DURECT CORP - Quarter Report: 2009 September (Form 10-Q)

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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

For the quarterly period ended September 30, 2009

OR

For the transition period from             to             

Commission file number 000-31615

DURECT CORPORATION

(Exact name of registrant as specified in its charter)

2 Results Way

Cupertino, California 95014

(Address of principal executive offices, including zip code)

(408) 777-1417

(Registrant’s telephone number, including area code)

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

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).    Yes  ¨    No  ¨

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

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

As of October 30, 2009, there were 86,748,668 shares of the registrant’s Common Stock outstanding.

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INDEX

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PART I. FINANCIAL INFORMATION

DURECT CORPORATION

CONDENSED BALANCE SHEETS

(in thousands)

The accompanying notes are an integral part of these financial statements.

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DURECT CORPORATION

CONDENSED STATEMENTS OF OPERATIONS

(in thousands, except per share amounts)

(unaudited)

The accompanying notes are an integral part of these financial statements.

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DURECT CORPORATION

CONDENSED STATEMENTS OF CASH FLOWS

(in thousands)

(unaudited)

The accompanying notes are an integral part of these financial statements.

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DURECT CORPORATION

NOTES TO UNAUDITED CONDENSED FINANCIAL STATEMENTS

Note 1. Summary of Significant Accounting Policies

Nature of Operations

DURECT Corporation (the Company) was incorporated in the state of Delaware on February 6, 1998. The Company is a pharmaceutical company developing therapies based on its proprietary drug formulations and delivery platform technologies. The Company has several products under development by itself and with third party collaborators. The Company also manufactures and sells osmotic pumps used in laboratory research, and designs, develops and manufactures a wide range of standard and custom biodegradable polymers and excipients for pharmaceutical and medical device clients for use as raw materials in their products. In addition, the Company conducts research and development of pharmaceutical products in collaboration with third party pharmaceutical and biotechnology companies.

Basis of Presentation

The accompanying unaudited financial statements include the accounts of the Company. These financial statements have been prepared in accordance with the rules and regulations of the Securities and Exchange Commission (SEC), and therefore, do not include all the information and footnotes necessary for a complete presentation of the Company’s results of operations, financial position and cash flows in conformity with U.S. generally accepted accounting principles (U.S. GAAP). The unaudited financial statements reflect all adjustments (consisting only of normal recurring adjustments) which are, in the opinion of management, necessary for a fair presentation of the financial position at September 30, 2009, the operating results for the three and nine months ended September 30, 2009 and 2008, and cash flows for the nine months ended September 30, 2009 and 2008. The Company has evaluated subsequent events through the time of filing this Form 10-Q on November 2, 2009, which is the date that these financial statements have been filed with the Securities and Exchange Commission (“SEC”). All appropriate subsequent event disclosures have been made in the notes to our unaudited condensed financial statements. The balance sheet as of December 31, 2008 has been derived from audited financial statements at that date but does not include all of the information and footnotes required by U.S. GAAP for complete financial statements. These financial statements and notes should be read in conjunction with the Company’s audited financial statements and notes thereto, included in the Company’s annual report on Form 10-K filed with the SEC.

The results of operations for the interim periods presented are not necessarily indicative of results that may be expected for any other interim period or for the full fiscal year.

Inventories

Inventories are stated at the lower of cost or market, with cost determined on a first-in, first-out basis.

Inventories consisted of the following (in thousands):

Revenue Recognition

Revenue from the sale of products is recognized when there is persuasive evidence that an arrangement exists, the product is shipped and title transfers to customers, provided no continuing obligation exists, the price is fixed or determinable and the collectability of the amounts owed is reasonably assured. The Company recognizes revenue from the sale of its products and license and collaboration agreements pursuant to Accounting Standards Codification (ASC) 605, Revenue Recognition. Multiple element agreements entered into are evaluated under the provisions of ASC 605-25. The Company evaluates whether there is stand-alone value for the delivered elements and objective and reliable evidence of fair value to allocate revenue to each element in multiple element agreements. When the delivered element does not have stand-alone value or there is insufficient evidence of fair value for the undelivered element(s), the Company recognizes the consideration for the combined unit of accounting in the same manner as the revenue is recognized for the final deliverable, which is generally ratably over the longest period of involvement. Returns or credits related to the sale of products have not had a material impact on our revenues or net loss.

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DURECT CORPORATION

NOTES TO UNAUDITED CONDENSED FINANCIAL STATEMENTS—(Continued)

Upfront payments received upon execution of collaborative agreements are recorded as deferred revenue and recognized as collaborative research and development revenue based on a straight-line basis over the period of the Company’s continuing involvement with the third-party collaborator pursuant to the applicable agreement. Such period generally represents the research and development period set forth in the work plan defined in the respective agreements between the Company and its third-party collaborators.

Research and development revenue related to services performed under the collaborative arrangements with the Company’s third-party collaborators is recognized as the related research and development services are performed. These research payments received under each respective agreement are not refundable and are generally based on reimbursement of qualified expenses, as defined in the agreements. Research and development expenses under the collaborative research and development agreements generally approximate or exceed the revenue recognized under such agreements over the term of the respective agreements. Deferred revenue may result when the Company does not expend the required level of effort during a specific period in comparison to funds received under the respective agreement. Pursuant to ASC 808-10, Collaborative Arrangements, for joint control and funding development activities, the Company will not recognize revenue from the reimbursement of the research and development expenses but instead those reimbursements receivable from the joint venture party will be recorded as a reduction in research and development expense.

Milestone payments under collaborative arrangements are recognized as collaborative research and development revenue upon achievement of the milestone events, which represent the culmination of the earnings process related to that milestone as defined in the agreement. Milestone payments are triggered either by the results of our research and development efforts or by events external to us, such as regulatory approval to market a product or the achievement of specified sales levels by a third-party collaborator. As such, the milestones are substantially at risk at the inception of the collaboration agreement, and revenue is only recognized upon the achievement of a milestone event if we have no future performance obligations related to that milestone payment.

The collaborative research and development and other revenues associated with the Company’s major third-party collaborators are as follows (in thousands):

Notes:

The Company amortizes upfront fees on a straight-line basis over the period in which the Company has continuing involvement with the third-party collaborator pursuant to the applicable agreement. Such period generally represents the research and development period set forth in the work plan under each collaboration agreement between the Company and its third-party collaborator. Revenue on cost-plus-fee contracts, such as under contracts to perform research and development for others, is recognized as the related services are rendered as determined by the extent of reimbursable costs incurred plus estimated fees thereon.

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DURECT CORPORATION

NOTES TO UNAUDITED CONDENSED FINANCIAL STATEMENTS—(Continued)

Research and Development Expenses

Research and development expenses are primarily comprised of salaries, benefits, stock-based compensation and other compensation cost associated with research and development personnel, overhead and facility costs, preclinical and non-clinical development costs, clinical trial and related clinical manufacturing costs, contract services, and other outside costs. Research and development costs are expensed as incurred. Research and development costs paid to third parties under sponsored research agreements are recognized as the related services are performed, generally ratably over the period of service. In addition, reimbursements by Nycomed for research and development expenses incurred by the Company are recorded as a reduction to research and development expenses. Research and development expenses incurred by Nycomed and reimbursed by the Company are recorded as additional research and development expenses.

The research and development expenses associated with our major development programs approximate the following (in thousands):

Comprehensive Loss

Components of other comprehensive income (loss) comprised entirely of unrealized gains and losses on the Company’s available-for-sale securities for all periods presented, are included in total comprehensive loss as follows (in thousands).

Accumulated other comprehensive income as of September 30, 2009 and December 31, 2008 is entirely comprised of net unrealized gains, net of taxes.

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DURECT CORPORATION

NOTES TO UNAUDITED CONDENSED FINANCIAL STATEMENTS—(Continued)

Net Loss Per Share

Basic net loss per share is calculated by dividing the net loss by the weighted-average number of common shares outstanding. Diluted net loss per share is computed using the weighted-average number of common shares outstanding and common stock equivalents (i.e., options and warrants to purchase common stock, convertible subordinated notes) outstanding during the year, if dilutive, using the treasury stock method for options and warrants and the if-converted method for convertible subordinated notes.

Shipping and Handling

Costs related to shipping and handling are included in cost of revenues for all periods presented.

Operating Leases

The Company leases administrative, manufacturing and laboratory facilities under operating leases. Lease agreements may include rent holidays, rent escalation clauses and tenant improvement allowances. The Company recognizes scheduled rent increases on a straight-line basis over the lease term beginning with the date the Company takes possession of the leased space. The Company records tenant improvement allowances as deferred rent liabilities on the balance sheets and amortizes the deferred rent over the terms of the lease to rent expense on the statements of operations.

Recent Accounting Pronouncements

Effective July 1, 2009, the Company adopted The “FASB Accounting Standards Codification” and the Hierarchy of Generally Accepted Accounting Principles (ASC 105). This standard establishes only two levels of U.S. generally accepted accounting principles (“GAAP”), authoritative and nonauthoritative. The Codification became the source of authoritative, nongovernmental GAAP, except for rules and interpretive releases of the SEC, which are sources of authoritative GAAP for SEC registrants. All other non-grandfathered, non-SEC accounting literature not included in the Codification became nonauthoritative. The Company began using the new guidelines and numbering system prescribed by the Codification when referring to GAAP in the third quarter of fiscal 2009. As the Codification was not intended to change or alter existing GAAP, it did not have any impact on the Company’s financial position or results of operations.

Effective April 1, 2009, the Company adopted a new accounting standard for subsequent events, as codified in ASC 855-10. The update modifies the names of the two types of subsequent events either as recognized subsequent events (previously referred to in practice as Type I subsequent events) or non-recognized subsequent events (previously referred to in practice as Type II subsequent events). In addition, the standard modifies the definition of subsequent events to refer to events or transactions that occur after the balance sheet date, but before the financial statements are issued (for public entities) or available to be issued (for nonpublic entities). It also requires the disclosure of the date through which subsequent events have been evaluated. The Company began applying the update in the second quarter of 2009 and its adoption did not impact the Company’s financial statements, other than the disclosures required by the update. See Note 1 to the unaudited condensed financial statements for additional disclosures pursuant to the update.

        Effective April 1, 2009, the Company adopted three accounting standard updates which were intended to provide additional application guidance and enhanced disclosures regarding fair value measurements and impairments of securities. They also provide additional guidelines for estimating fair value in accordance with fair value accounting. The first update, as codified in ASC 820-10-65, provides additional guidelines for estimating fair value in accordance with fair value accounting. The second accounting update, as codified in ASC 320-10-65, changes accounting requirements for other-than-temporary-impairment (OTTI) for debt securities by replacing the current requirement that a holder have the positive intent and ability to hold an impaired security to recovery in order to conclude an impairment was temporary with a requirement that an entity conclude it does not intend to sell an impaired security and it will not be required to sell the security before the recovery of its amortized cost basis. The third accounting update, as codified in ASC 825-10-65, increases the frequency of fair value disclosures. These updates were effective for fiscal years and interim periods ended after June 15, 2009. The adoption of these accounting updates did not have any impact on the Company’s financial statements.

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DURECT CORPORATION

NOTES TO UNAUDITED CONDENSED FINANCIAL STATEMENTS—(Continued)

Effective January 1, 2009, the Company adopted a new accounting standard update for convertible debt instruments, as codified in ASC 470-20. This update requires the issuer of certain convertible debt instruments that may be settled in cash or other assets on conversion, either in part or in full, to separately account for the liability (debt) and equity (conversion option) components of the instrument in a manner that results in the recognition of interest expense equal to the issuer’s nonconvertible debt borrowing rate. The adoption of this accounting update did not have any impact on the Company’s financial statements.

Effective January 1, 2009, the Company adopted a new accounting standard update, as codified in ASC 820-10, that delayed the effective date of fair value measurements accounting for all non-financial assets and non-financial liabilities, except for items that are recognized or disclosed at fair value in the financial statements on a recurring basis (at least annually), until the beginning of the first quarter of fiscal 2009. These include goodwill and other non-amortizable intangible assets. The adoption of this accounting update did not have any impact on the Company’s financial statements.

Effective January 1, 2009, the Company adopted a new accounting standard update related to accounting for collaborative arrangements, as codified in ASC 808-10. In December 2007, the Emerging Issues Task Force of the FASB issued a consensus ASC 808-10. The scope of ASC808-10 is limited to collaborative arrangements where no separate legal entity exists and in which the parties are active participants and are exposed to significant risks and rewards that depend on the success of the activity. The Task Force concluded that revenue transactions with third parties and associated costs incurred should be reported in the appropriate line item in each company’s financial statements pursuant to the guidance in ASC 605-45. The Task Force also concluded that the equity method of accounting under ASC 323, should not be applied to arrangements that are not conducted through a separate legal entity. The Task Force also concluded that the income statement classification of payments made between the parties in an arrangement should be based on a consideration of the following factors: the nature and terms of the arrangement; the nature of the entities’ operations; and whether the parties’ payments are within the scope of existing GAAP. To the extent such costs are not within the scope of other authoritative accounting literature, the income statement characterization for the payments should be based on an analogy to authoritative accounting literature or a reasonable, rational, and consistently applied accounting policy election. The provisions of ASC 808-10 were effective for fiscal years beginning on or after December 15, 2008, and companies are required to apply the provisions through retrospective application to all collaborative arrangements existing at adoption as a change in accounting principle. The adoption of this accounting update did not have any impact on the Company’s financial statements.

In September 2009, the FASB issued Update No. 2009-13, “Multiple-Deliverable Revenue Arrangements—a consensus of the FASB Emerging Issues Task Force” (ASU 2009-13). It updates the existing multiple-element revenue arrangements guidance currently included under ASC 605-25, which originated primarily from the guidance in EITF Issue No. 00-21, “Revenue Arrangements with Multiple Deliverables” (EITF 00-21). The revised guidance primarily provides two significant changes: (1) eliminates the need for objective and reliable evidence of the fair value for the undelivered element in order for a delivered item to be treated as a separate unit of accounting, and (2) eliminates the residual method to allocate the arrangement consideration. In addition, the guidance also expands the disclosure requirements for revenue recognition. ASU 2009-13 will be effective for the first annual reporting period beginning on or after June 15, 2010, with early adoption permitted provided that the revised guidance is retroactively applied to the beginning of the year of adoption. The Company is currently assessing the future impact of this new accounting update to its financial statements.

In August 2009, the FASB issued Update No. 2009-05, “Fair Value Measurements and Disclosures (Topic 820) – Measuring Liabilities at Fair Value” (ASU 2009-05). ASU 2009-05 amends ASC 820, Fair Value Measurements and Disclosures, of the FASB Accounting Standards Codification (the Codification) to provide further guidance on how to measure the fair value of a liability. It primarily does three things: (1) sets forth the types of valuation techniques to be used to value a liability when a quoted price in an active market for the identical liability is not available, (2) clarifies that when estimating the fair value of a liability, a reporting entity is not required to include a separate input or adjustment to other inputs relating to the existence of a restriction that prevents the transfer of the liability, and (3) clarifies that both a quoted price in an active market for the identical liability at the measurement date and the quoted price for the identical liability when traded as an asset in an active market when no adjustments to the quoted price of the asset are required are Level 1 fair value measurements. This standard is effective beginning in the fourth quarter of 2009 for the Company. The adoption of this standard update is not expected to impact the Company’s financial statements.

Note 2. Strategic Agreements

Agreement with Alpharma Ireland Limited, an affiliate of Alpharma Inc. (Alpharma) (acquired by King)

Effective October 2008, the Company and Alpharma, entered into a development and license agreement granting Alpharma the exclusive worldwide rights to develop and commercialize ELADUR, DURECT’s investigational transdermal bupivacaine patch. As a result of the acquisition of Alpharma by King in December 2008, King has assumed all the rights and obligations of Alpharma under the agreement.

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DURECT CORPORATION

NOTES TO UNAUDITED CONDENSED FINANCIAL STATEMENTS—(Continued)

Under the terms of the agreement, upon closing of the transaction, Alpharma paid the Company an upfront license fee of $20.0 million, with possible additional payments of up to $93.0 million upon the achievement of predefined development and regulatory milestones spread over multiple clinical indications and geographical territories as well as possible additional payments of up to $150.0 million in sales-based milestones. If ELADUR is commercialized, the Company would also receive royalties on product sales. Alpharma will control and fund further development of the program. The Company will perform development activities through completion of Phase 2, and formulation and manufacturing scale-up activities for the program, the costs of which shall be reimbursed by Alpharma. The term of the agreement will continue on a jurisdiction-by-jurisdiction basis until the later of fifteen (15) years from the date of first commercial sale of ELADUR or the expiration of patent coverage or data exclusivity in such jurisdiction. During the term of the agreement, subject to specified conditions, neither party nor their affiliates may develop or commercialize a transdermal patch containing bupivacaine. Upon expiration of the term of the agreement, the rights and licenses granted to Alpharma shall convert to fully paid-up, non-royalty bearing, perpetual rights and licenses. The agreement provides each party with specified termination rights, including the right of Alpharma to terminate at any time without cause and each party to terminate the agreement upon material breach of the agreement by the other party. The agreement also contains terms and conditions customary for this type of arrangement, including representations, warranties and indemnities.

