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

        The discussion below contains forward-looking statements that are based on the beliefs of management, as well as assumptions made by, and information currently available to, management. Our future results, performance or achievements could differ materially from those expressed in, or implied by, any such forward-looking statements as a result of certain factors, including, but not limited to, those discussed in this section as well as in the section entitled “Risk Factors” and elsewhere in the Company’s most recent Form 10-K and Form 10-Q filed with the Securities and Exchange Commission.

        The business is subject to significant risks including, but not limited to, the success of research and development efforts, dependence on corporate partners for marketing, distribution and other resources, obtaining and enforcing patents important to the business, clearing the lengthy and expensive regulatory process and possible competition from other products. Even if the products appear promising at various stages of development, they may not reach the market or may not be commercially successful for a number of reasons. Such reasons include, but are not limited to, the possibilities that the potential products may be found to be ineffective during clinical trials, fail to receive necessary regulatory approvals, are difficult to manufacture on a large scale, are uneconomical to market, are precluded from commercialization by proprietary rights of third parties or may not gain acceptance from health care professionals and patients. Readers are cautioned not to place undue reliance on the forward-looking statements contained herein. We undertake no obligation to publicly release the results of any revision to these forward-looking statements that may be made to reflect events or circumstances occurring after the date hereof or to reflect the occurrence of unanticipated events.

Overview

        Since our inception in 1991, we have been engaged in the development of innovative drug delivery systems. Beginning with our AERx pulmonary delivery system and more recently with the Intraject subcutaneous delivery technology acquired in May 2003 from Weston Medical, we are building a solid platform in needle-free drug delivery. As of June 30, 2004, we had an accumulated deficit of $231 million. We have never been profitable since inception and expect to incur additional operating losses over the next several years as research and development efforts, preclinical and clinical testing activities and manufacturing scale-up efforts expand and as we plan and build our late-stage clinical and early commercial production capabilities. To date, we have not had any material product sales and do not anticipate receiving any revenue from the sale of products in the upcoming year. Our sources of working capital have been equity financings, equipment lease financings, contract revenues and interest earned on investments.

        We have performed initial feasibility work on a number of compounds with the AERx system and have been compensated for expenses incurred while performing this work in several cases pursuant to feasibility study agreements with third parties. Once feasibility is demonstrated with respect to a potential product, we seek to enter into development contracts with pharmaceutical corporate partners. We currently have an agreement pursuant to which we are developing pulmonary delivery systems with Novo Nordisk A/S, to manage diabetes using insulin.

        We expect to perform various studies evaluating our Intraject subcutaneous delivery platform following the completion of clinical performance verification trials scheduled for later this year. While Aradigm will be actively engaging partners for discussions on Intraject, we believe that it is unlikely that a new commercial agreement for Intraject will be signed until the clinical verification trial is completed and presented to potential partners later this year. In some cases, a partnership may not be disclosed until a long-term development agreement has been established.

        Our lead development program is developing pulmonary delivery systems to manage diabetes using insulin with our partner Novo Nordisk. Since Novo Nordisk and we successfully initiated Phase 3 clinical trials in September 2002, we have been focused on supporting our partner in the existing and planned additional Phase 3 clinical trials that will be needed for their regulatory submission and commercial scale-up activities. In April 2004, Novo Nordisk and we announced results from a planned interim analysis of the initial Phase 3 trial. Although the results showed that the trial met its primary safety and efficacy

 

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endpoints, the analysis showed delayed post-meal plasma glucose suppression in type 1 diabetics using the AERx system. Because of the unexpected nature of these observations, Novo Nordisk has decided to amend the current trial protocol. Novo Nordisk will make decisions concerning the structure and timing of additional clinical trials after these observations have been fully assessed.

        The collaborative agreement with Novo Nordisk provides for reimbursement of research and development expenses as well as additional payments to us as we achieve certain significant milestones. We also expect to receive royalties from this development partner based on revenues from product sales and to receive revenue from the manufacturing of unit dose packets and hand-held devices. We recognize revenues under the terms of our collaborative agreement as the research and development expenses are incurred, to the extent they are reimbursable. For the six months ended June 30, 2004, this partner-funded program has contributed approximately 99.2% of our total contract revenues. At June 30, 2004, Novo Nordisk and its affiliate, Novo Nordisk Pharmaceuticals, Inc., own approximately 11.3% of our total outstanding common stock (on an as-converted basis) and are considered a related party.

        In general, it is our policy not to disclose the partner and/or the drug until a long-term development agreement has been established; both parties agree to highlight a clinical advancement in the program or under special circumstances in which both parties agree to disclosure.

Critical Accounting Policies

        We consider certain accounting policies related to revenue recognition and the use of estimates to be critical accounting policies that require the use of significant judgments and estimates relating to matters that are inherently uncertain and may result in materially different results under different assumptions and conditions.

       Revenue Recognition

        Contract revenues consist of revenue from collaboration agreements and feasibility studies. We recognize revenue under the agreements as costs are incurred. Deferred revenue represents the portion of all refundable and nonrefundable research payments received that have not been earned. In accordance with contract terms, milestone payments from collaborative research agreements are considered reimbursements for costs incurred under the agreements and, accordingly, are generally recognized as revenue either upon the completion of the milestone effort when payments are contingent upon completion of the effort or are based on actual efforts expended over the remaining term of the agreements when payments precede the required efforts. Costs of contract revenues are approximate or are greater than such revenue and are included in research and development expenses. Refundable development and license fee payments are deferred until the specified performance criteria are achieved. Refundable development and license fee payments are generally not refundable once the specific performance criteria are achieved.

       Impairment of Long-Lived Assets

        We review for impairment whenever events or changes in circumstances indicate that the carrying amount of property and equipment may not be recoverable. Determination of recoverability is based on an estimate of undiscounted future cash flows resulting from the use of the asset and its eventual disposition. In the event that such cash flows are not expected to be sufficient to recover the carrying amount of the assets, the assets are written down to their estimated fair values and the loss is recognized on the Statements of Operations.

       Use of Estimates

        The preparation of financial statements in conformity with generally accepted accounting principles requires us to make estimates and assumptions that affect the amounts reported in the financial statements

 

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and accompanying notes to the financial statements. These estimates include useful lives for property and equipment and related depreciation calculations, estimated amortization period for payments received from product development and license agreements as they relate to the revenue recognition of deferred revenue and assumptions for valuing options and warrants. Actual results could differ from these estimates.

Three Months Ended June 30, 2004 and 2003

         Contract and License Revenues: Contract revenues for the three months ended June 30, 2004 decreased to $7.1 million from $9.4 million for the same period in 2003. Revenue from Novo Nordisk was $7.0 million for the three months ended June 30, 2004 and $9.3 million for the same period in 2003. Clinical supply and product development activities for the ongoing Phase 3 clinical program with Novo Nordisk were higher for the same period in 2003 and are decreasing as the program matures. