, Ahwatukee Hills Investors LLC and J. Alexander’s LLC (filed as Exhibit 10.2 to our Quarterly Report on Form 10-Q for the Quarter ended June 30, 2003 and incorporated herein by reference).

10.4		Second Amendment, dated February 4, 2004, to Lease Agreement dated April 23, 2002, with Phase 3 Science Center LLC, Ahwatukee Hills Investors LLC and J. Alexander’s LLC (filed as Exhibit 10.24 to our Annual Report on Form 10-K for the year ended December 31, 2003 and incorporated herein by reference).

10.5		Lease Agreement for facilities at 80 Davids Drive, Hauppauge, NY, effective as of July 1, 2005 (filed as Exhibit 10.5 to our Quarterly Report on Form 10-Q for the Quarter Ended June 30, 2005 and incorporated herein by reference).

10.6		Lease Agreement for facilities at 3830 Monte Villa Parkway, Bothell, WA, with Ditty Properties Limited Partnership, effective as of March 1, 2006 (filed as Exhibit 10.1 to Amendment No. 1 to our Current Report on Form 8-K/A dated March 1, 2006 and filed on July 26, 2006 and incorporated herein by reference).(1)

10.7		First Amendment, dated July 17, 2006, to Lease Agreement dated March 1, 2006 with Ditty Properties Limited Partnership for facilities at 3830 Monte Villa Parkway, Bothell, WA (filed as Exhibit 10.7 to our Quarterly Report on Form 10-Q for the quarter ended June 30, 2006 and incorporated herein by reference).

10.8		Amended and Restated Employment Agreement, dated May 2, 2002, with Steven C. Quay, M.D., Ph.D. (filed as Exhibit 10.27 to our Quarterly Report on Form 10-Q for the Quarter Ended March 31, 2002 and incorporated herein by reference).


Exhibit
No.		Description
10.9		Employment Agreement dated June 3, 2005 by and between Nastech Pharmaceutical Company Inc. and Steven C. Quay, M.D., Ph.D. (filed as Exhibit 10.1 to our Current Report on Form 8-K dated June 3, 2005 and incorporated herein by reference).

10.10		Amended and Restated Employment Agreement dated December 16, 2005 by and between Nastech Pharmaceutical Company Inc. and Steven C. Quay, M.D., Ph.D. (filed as Exhibit 10.1 to our Current Report on Form 8-K dated December 16, 2005 and incorporated herein by reference).

10.11		Employment Agreement effective as of January 1, 2006 by and between Nastech Pharmaceutical Company Inc. and Philip C. Ranker (filed as Exhibit 10.1 to our Current Report on Form 8-K dated January 1, 2006 and incorporated herein by reference).

10.12		Employment Agreement effective as of August 17, 2006 by and between Nastech Pharmaceutical Company Inc. and Gordon C. Brandt, M.D. (filed as Exhibit 10.1 to our Current Report on Form 8-K dated August 17, 2006 and incorporated herein by reference).

10.13		Employment Agreement effective as of September 15, 2006 by and between Nastech Pharmaceutical Company Inc. and Timothy M. Duffy (filed as Exhibit 10.1 to our Current Report on Form 8-K dated September 15, 2006 and incorporated herein by reference).

10.14		Termination and Mutual Release Agreement, dated September 30, 2002, with Schwarz Pharma, Inc. (Filed as Exhibit 10.3 to our Current Report on Form 8-K dated September 30, 2002 and incorporated herein by reference).

10.15		Divestiture Agreement, dated January 24, 2003, with Pharmacia & Upjohn Company (filed as Exhibit 10.1 to our Current Report on Form 8-K dated January 24, 2003 and incorporated herein by reference).

10.16		Nastech Pharmaceutical Company Inc. 1990 Stock Option Plan (filed as Exhibit 4.2 to our Registration Statement on Form S-8, File No. 333-28785, and incorporated herein by reference).

10.17		Amended and Restated Nastech Pharmaceutical Company Inc. 2000 Nonqualified Stock Option Plan (filed as Exhibit 4.4 to our Registration Statement on Form S-8, File No. 333-49514, and incorporated herein by reference).

10.18		Amendment No. 1 to the Amended and Restated Nastech Pharmaceutical Company Inc. 2000 Nonqualified Stock Option Plan. (Filed as Exhibit 10.18 to our Annual Report on Form 10-K for the year ended December 31, 2005 and incorporated herein by reference).

10.19		Amendment No. 2 to the Amended and Restated Nastech Pharmaceutical Company Inc. 2000 Nonqualified Stock Option Plan. (Filed as Exhibit 10.19 to our Annual Report on Form 10-K for the year ended December 31, 2006 and incorporated herein by reference).

10.20		Nastech Pharmaceutical Company Inc. 2002 Stock Option Plan (filed as Exhibit 10.28 to our Quarterly Report on Form 10-Q for the Quarter Ended June 30, 2002 and incorporated herein by reference).

10.21		Amendment No. 1 to the Nastech Pharmaceutical Company Inc. 2002 Stock Option Plan. (filed as Exhibit 10.20 to our Annual Report on Form 10-K for the year ended December 31, 2005 and incorporated herein by reference).

10.22		Nastech Pharmaceutical Company Inc. 2004 Stock Incentive Plan (filed as Exhibit 99 to our Registration Statement on Form S-8, File No. 333-118206, and incorporated herein by reference).