For the three and nine months ended September 30, 2009, the Company recognized $804,000 and $2.6 million as collaborative research and development revenue from the amortization of the $20.0 million upfront fee received, and $480,000 and $1.9 million as collaborative research and development revenue from research expenses that are qualified for reimbursement by Alpharma. The Company’s estimate of the remaining term of our continuing involvement was adjusted in the second quarter of 2009 as a result of an updated development plan provided by King for ELADUR. Total collaborative research and development revenue recognized under this arrangement was $1.3 million and $4.5 million for the three and nine months ended September 30, 2009. No amounts were recorded in the three and nine months ended September 30, 2008 as the agreement with Alpharma was executed in the third quarter of 2008 and became effective in the fourth quarter of 2008. The cumulative aggregate payments received by the Company as of September 30, 2009 were $24.3 million under this agreement.

Agreement with Nycomed

In November 2006, the Company entered into a collaboration agreement (“the Agreement”) with Nycomed. Under the terms of the agreement, the Company licensed to Nycomed the exclusive commercialization rights to POSIDUR for the European Union (E.U.) and certain other countries. Nycomed paid an upfront license fee of $14.0 million in 2006 and a milestone payment of $8.0 million in 2007, with future potential additional milestone payments of up to $180.0 million upon achievement of defined development, regulatory and sales milestones. The Company will jointly direct and equally fund with Nycomed a development program for POSIDUR intended to secure regulatory approval in both the U.S. and the E.U. In addition, the Company will manufacture and supply the product to Nycomed for commercial sale in the territory licensed to Nycomed. Nycomed will pay the Company blended royalties on sales in the defined territory of 15-40% depending on annual sales, as well as a manufacturing markup. The Company retains full commercial rights to POSIDUR in the U.S., Canada, Asia and other countries. The agreement shall continue in effect until terminated. The agreement provides each party with specified termination rights, including the right of each party to terminate the agreement upon material breach of the agreement by the other party. In addition, Nycomed shall have the right to terminate the agreement after expiry of patents covering POSIDUR in all major market countries in the E.U. and for adverse product events.

In contrast to the Company’s other collaborations, because the Company and Nycomed jointly control, fund, and benefit from the development of POSIDUR, the Company does not recognize revenue from the reimbursement of qualified research expenses by Nycomed pursuant to ASC 808-10, Collaborative Arrangements. Rather, the Company records research expense equal to its share of the joint expenses incurred under the product development plan. Research and development expenses for POSIDUR incurred by the Company but reimbursable by Nycomed under the terms of the Company’s agreement with Nycomed were $975,000 and $2.9 million in the three and nine months ended September 30, 2009, respectively, compared to $960,000 and $2.6 million for the corresponding periods in 2008, which are accounted for as a reduction of research and development expenses. Research and development expenses for POSIDUR incurred by Nycomed but reimbursable by the Company under the terms of its agreement with Nycomed were $1.1 million and $3.1 million in the three and nine months ended September 30, 2009, respectively, compared to $441,000 and $1.5 million for the corresponding periods in 2008, which are accounted for as additional research and development expenses. Both parties bear 50% of the development expenses under the collaboration agreement for POSIDUR. The Company recognized $381,000 and $1.1 million for the three and nine months ended September 30, 2009, compared to $763,000 and $2.3 million for the corresponding periods in 2008, respectively, as collaborative research and development revenue from the amortization of the $14.0 million upfront fee received in 2006. The Company’s estimate of the remaining term of its continuing involvement was adjusted in the first quarter of 2009 as a result of an updated development plan for POSIDUR in Europe. The cumulative aggregate payments received by the Company from Nycomed as of September 30, 2009 were $33.6 million under this agreement. In addition, the cumulative aggregate payments paid by the Company to Nycomed were $5.4 million as of September 30, 2009.

Agreement with Endo

On March 10, 2005, the Company entered into a license agreement with Endo under which the Company granted to Endo the exclusive right to develop, market and commercialize TRANSDUR-Sufentanil in the U.S. and Canada. The Company received an initial payment of $10.0 million in connection with the execution of the Agreement. The license agreement was terminated by Endo effective August 26, 2009.

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DURECT CORPORATION

NOTES TO UNAUDITED CONDENSED FINANCIAL STATEMENTS—(Continued)

The $10.0 million upfront fee was recognized as revenue ratably over the term of the Company’s obliged continuing involvement with Endo with respect to TRANSDUR-Sufentanil. The term of the continuing involvement had been estimated based on the product development plan pursuant to the agreement. The Company’s estimate of the remaining term of its continuing involvement was adjusted in the fourth quarter of 2008 as a result of Endo’s termination notice received by the Company in February 2009.

The Company recognized zero and $875,000 respectively as collaborative research and development revenue from the amortization of the $10.0 million upfront fee for the three and nine months ended September 30, 2009, compared to $547,000 and $1.6 million for the corresponding periods in 2008, respectively. The $10.0 million upfront fee from Endo has been fully amortized as of September 30, 2009. Total collaborative research and development revenue recognized under this arrangement was zero and $985,000 for the three and nine months ended September 30, 2009, compared to $926,000 and $2.6 million for the corresponding periods in 2008, respectively. The cumulative aggregate payments received by the Company as of September 30, 2009 were $21.5 million under this agreement.

Agreement with Pain Therapeutics

In December 2002, the Company entered into an exclusive agreement with Pain Therapeutics to develop and commercialize on a worldwide basis Remoxy and other oral sustained release, abuse deterrent opioid products incorporating four specified opioid drugs, using the ORADUR technology. The agreement also provides Pain Therapeutics with the exclusive right to commercialize products developed under the agreement on a worldwide basis. In connection with the execution of the agreement, Pain Therapeutics paid the Company upfront fees of $900,000 in December 2002 and $100,000 in October 2003. In December 2005, the Company amended its agreement with Pain Therapeutics in order to specify its obligations with respect to the supply of key excipients for use in the licensed products. Under the agreement, as amended, the Company is responsible for formulation development, supply of selected key excipients used in the manufacture of licensed products and other specified tasks. Under the agreement with Pain Therapeutics, the Company is eligible to receive milestone payments of up to $9.3 million in the aggregate upon the achievement of predetermined development and regulatory milestones for the four drug candidates currently in development. As of September 30, 2009, the Company has received $1.7 million in milestone payments. In addition, if commercialized, the Company will receive royalties for Remoxy and other licensed products which do not contain an opioid antagonist of between 6.0% to 11.5% of net sales of the product depending on sales volume. This agreement can be terminated by either party for material breach by the other party and by Pain Therapeutics without cause. Under the agreement, Pain Therapeutics reimburses the Company for qualified expenses incurred by the Company in connection with the development program. The Company recognizes collaborative research and development revenue related to research and development activities for Remoxy and other development programs based on reimbursement of qualified expenses as defined in the collaborative agreement and related amendment with Pain Therapeutics. Total collaborative research and development revenue recognized under the agreements with Pain Therapeutics was $4,000 and $326,000 for the three and nine months ended September 30, 2009, compared to $2.3 million and $6.3 million for the corresponding periods in 2008, respectively. The cumulative aggregate payments received by the Company from Pain Therapeutics as of September 30, 2009 were $31.2 million under this agreement.

In March 2009, King assumed the responsibility for further development of Remoxy from Pain Therapeutics. As a result of this change, the Company shall continue to perform Remoxy related activities in accordance with the terms and conditions set forth in the license agreement between the Company and Pain Therapeutics, but with King substituted in lieu of Pain Therapeutics with respect to interactions with the Company in the Company’s performance of those activities including the obligation to pay the Company with respect to all Remoxy related costs incurred by the Company. Total collaborative research and development revenue recognized for Remoxy-related work performed by the Company for King was $339,000 and $708,000 for the three and nine months ended September 30, 2009, respectively, compared to zero for the corresponding periods in 2008. Prior to March 2009, the Company recognized collaborative research and development revenue for Remoxy related work under the agreements with Pain Therapeutics. The cumulative aggregate payments received by the Company from King as of September 30, 2009 were $370,000 under this agreement.

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DURECT CORPORATION

NOTES TO UNAUDITED CONDENSED FINANCIAL STATEMENTS—(Continued)

Long Term Supply Agreement with King

During 2008, the Company began to manufacture commercial lots of certain key excipients that are included in Remoxy to meet the anticipated requirements for these components. In addition, during the second, third and fourth quarters of 2008 and the first quarter of 2009, the Company made shipments of these materials to meet the production requirements of King, which has rights to commercialize Remoxy upon approval by the FDA. During these periods, all product revenue and associated cost of goods sold was deferred pending the establishment of definitive final terms and conditions even though cash receipts and expenditures occurred during these periods.

In August 2009, the Company signed an exclusive long term excipient supply agreement with respect to REMOXY with King. This agreement stipulates the terms and conditions under which the Company will supply to King, based on the Company’s manufacturing cost plus a specified percentage mark-up, two key excipients used in the manufacture of REMOXY. In the third quarter of 2009, the Company recognized $3.0 million of product revenue and $2.0 million of cost of goods sold related to its past shipments to King upon execution of the long term supply agreement at which point all criteria of revenue recognition were met.

The term of the agreement commenced on August 5, 2009 and will continue in effect until the earlier of the expiration of all licenses granted under the development and license agreement between the Company and Pain Therapeutics or the termination or expiration of the 2005 development and license agreement between Pain Therapeutics and King, unless the agreement is terminated earlier in accordance with its terms. The agreement provides each party with specified termination rights, which include, but are not limited to, the right of King to terminate the agreement in the event that governmental action requires the withdrawal of REMOXY from all countries in the territory or results in the withdrawal of required manufacturing approvals, or upon a change of control of the Company, in which case termination will be effective one year after notice by King. The Company may terminate the agreement if the Company is unable to procure suitable and sufficient quantities of certain raw materials required to produce the excipient ingredients. Each party may terminate the agreement upon material breach of the agreement by, or the bankruptcy or insolvency of, the other party, in each case subject to a cure period. The agreement further specifies the rights and obligations of the Company and King with respect to plant allocation, adding additional production capacity and sourcing of raw materials, as well as other terms and conditions customary for this type of agreement, including those regarding forecasting, purchasing, invoicing, representations, warranties and indemnities.

Agreement with EpiCept Corporation

In December 2006, the Company entered into a license agreement with EpiCept which provided the Company with the exclusive, worldwide rights to certain of EpiCept’s intellectual property for a transdermal patch containing bupivacaine for the treatment of back pain. Pursuant to the agreement, the Company paid EpiCept a $1.0 million upfront fee in 2006 and subject to the Company’s achievement of specified milestones, agreed to pay EpiCept an additional $9.0 million in milestone payments as well as an undisclosed royalty on net sales of any product covered by the license. The $1.0 million fee was recognized as research and development expense at the execution of the agreement since the rights purchased had not yet reached technological feasibility and such rights also had no future alternative uses.

In September 2008, the Company and EpiCept entered into an amendment to the license agreement. Under the amendment, among other changes, the scope of the license was broadened from the treatment of back pain to all uses covered by the EpiCept intellectual property including myofascial pain and muscle tension pain, and the license was converted to an exclusive, worldwide, fully paid up, royalty-free, perpetual and irrevocable license. In consideration of this amendment, the Company made a one-time payment of $2.25 million to EpiCept in full satisfaction of all future payment obligations to EpiCept under the license agreement. The Company recorded the payment of $2.25 million as a research and development expense in the third quarter of 2008 since the rights purchased had not yet reached technological feasibility and such rights also had no future alternative uses. The Company recorded zero as research and development expenses under this agreement for the three and nine months ended September 30, 2009, compared with $2.25 million for the corresponding periods in 2008.

Agreement with ALZA Corporation

        In April 1998, the Company entered into a development and commercialization agreement with ALZA, which has been subsequently amended and restated, most recently in October 2002. The agreement provides the Company with exclusive rights to develop, commercialize and manufacture products using ALZA’s patented DUROS^® technology in selected fields of use, and obligates the Company to pay ALZA a royalty on the net sales of the Company’s DUROS-based products and a percentage of upfront license fees, milestone payments, or any other payments or consideration received by the Company with respect to such DUROS-based products. In connection with the execution of the Agreement, the Company issued 5,600,000 shares of Series A-1 preferred stock, which were subsequently converted into 5,600,000 shares of common stock concurrent with the Company’s initial public offering in 2000. The Company issued an additional 1,000,000 shares of its common stock and a warrant to purchase 1,000,000 shares of its common stock to ALZA in connection with an amendment of the Agreement in April 2000. The Company recorded the fair value of the common stock and the warrant in the amount of $13.5 million as additional paid-in capital and as a contra-equity account referred to as deferred royalties and commercial rights. The warrant expired in September 2004. At the end of 2008, the Company

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DURECT CORPORATION

NOTES TO UNAUDITED CONDENSED FINANCIAL STATEMENTS—(Continued)

made the strategic decision that other research and development programs would take priority over CHRONOGESIC and recorded a $13.5 million non-cash write down of deferred royalties and commercial rights associated with CHRONOGESIC given the fact that there are no plans in the foreseeable future to develop CHRONOGESIC. This agreement can be terminated by either party for material breach by the other party and by the Company without cause.

Note 3. Fair Value Measurements

ASC 820-10 defines fair value, establishes a framework for measuring fair value under generally accepted accounting principles and enhances disclosures about fair value measurements. Fair value is defined under ASC 820-10 as the exchange price that would be received for an asset or paid to transfer a liability (an exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date. Valuation techniques used to measure fair value under ASC 820-10 must maximize the use of observable inputs and minimize the use of unobservable inputs. The standard describes a fair value hierarchy based on three levels of inputs, of which the first two are considered observable and the last unobservable, that may be used to measure fair value. These levels of inputs are the following:

The financial instruments are valued using quoted prices in active markets or based upon other observable inputs. The following table sets forth the fair-value of the Company’s financial assets that were measured on a recurring basis as of September 30, 2009 (in thousands):

The following table sets forth the fair value of our financial assets that were measured on a recurring basis as of December 31, 2008 (in thousands):

The fair value of the Level 2 assets is estimated using pricing models using current observable market information for similar securities. There is a small degree of variation in the pricing sources for these securities, however, we believe the potential differences in the estimate of fair value for the Company’s available-for-sale securities are immaterial.

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DURECT CORPORATION

NOTES TO UNAUDITED CONDENSED FINANCIAL STATEMENTS—(Continued)

The following is a summary of available-for-sale securities (in thousands):

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DURECT CORPORATION

NOTES TO UNAUDITED CONDENSED FINANCIAL STATEMENTS—(Continued)

The following is a summary of the cost and estimated fair value of available-for-sale securities at September 30, 2009, by contractual maturity (in thousands):

During the three and nine months ended September 30, 2009 and 2008, realized gains or losses recognized on the sale of investments were not material.

The following is a summary of unrealized losses for available-for-sale securities at September 30, 2009 (in thousands):

The following is a summary of unrealized losses for available-for-sale securities at December 31, 2008 (in thousands):

There were no securities that have had an unrealized loss for more than 12 months as of September 30, 2009 and December 31, 2008.

To date the Company has not recorded any impairment charges on marketable securities related to other-than-temporary declines in market value. The Company recognizes an impairment charge when the decline in the estimated fair value of a marketable security below the amortized cost is determined to be other-than-temporary. The Company considers various factors in determining whether to recognize an impairment charge, including the duration of time and the severity to which the fair value has been less than our amortized cost, any adverse changes in the investees’ financial condition and our intent to sell the security, our ability to hold the security to recovery and our assessment of the credit quality of the security, including whether we expect to recover the amortized cost of the security.

Note 4. Stock-Based Compensation

As of September 30, 2009, the Company has five stock-based employee compensation plans, which have not changed in 2008 or 2009. The employee stock-based compensation cost that has been included in the statements of operations was $2.5 million and $8.4 million for the three and nine months ended September 30, 2009, compared to $2.0 million and $6.4 million for the corresponding periods in 2008, respectively.

As of September 30, 2009 and December 31, 2008, $27,000 and $87,000, respectively, of stock-based compensation cost was capitalized in inventory on the Company’s balance sheets.

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DURECT CORPORATION

NOTES TO UNAUDITED CONDENSED FINANCIAL STATEMENTS—(Continued)

The Company uses the Black-Scholes option pricing model to value its stock options. The expected life computation is based on historical exercise patterns and post-vesting termination behavior. The Company considered its historical volatility in developing its estimate of expected volatility.

The Company used the following assumptions to estimate the fair value of options granted and shares purchased under its employee stock purchase plan for the three and nine months ended September 30, 2009 and 2008:

Note 5. Reduction in Force

In March 2009, the Company reduced the size of its California workforce by 41 employees or approximately 24% of its headcount. The goal of this action was to better align its cost structure with anticipated revenues and operating expenses, while not compromising the Company’s key corporate objectives for the year. The Company substantially completed this headcount reduction during the first quarter of 2009, and incurred approximately $443,000 in severance costs for the impacted employees, of which approximately $16,000 was paid in the first quarter of 2009. Accrued severance costs were approximately $427,000 as of March 31, 2009, all of which were paid in April 2009.

As of September 30, 2009, the Company had 125 employees, including 74 in research and development, 22 in manufacturing and 29 in selling, general and administrative.

Note 6. Accrued Asset Retirement Obligation

In accordance with ASC 410-20, Accounting for Asset Retirement Obligations, the Company recorded $383,000 in the three months ended June 30, 2009 as a liability on its balance sheet for an asset retirement obligation associated with the estimated restoration cost recorded for one of its buildings whose lease had expired. The charge to record these costs was classified as research and development expense and general and administration expense of $285,000 and $98,000, respectively, in the Company’s statements of operations for the three months ended June 30, 2009.

Note 7. Equity Financing

On September 10, 2009, the Company entered into a privately negotiated transaction to sell 4,444,444 shares of its common stock to affiliates of Venrock at a price of $2.25 per share, raising total proceeds to DURECT of approximately $10 million. This transaction was closed on September 18, 2009. Total stock issuance costs related to this financing were approximately $126,000.