10.23		Amendment No. 1 to Nastech Pharmaceutical Company Inc. 2004 Stock Incentive Plan (filed as Exhibit 10.4 to our Current Report on Form 8-K dated July 20, 2005 and incorporated herein by reference).

10.24		Amendment No. 2 to Nastech Pharmaceutical Company Inc. 2004 Stock Incentive Plan (filed as Exhibit 10.18 to our Quarterly Report on Form 10-Q for the Quarter Ended September 30, 2005 and incorporated herein by reference).

10.25		Amendment No. 3 to Nastech Pharmaceutical Company Inc. 2004 Stock Incentive Plan. (filed as Exhibit 10.24 to our Annual Report on Form 10-K for the year ended December 31, 2005 and incorporated herein by reference).

10.26		Amendment No. 4 to Nastech Pharmaceutical Company Inc. 2004 Stock Incentive Plan. (filed as Exhibit 10.5 to our Registration Statement on Form S-8, File No. 333-135724, and incorporated herein by reference).

10.27		Amendment No. 5 to Nastech Pharmaceutical Company Inc. 2004 Stock Incentive Plan. (Filed as Exhibit 10.27 to our Annual Report on Form 10-K for the year ended December 31, 2006 and incorporated herein by reference).

10.28		Asset Purchase Agreement dated June 16, 2003, by and between the Company and Questcor Pharmaceuticals, Inc. (filed as Exhibit 2.1 to our Current Report on Form 8-K dated June 17, 2003 and incorporated herein by reference).


Exhibit
No.		Description
10.29		Form of Purchase Agreement (filed as Exhibit 99.2 to our Current Report on Form 8-K dated September 4, 2003 and incorporated herein by reference).

10.30		Form of Warrant (filed as Exhibit 99.3 to our Current Report on Form 8-K dated September 4, 2003, and incorporated herein by reference).

10.31		Exclusive Development, Commercialization and License Agreement by and between Merck & Co., Inc. and the Company effective as of September 24, 2004 (filed as Exhibit 10.1 to our Current Report on Form 8-K dated September 24, 2004 and incorporated herein by reference).(1)

10.32		Supply Agreement by and between the Company and Merck & Co., Inc. effective as of September 24, 2004 (filed as Exhibit 10.2 to our Current Report on Form 8-K dated September 24, 2004 and incorporated herein by reference).(1)

10.33		License and Supply Agreement by and between Par Pharmaceutical, Inc. and Nastech Pharmaceutical Company Inc. effective as of October 22, 2004 (filed as Exhibit 10.1 to our Current Report on Form 8-K dated October 22, 2004 and incorporated herein by reference).(1)

10.34		Agreement dated as of September 23, 2005 by and between Nastech Pharmaceutical Company Inc. and QOL Medical, LLC. (filed as Exhibit 10.1 to Amendment No. 1 to our Current Report on Form 8-K/A dated October 17, 2005 and filed on July 26, 2006 and incorporated herein by reference).(1)

10.35		Product Development and License Agreement by and between Nastech Pharmaceutical Company Inc. and Procter & Gamble Pharmaceuticals, Inc. dated January 27, 2006 (filed as Exhibit 10.1 to our Current Report on Form 8-K dated January 27, 2006 and incorporated herein by reference).(1)

10.36		First Amendment dated as of December 4, 2006 to Product Development and License Agreement by and between Nastech and Procter & Gamble Pharmaceuticals, Inc (filed as Exhibit 10.46 to our Annual Report on Form 10-K dated March 7, 2007 and incorporated herein by reference).

10.37		Supply Agreement by and between the Company and Procter & Gamble Pharmaceuticals, Inc. dated June 2, 2006 (filed as Exhibit 10.1 to our Current Report on Form 8-K dated June 2, 2006 and incorporated herein by reference).(1)

10.38		Development and License Agreement by and between Nastech Pharmaceutical Company Inc. and Amylin Pharmaceuticals, Inc. dated June 23, 2006.(1) (filed as exhibit 10.66 to our Quarterly Report on Form 10-Q for the quarter ended June 30, 2006 and incorporated herein by reference).

10.39		Employment Agreement effective as of November 1, 2006 by and between the Company and Paul H. Johnson, Ph.D. (filed as Exhibit 10.1 to our Current Report on Form 8-K dated November 1, 2006 and incorporated herein by reference).

10.40		Form of Restricted Stock Grant Agreement (filed as Exhibit 10.1 to our Current Report on Form 8-K, dated February 6, 2007 and incorporated herein by reference).

10.41		Form of Stock Option Agreement (filed as Exhibit 10.2 to our Current Report on Form 8-K, dated February 6, 2007 and incorporated herein by reference).

10.42		Form of Omnibus Amendment to Certain Grant Agreements, dated May 4, 2007.(2)

31.1		Certification of our Chairman of the Board, President and Chief Executive Officer pursuant to Rules 13a–14 and 15d-14 under the Securities Exchange Act of 1934, as amended.(2)

31.2		Certification of our Chief Financial Officer pursuant to Rules 13a–14 and 15d-14 under the Securities Exchange Act of 1934, as amended.(2)

32.1		Certification of our Chairman of the Board, President and Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.(2)

32.2		Certification of our Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.(2)


(1)		Portions of this exhibit have been omitted pursuant to a request for confidential treatment under Rule 24b-2 of the Securities Exchange Act of 1934, amended, and the omitted material has been separately filed with the Securities and Exchange Commission.

(2)		Filed Herewith.

Adhera Therapeutics, Inc. - Quarter Report: 2007 March (Form 10-Q)

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