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This Management’s Discussion and Analysis of Financial Condition and Results of Operations for the three and nine months ended September 30, 2009 and 2008 should be read in conjunction with our annual report on Form 10-K filed with the Securities and Exchange Commission and “Risk Factors” section included elsewhere in this Form 10-Q. This Form 10-Q contains forward-looking statements within the meaning of Section 21E of the Securities Exchange Act of 1934, as amended, and Section 27A of the Securities Act of 1933, as amended. Such forward-looking statements are based on current expectations and beliefs. Any such forward-looking statements are not guarantees of future performance and involve risks and uncertainties. Actual events or results may differ materially from those discussed in the forward-looking statements as a result of various factors.

Forward-looking statements made in this report include, for example, statements about:

Forward-looking statements are not guarantees of future performance and involve risks and uncertainties. Actual events or results may differ materially from those discussed in the forward-looking statements as a result of various factors. For a more detailed discussion of such forward looking statements and the potential risks and uncertainties that may impact upon their accuracy, see the “Risk Factors” section and “Overview” section of this Management’s Discussion and Analysis of Financial Condition and Results of Operations. These forward-looking statements reflect our view only as of the date of this report. We undertake no obligations to update any forward-looking statements. You should also carefully consider the factors set forth in other reports or documents that we file from time to time with the Securities and Exchange Commission.

Overview

We are an emerging specialty pharmaceutical company focused on the development of pharmaceutical systems based on proprietary drug delivery technology platforms. We are developing and commercializing pharmaceutical systems that will deliver the right drug to the right place in the right amount at the right time to treat chronic or episodic diseases and conditions. By integrating chemistry and engineering advancements, we seek to achieve what drugs or devices alone cannot. Our pharmaceutical systems enable optimized therapy for a given disease or patient population by controlling the rate and duration of drug administration and providing sustained drug delivery.

NOTE: POSIDUR™, SABER™, TRANSDUR™, ORADUR^®, ELADUR™, DURIN™, CHRONOGESIC^®, MICRODUR™, ALZET^® and LACTEL^® are trademarks of DURECT Corporation. Other trademarks referred to belong to their respective owners.

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In addition to developing our own proprietary products, we enter into strategic collaborations with pharmaceutical companies to develop and commercialize proprietary and enhanced pharmaceutical products based on our technologies. We have seven disclosed on-going product candidates in development. The following are our publicly announced product candidates in development:

POSIDUR™ (SABER™-Bupivacaine)

Our post-operative pain relief depot, POSIDUR, is a sustained release injectable using our SABER delivery system to deliver bupivacaine, an off-patent anesthetic agent. SABER is a patented controlled drug delivery technology that can be formulated for systemic or local administration of drugs via the parenteral (i.e., injectable) route. POSIDUR is designed to be administered to a surgical site at the time of surgery for post-operative pain relief and is intended to provide local analgesia for up to 3 days, which we believe coincides with the time period of the greatest need for post surgical pain control in most patients.

In November 2006, we entered into a collaboration agreement with Nycomed. Under the terms of the agreement, we licensed to Nycomed the exclusive commercialization rights to POSIDUR for the European Union (E.U.) and certain other countries. Nycomed paid us an upfront license fee of $14.0 million in 2006 and an $8.0 million milestone payment in 2007, with future potential additional milestone payments of up to $180.0 million upon achievement of defined development, regulatory and sales milestones. We jointly direct and equally fund with Nycomed a development program for POSIDUR intended to secure regulatory approval in both the U.S. and the E.U. In addition, we will manufacture and supply the product to Nycomed for commercial sale in the territory licensed to Nycomed. Nycomed will pay us blended royalties on sales in the defined territory of 15-40% depending on annual sales, as well as a manufacturing markup. We retain full commercial rights to POSIDUR in the U.S., Canada, Asia and certain other countries.

In 2007, we successfully completed a 122 patient Phase IIb clinical trial of POSIDUR for treatment of post-operative pain in patients undergoing inguinal hernia repair. In the Phase IIb trial, POSIDUR at a dose of 5 mL demonstrated statistically significant reductions in pain and in total consumption of supplemental opioid analgesic medications versus placebo. These successful results triggered the $8.0 million milestone payment by Nycomed to us under our agreement with Nycomed.

In the first quarter of 2009, we received detailed feedback from the FDA on our proposed Phase III program. We are pursuing a target label for POSIDUR that would allow POSIDUR to be used for a broad range of surgeries. Based on FDA feedback, we anticipate conducting one pivotal efficacy study and several other supportive clinical studies in additional surgical models to provide greater definition for the settings in which the product should be used and to support our target label. We currently expect that the total number of humans dosed that we will submit to the FDA in an NDA will be approximately 700-800. Under our current development program, over 300 humans have been dosed with POSIDUR. Assuming the program progresses as we expect, we anticipate that the Phase III program should take approximately two years from initiation to NDA filing. We currently anticipate commencing the Phase III program in the first half of 2010. Our major on-going clinical activities for POSIDUR are as follows:

Remoxy^® and other ORADUR-based opioid products licensed to Pain Therapeutics

In December 2002, we entered into an agreement with Pain Therapeutics, amended in December 2005, under which we granted Pain Therapeutics the exclusive, worldwide right to develop and commercialize selected long-acting oral opioid products using our ORADUR technology incorporating four specified opioid drugs. The first product being developed under the collaboration is Remoxy, a novel long-acting oral formulation of the opioid oxycodone targeted to decrease the potential for oxycodone abuse. Remoxy is intended for patients with chronic pain. In November 2005, Pain Therapeutics and King entered into collaboration and license agreements for the development and commercialization of Remoxy by King.

        In December 2007, Pain Therapeutics and King reported positive results from the pivotal Phase III trial submitted under an approved Special Protocol Assessment (SPA) with the FDA. The NDA was submitted to the FDA in June 2008, and in August 2008 the NDA was accepted by the FDA and granted priority review. In December 2008, Pain Therapeutics received a Complete Response Letter for its NDA for Remoxy in which the FDA determined that the NDA was not approved. According to Pain Therapeutics, the FDA indicated that additional non-clinical data would be required to support the approval of Remoxy, but the FDA had not requested or recommended additional clinical efficacy studies prior to approval. King Pharmaceuticals, the commercialization partner of Pain Therapeutics for Remoxy, assumed responsibility for further development of Remoxy from Pain Therapeutics in March 2009. Since that time, we continued to perform development activities in support of the Remoxy NDA filing in accordance with the terms and conditions of the Development and License Agreement between us and Pain Therapeutics but with King substituted in lieu of Pain Therapeutics with respect to our performance of those activities. On July 2, 2009, King met with the FDA to discuss the Complete Response Letter. According to King and Pain Therapeutics, the outcome of that meeting provided King with a clear path forward to resubmit the REMOXY NDA and to address all FDA comments in the Complete Response Letter. According to the King Pharmaceuticals / Pain Therapeutics press release dated July 7, 2009, King anticipates the resubmission of the NDA could occur mid-year 2010. King has stated that it remains committed to the development and commercialization of REMOXY and looks forward to working closely with the FDA toward approval of the product.

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During 2008, we began to manufacture commercial lots of certain key excipients that are included in Remoxy to meet the anticipated requirements for these components. In addition, during the second, third and fourth quarters of 2008 and the first quarter of 2009 we made shipments of these materials to meet the production requirements of King, which has rights to commercialize Remoxy upon approval by the FDA. Revenue attributable to these key components aggregating $3.0 million and cost of goods sold aggregating $2.0 million was recognized in the third quarter of 2009 upon the execution of a long term supply agreement with King.

We have also worked with King and Pain Therapeutics on the development of ORADUR-based abuse-resistant opioid drug candidates in addition to Remoxy. Phase I clinical trials have been completed for two of these ORADUR-based drug candidates. According to Pain Therapeutics, the data from these Phase I trials indicate that these drug candidates are safe and well-tolerated with a release profile that appears well suited to use with a chronic pain population. The active ingredients in these two drug candidates are opioids whose identities have not been publicly disclosed.

TRANSDUR™-Sufentanil

Our transdermal sufentanil patch (TRANSDUR-Sufentanil) uses our proprietary TRANSDUR delivery system to deliver sufentanil, an opioid medication. TRANSDUR-Sufentanil is designed to provide extended chronic pain relief for up to seven days, as compared to the two to three days of relief provided with currently available opiate patches. We anticipate that the small size of our sufentanil patch (potentially as small as 1/5^th the size of currently marketed transdermal fentanyl patches for a therapeutically equivalent dose) may offer improved convenience and compliance for patients. In 2005, DURECT successfully completed a Phase II clinical trial of TRANSDUR-Sufentanil in chronic pain.

In March 2005, we entered into an agreement with Endo granting Endo exclusive rights to develop, market and commercialize TRANSDUR-Sufentanil in the U.S. and Canada. We received an initial payment of $10.0 million in connection with the execution of the Agreement. In February 2009, Endo notified the Company that it was terminating the license agreement with the Company, and returned to the Company Endo’s right to develop and commercialize TRANSDUR-Sufentanil in the U.S. and Canada effective August 26, 2009.

In 2008, Endo successfully completed a Phase II trial for TRANSDUR-Sufentanil in which they evaluated the conversion of patients on oral and transdermal opioids to TRANSDUR-Sufentanil. This Phase II study met its primary and secondary objectives of establishing a successful dose-titration regimen and dose potency relationships, demonstrating safety and tolerability at the therapeutic dose, and achieving effective analgesic pain control. The Phase II data, extensive non-clinical data that had been generated by Endo and detailed proposed protocols for Phase III were reviewed with the FDA at an end-of-Phase II meeting on February 19, 2009. As a result of that meeting, we believe we understand the anticipated regulatory pathway for the Phase III program and approval, which will follow a 505(b)2 pathway as discussed with FDA. This pathway would allow us to reference third-party data, potentially reducing time and expense. We are now in active discussions with multiple parties regarding licensing of the program.

ELADUR (TRANSDUR™-Bupivacaine)

Our transdermal bupivacaine patch (ELADUR) uses our proprietary TRANSDUR transdermal technology and is intended to provide continuous delivery of bupivacaine for up to three days from a single application, as compared to a wearing time limited to 12 hours with currently available lidocaine patches.

In 2007, we successfully completed a 60 patient Phase IIa clinical trial for ELADUR. In this study of patients suffering from post-herpetic neuralgia, ELADUR showed improved pain control versus placebo during the three-day continuous treatment period. In addition, ELADUR appeared well tolerated overall, and patients treated with ELADUR and placebo exhibited similar safety profiles. During 2008, we continued to develop our clinical and regulatory strategy, and to conduct manufacturing scale-up and processing activities to secure additional Phase II and Phase III supplies. In June 2008, the FDA granted to us orphan drug designation for bupivacaine for relief of persistent pain associated with post-herpetic neuralgia (PHN). If ELADUR is the first bupivacaine product approved for PHN, under the 1983 Orphan Drug Act, ELADUR will receive seven years of market exclusivity following the approval of the product by the FDA. There can be no assurance that ELADUR will be the first bupivacaine product approved for PHN, and therefore ELADUR may not be entitled to the seven year exclusivity for orphan drugs.

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Effective in October 2008, we entered into a development and license agreement with Alpharma granting Alpharma the exclusive worldwide rights to develop and commercialize ELADUR. Alpharma paid us an upfront license fee of $20 million in October 2008. Alpharma was acquired by King in December 2008 and, as a result, the rights and obligations of the agreement are now controlled by King. Our main activities since December 2008 have involved interacting with the King team on details associated with next steps in the clinical program, which King expects to initiate in the first half of 2010.

Other Programs

Biologics Programs

The proteins and genes identified by the biotechnology industry are large, complex, intricate molecules, and many are unsuitable as drugs. If these molecules are given orally, they are often digested before they can have an effect; if given by injection, they may be destroyed by the body’s natural processes before they can reach their intended sites of action. The body’s natural elimination processes require frequent, high dose injections that may result in unwanted side effects. As a result, the development of biotechnology molecules for the treatment of human diseases has been limited, and advanced drug delivery systems such as we possess are required to realize the full potential of many of these protein and peptide drugs. We have active programs underway to apply our drug delivery systems to various biotechnology drugs and drug candidates, and have entered into a number of feasibility studies with biotechnology and pharmaceutical companies to test their products in our systems.

Research and Development Programs in Other Therapeutic Categories

We have underway a number of research programs covering medical diseases and conditions other than pain. Such programs include various diseases and disorders of the central nervous system (CNS), including schizophrenia and attention deficit/hyperactivity disorder. Another area of focus includes cardiovascular disease, including congestive heart failure. In conducting our research programs and determining which particular efforts to prioritize for formal development, we employ a rigorous opportunity assessment process that takes into account the unmet medical need, commercial opportunity, technical feasibility, clinical viability, intellectual property considerations, and the development path including costs to achieve various critical milestones.

Collaborative Research and Development Revenues

Collaborative research and development revenues consist of three broad categories: (a) the amortization of upfront license payments on a straight-line basis over the period of our continuing involvement with the third party, (b) the reimbursement of qualified research expenses by third parties, and (c) milestone payments in connection with our collaborative agreements. During the last several years, we generated collaborative research and development revenues from collaborative agreements with Endo, Pain Therapeutics, Nycomed, King and others. In contrast to our other collaborations, due to the terms and nature of the Nycomed collaboration, we do not recognize revenue from the reimbursement of qualified research expenses by Nycomed pursuant to ASC 808-10, Accounting for Collaborative Arrangements. Rather, we record research and development expense equal to our net share of the joint research and development expenses undertaken under the product development plan.

Product Revenues

We currently generate product revenue from the sale of three product lines:

Because we consider our core business to be developing and commercializing pharmaceutical systems, we do not intend to significantly increase our investments in or efforts to sell or market any of our existing product lines. However, we expect that we will

continue to make efforts to increase our revenue related to collaborative research and development by entering into additional research and development agreements with third-party collaborators to develop product candidates based on our drug delivery technologies.

Reduction In Force

In March 2009, we reduced the size of our California workforce by 41 employees or approximately 24% of our headcount. The goal of this action was to better align our cost structure with anticipated revenues and operating expenses, while not compromising our key corporate objectives for the year. We substantially completed this headcount reduction during the first quarter of 2009, and incurred approximately $443,000 in severance costs for the impacted employees, of which approximately $16,000 was paid in the first quarter of 2009. Accrued severance costs were approximately $427,000 as of March 31, 2009, all of which were paid in April 2009.

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Operating Results

Since our inception in 1998, we have had a history of operating losses. At September 30, 2009, we had an accumulated deficit of $305.3 million and our net losses were $5.5 million and $21.7 million for the three and nine months ended September 30, 2009. Our net losses were $43.9 million, $24.3 million and $33.3 million for the twelve months ended December 31, 2008, 2007 and 2006, respectively. These losses have resulted primarily from costs incurred to research and develop our product candidates and to a lesser extent, from selling, general and administrative costs associated with our operations and product sales. We expect our research and development expenses to increase in the near future as we expect to continue to expand our nonclinical studies, clinical trials and other research and development activities as well as to incur additional stock-based compensation costs related to research and development personnel. We expect selling, general and administrative expenses to remain comparable in the near future. We do not anticipate meaningful revenues from our pharmaceutical systems, should they be approved, for at least the next twelve months. Therefore, we expect to incur continuing losses and negative cash flow from operations for the foreseeable future.

Critical Accounting Policies and Estimates

The preparation of financial statements in conformity with generally accepted accounting principles requires 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 dates of the financial statements and the reported amounts of revenues and expenses during the reporting periods. On an ongoing basis, we evaluate our critical accounting policies and estimates. The most significant estimates and assumptions relate to revenue recognition, the recoverability of our long-lived assets, including goodwill and other intangible assets, accrued liabilities, contract research liabilities and stock-based compensation. Actual amounts could differ significantly from these estimates. Our critical accounting policies and estimates are discussed in our Annual Report on Form 10-K for the fiscal year ended December 31, 2008.

Results of Operations

Three and nine months ended September 30, 2009 and 2008

Revenues. Net revenues were $8.4 million and $19.4 million for the three and nine months ended September 30, 2009, compared to $6.6 million and $19.4 million for the corresponding periods in 2008, respectively. The increases in total revenues in the three and nine months ended September 30, 2009 were primarily attributable to higher product revenue from the sale of certain excipients included in Remoxy to King; revenues in the 2009 periods included $3.0 million related to shipments to King that occurred in 2008 and the first quarter of 2009 but that had been deferred until a long term supply agreement was signed such that final terms and conditions of the sales were established. This agreement was executed in the quarter ended September 30, 2009, and all of the deferred revenue was recognized as product revenue in that period. In addition, the 2009 periods reflected higher collaborative research and development revenue from King, partially offset by lower collaborative research and development revenue recognized from our agreements with Pain Therapeutics, Endo and Nycomed.

Collaborative research and development and other revenue

We recognize revenues from collaborative research and development activities and service contracts. We recorded $3.0 million and $9.4 million of collaborative research and development revenue for the three and nine months ended September 30, 2009 compared to $4.3 million and $12.5 million for the corresponding periods in 2008. Collaborative research and development revenue represents reimbursement of qualified expenses related to collaborative agreements with various third parties to research, develop and commercialize potential products using our drug delivery technologies and revenue recognized from amortization of upfront fees. The decreases in collaborative research and development revenue in the three and nine months ended September 30, 2009 were primarily attributable to lower revenue recognized in connection with our agreements with Pain Therapeutics, Endo and amortization of the upfront payment under our agreement with Nycomed, partially offset by higher collaborative research and development revenue recognized in connection with our agreements with King and other feasibility agreements compared with the same periods in 2008.

We received a $10.0 million upfront fee in connection with the license agreement signed with Endo in March 2005 relating to TRANSDUR-Sufentanil. The $10.0 million upfront fee was recognized as revenue ratably over the term of our continuing involvement with Endo with respect to TRANSDUR-Sufentanil. For the three and nine months ended September 30, 2009, we recognized zero and $875,000, respectively, in collaborative research and development revenue related to this upfront fee, compared to $547,000 and $1.6 million for the corresponding periods in 2008. Our estimate of the remaining term of our continuing involvement was adjusted in the fourth quarter of 2008 as a result of Endo’s termination notice received by us in February 2009. The $10.0 million upfront fee from Endo has been fully amortized as of September 30, 2009.

        We also received a $14.0 million upfront fee in connection with the development and license agreement with Nycomed in November 2006 relating to POSIDUR. The $14.0 million up-front fee is recognized as collaborative research and development revenue ratably over the term of our continuing involvement with Nycomed with respect to POSIDUR. For the three and nine months ended September 30, 2009, we recognized $381,000 and $1.1 million, respectively, in collaborative research and development revenue related to this upfront fee, compared to $763,000 and $2.3 million for the corresponding periods in 2008. Our estimate of the remaining term of our continuing involvement was adjusted in the first quarter of 2009 as a result of an updated development plan for POSIDUR in Europe.

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We also received a $20.0 million upfront fee in connection with the development and license agreement signed with Alpharma (acquired by King) in September 2008 relating to ELADUR. The $20.0 million upfront fee is recognized as collaborative research and development revenue ratably over the term of our continuing involvement with Alpharma (King) with respect to ELADUR. For the three and nine months ended September 30, 2009, we recognized $804,000 and $2.6 million, respectively, in collaborative research and development revenue related to this upfront fee, compared to zero for the corresponding periods in 2008. Our estimate of the remaining term of our continuing involvement was adjusted in the second quarter of 2009 as a result of an updated development plan for ELADUR.

We expect our collaborative research and development revenue to fluctuate in future periods pending our efforts to enter into potential new collaborations and our existing third party collaborators’ commitment to and progress in the research and development programs. The collaborative research and development revenues associated with our major collaborators are as follows (in thousands):

Notes:

We amortize upfront fees on a straight-line basis over the period in which we have continuing involvement with the third-party collaborator pursuant to the applicable agreement. Such period generally represents the research and development period set forth in the work plan under each collaboration agreement between us and our third-party collaborator.

Revenues from service contracts revenues were $19,000 and $49,000 in the three and nine months ended September 30, 2009, compared to $30,000 and $79,000 for the corresponding periods in 2008. Service contract revenues recognized were related to certain polymer related service contracts we signed with various customers. We currently do not expect to increase our effort to generate significant revenue from our service contracts related to our polymer business in the future.

Product revenue

A portion of our revenues is derived from our product sales, which include our ALZET mini pump product line, our LACTEL biodegradable polymer product line and certain excipients that are included in Remoxy. Net product revenues were $5.4 million and $10.0 million in the three and nine months ended September 30, 2009, respectively, compared to $2.3 million and $6.9 million for the corresponding periods in 2008. The increases in the three and nine months ended September 30, 2009 were primarily attributable to higher product revenue from the sale of certain excipients included in Remoxy to King; revenues in the 2009 periods included $3.0 million related to shipments to King that occurred in 2008 and the first quarter of 2009 but that had been deferred until a long term supply agreement was signed such that final terms and conditions of the sales were established. This agreement was executed in the quarter ended September 30, 2009, and all of the deferred revenue was recognized as revenue in that period. In addition, we experienced higher product revenue from our LACTEL polymer product line as a result of higher units sold, partially offset by lower revenue from our ALZET mini pump product line as a result of lower units sold in the three and nine months ended September 30, 2009.

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Cost of revenues. Cost of revenues was $2.8 million and $4.5 million for the three and nine months ended September 30, 2009, respectively, compared to $870,000 and $2.7 million for the corresponding periods in 2008. The increase in the cost of product revenue in the three and nine months ended September 30, 2009 was primarily the result of recognizing $2.0 million of cost of goods sold for the sale of excipients to King, partially offset by lower units sold from our ALZET mini pump product line and improved manufacturing efficiency from our LACTEL polymer product line. Cost of product revenue and gross profit margin will fluctuate from period to period depending upon the product mix in a particular period. Cost of service contract revenue was $3,000 and $9,000 for the three and nine months ended September 30, 2009, respectively, compared to $8,600 and $27,600 for the corresponding periods in 2008. Stock based compensation expense recognized related to cost of revenues was $91,000 and $286,000 for the three and nine months ended September 30, 2009, respectively, compared to $44,000 and $110,000 for the corresponding periods in 2008.

As of September 30, 2009 and 2008, we had 22 and 30 manufacturing employees, respectively. The decrease in 2009 was due to the lower number of employees involved in commercial manufacturing of certain excipients that are components of Remoxy.

Research and development. Research and development expenses are primarily comprised of salaries, benefits, stock-based compensation and other compensation cost associated with research and development personnel, overhead and facility costs, preclinical and non-clinical development costs, clinical trial and related clinical manufacturing costs, contract services, and other

outside costs. Research and development expenses were $7.6 million and $25.4 million for the three and nine months ended September 30, 2009, respectively, compared to $11.4 million and $31.0 million for the corresponding periods in 2008. Excluding the impact of stock-based compensation expenses, research and development expenses decreased by $4.2 million and $6.6 million in the three and nine months ended September 30, 2009 compared to the corresponding periods in 2008. The decreases in the three and nine months ended September 30, 2009 were primarily attributable to lower development costs associated with ELADUR, Remoxy and other select ORADUR-based opioid drug candidates and our biologics programs, partially offset by higher development costs associated with POSIDUR and other research programs compared to the corresponding periods in 2008 as more fully discussed below. In addition, we paid $2.25 million to EpiCept in the third quarter of 2008 under the amended agreement with EpiCept and recorded this amount as a research and development expense in the three and nine months ended September 30, 2008. Stock-based compensation expense recognized related to research and development personnel was $1.7 million and $5.3 million for the three and nine months ended September 30, 2009, respectively, compared to $1.3 million and $4.3 million for the corresponding periods in 2008.

POSIDUR

Our research and development expenses for POSIDUR increased to $2.9 million and $9.3 million in the three and nine months ended September 30, 2009 from $2.0 million and $6.3 million in the corresponding periods in 2008 due to higher employee related costs as well as higher costs associated with clinical trial expenses and contract manufacturing development activities for POSIDUR. Research and development expenses for POSIDUR incurred by us but reimbursable by Nycomed under the terms of our agreement with Nycomed were $975,000 and $2.9 million in the three and nine months ended September 30, 2009, respectively, compared to $960,000 and $2.6 million for the corresponding periods in 2008, which are accounted for as a reduction of research and development expenses. Research and development expenses for POSIDUR incurred by Nycomed but reimbursable by us under the terms of our agreement with Nycomed were $1.1 million and $3.1 million in the three and nine months ended September 30, 2009, respectively, compared to $441,000 and $1.5 million for the corresponding periods in 2008, which are accounted for as additional research and development expenses. As a result of the collaboration agreement with Nycomed, our research and development expenses were increased by $75,000 and $199,000 in the three and nine months ended September 30, 2009, respectively, compared to a reduction of $519,000 and $1.1 million for the corresponding periods in 2008. The net increase or reduction in research and development expenses represents a net reimbursement from or a net payment to Nycomed reflecting that both parties bore 50% of the development expenses defined under the collaboration agreement for POSIDUR.

ELADUR

Our research and development expenses for ELADUR decreased to $661,000 and $2.8 million in the three and nine months ended September 30, 2009 from $4.6 million and $9.0 million in the corresponding periods in 2008. The decreases in 2009 were primarily due to lower employee costs, animal studies and contract manufacturing expenses related to this product candidate. In addition, we paid $2.25 million to EpiCept in the third quarter of 2008 related to certain intellectual property for ELADUR under the amended agreement with EpiCept.

ORADUR-ADHD

Our research and development expenses for ORADUR-ADHD increased to $432,000 and $1.6 million in the three and nine months ended September 30, 2009 from $250,000 and $250,000 for the corresponding periods in 2008. The increases were primarily due to increased formulation and other development activities for this drug candidate in 2009.

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Remoxy and other select ORADUR-based opioid products

Our research and development expenses for Remoxy and other opioids partnered with Pain Therapeutics decreased to $388,000 and $1.3 million in the three and nine months ended September 30, 2009 from $1.3 million and $4.8 million in the corresponding periods in 2008. The decreases were primarily due to decreased support activities for Remoxy after the filing of the Remoxy NDA as well as decreased formulation and clinical manufacturing activities for other select ORADUR-based opioid drug candidates in 2009.

TRANSDUR-Sufentanil

Our research and development expenses for TRANSDUR-Sufentanil decreased to $382,000 in the three months ended September 30, 2009 from $471,000 for the corresponding period in 2008. The decrease was primarily due to decreased external costs after Endo returned the program to us in 2009. Our research and development expenses for TRANSDUR-Sufentanil increased to $1.2 million in the nine months ended September 30, 2009 from $1.1 million for the corresponding period in 2008. The slight increase was primarily due to higher employee costs associated with transferring the program back to us from Endo in 2009.

Biologics programs

Our research and development expenses for biologics programs decreased to $233,000 and $1.3 million in the three and nine months ended September 30, 2009 from $1.4 million and $3.7 million in the corresponding periods in 2008. The decreases were primarily due to lower external costs and employee related costs in support of these programs in 2009.

Other DURECT research programs

Our research and development expenses for all other programs increased to $2.6 million and $7.8 million in the three and nine months ended September 30, 2009 from $1.4 million and $5.8 million in the corresponding periods in 2008. The increases were primarily due to higher employee related costs and increased formulation and other development activities for these programs in 2009.

As of September 30, 2009, we had 74 research and development employees compared with 113 as of September 30, 2008 largely as a result of the reduction in force in March 2009. We expect our research and development expenses to increase in the near future as we expect to continue to expand our nonclinical studies, clinical trials and other research and development activities.

The research and development expenses associated with our major development programs approximate the following (in thousands):

We cannot reasonably estimate the timing and costs of our research and development programs due to the risks and uncertainties associated with developing pharmaceutical systems as outlined in the “Risk Factors” section of this report. The duration of development of our research and development programs may span as many as ten years or more, and estimation of completion dates or costs to complete would be highly speculative and subjective due to the numerous risks and uncertainties associated with

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developing pharmaceutical products, including significant and changing government regulation, the uncertainties of future preclinical and clinical study results, the uncertainties with our collaborators’ commitment and progress to the programs and the uncertainties associated with process development and manufacturing as well as sales and marketing. In addition, with respect to our development programs subject to third-party collaborations, the timing and expenditures to complete the programs are subject to the control of our collaborators. Therefore, we cannot reasonably estimate the timing and estimated costs of the efforts necessary to complete the research and development programs. For additional information regarding these risks and uncertainties, see “Risk Factors” below.

Selling, general and administrative. Selling, general and administrative expenses are primarily comprised of salaries, benefits, stock-based compensation and other compensation cost associated with finance, legal, business development, sales and marketing and other administrative personnel, overhead and facility costs, and other general and administrative costs. Selling, general and administrative expenses were $3.6 million and $11.6 million for the three and nine months ended September 30, 2009, respectively, compared to $3.8 million and $11.8 million for the corresponding periods in 2008. Excluding the impact of stock-based compensation expenses, selling, general and administrative expenses decreased by $449,000 and $977,000 in the three and nine months ended September 30, 2009 compared to the corresponding periods in 2008 primarily due to lower employee and consulting expenses incurred in the three and nine months ended September 30, 2009. Stock-based compensation expense recognized related to selling, general and administrative personnel was $785,000 and $2.8 million for the three and nine months ended September 30, 2009, compared to $619,000 and $2.1 million for the corresponding periods in 2008.

As of September 30, 2009, we had 29 selling, general and administrative personnel compared with 38 as of September 30, 2008 largely as a result of the reduction in force in March 2009. We expect selling, general and administrative expenses to remain comparable in the near future.

Other income (expense). Interest and other income was $82,000 and $367,000 for the three and nine months ended September 30, 2009, respectively, compared to $349,000 and $1.3 million for the corresponding periods in 2008. The decreases in interest income were primarily the result of lower yields as well as lower average cash and investment balances during the three and nine months ended September 30, 2009 compared to the corresponding periods in 2008.

Interest and other expense was $9,000 and $31,000 for the three and nine months ended September 30, 2009, respectively, compared to $14,000 and $773,000 for the corresponding periods in 2008. The slight decrease in interest expense in the three month ended September 30, 2009 compared with the same period of 2008 was primarily due to lower principal balance of the bonds payable in the third quarter of 2009. The decrease in interest expense in the nine months ended September 30, 2009 compared with the same period of 2008 was primarily due to the conversion of $23.6 million in aggregate principal amount of convertible notes in the second quarter of 2008.

Liquidity and Capital Resources

We had cash, cash equivalents and investments totaling $47.2 million at September 30, 2009 compared to $52.7 million at December 31, 2008. These balances include $803,000 and $1.0 million of interest-bearing marketable securities classified as restricted investments on our balance sheets as of September 30, 2009 and December 31, 2008, respectively. The decrease in cash, cash equivalents and investments during the nine months ended September 30, 2009 was primarily the result of ongoing operating expenses, partially offset by payments received from customers and our recent equity financing.

Working capital was $40.6 million and $43.4 million at September 30, 2009 and December 31, 2008, respectively. The decrease in working capital was primarily attributable to an increase in our operating expenditures, partially offset by the receipt of net proceeds from our recent equity financing in the nine months ended September 30, 2009.

We used $15.5 million of cash in operating activities for the nine months ended September 30, 2009 compared to $22.8 million for the corresponding period in 2008. The cash used for operations was primarily to fund operations as well as our working capital requirements. The decrease in cash used for operations was primarily attributable to the increases in accounts receivable from our third party collaborators, inventory and prepaid expenses for the nine months ended September 30, 2009, partially offset by decreases in accounts payable, accrued liabilities and contract research liability compared to the corresponding period in 2008.

We used $6.2 million of cash for investing activities for the nine months ended September 30, 2009 compared to $7.6 million of cash received for the corresponding period in 2008. The increase in cash used in investing activities was primarily due to an increase in net purchases of short-term and long-term investments for the nine months ended September 30, 2009 compared to the corresponding period in 2008.

We received $10.2 million of cash from financing activities for the nine months ended September 30, 2009 compared to $704,000 for the corresponding period in 2008. The increase was primarily due to approximately $9.9 million of cash received from a recent equity financing, partially offset by lower proceeds from exercises of stock options and purchases from our employee stock purchase plan in the nine months ended September 30, 2009 compared to the corresponding period in 2008.

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In June and July 2003, we completed a private placement of an aggregate of $60.0 million in convertible subordinated notes and received net proceeds of approximately $56.7 million after deducting underwriting fees of $3.0 million and related expenses of $300,000. The notes bore interest at a fixed rate of 6.25% per annum and were due on June 15, 2008. The notes were all converted to our common stock between the third quarter of 2005 and the second quarter of 2008. As of September 30, 2009, the remaining principal balance of our convertible subordinated notes was zero.

In conjunction with the acquisition of SBS in April 2001, we assumed the SBS Bonds with remaining principal payments of $1.7 million as of April 30, 2001, and an interest rate of 6.35% increasing each year up to 7.20% at maturity on November 1, 2009. As part of the acquisition agreement, we were required to guarantee and collateralize these bonds with a letter of credit of approximately $2.4 million that we secured with investments deposited with a financial institution in July 2001. Interest payments on the SBS Bonds are due semi-annually and principal payments are due annually. Principal payments on the SBS Bonds increase in annual increments from $150,000 to $240,000 over the term of the bonds until the principal is fully paid in 2009. We have an option to call the SBS Bonds at any time. On December 31, 2002, SBS was merged into DURECT and the SBS bonds were assigned to DURECT with the terms unchanged. At September 30, 2009, the remaining principal balance of the bonds was $240,000.

On September 10, 2009, we entered into a privately negotiated transaction to sell 4,444,444 shares of our common stock to affiliates of Venrock at a price of $2.25 per share, raising total gross proceeds to DURECT of approximately $10 million. This transaction was closed on September 18, 2009. Total stock issuance costs related to this financing were approximately $126,000.

We anticipate that cash used in operating and investing activities will increase in the near future as we continue to research, develop and manufacture our products through internal efforts and partnering activities.

During the nine months ended September 30, 2009, we believe there have been no significant changes in our future payments due under contractual obligations as disclosed in our Annual Report on Form 10-K for the year ended December 31, 2008 except for incremental rent payments of approximately $3.2 million associated with recent lease renewals for two of our buildings.

We anticipate incurring capital expenditures of approximately $500,000 over the next 12 months to purchase research and development and other capital equipment. The amount and timing of these capital expenditures will depend on, among other things, the timing of clinical trials for our products and our collaborative research and development activities.

We believe that our existing cash, cash equivalents and investments will be sufficient to fund our planned operations, existing debt and contractual commitments, and planned capital expenditures through at least the next 12 months. We may consume available resources more rapidly than currently anticipated, resulting in the need for additional funding. Additionally, we do not expect to generate meaningful revenues from our pharmaceutical systems currently under development for at least the next twelve months, if at all. Depending on whether we enter into additional collaborative agreements in the near term, we may be required to raise additional capital through a variety of sources, including: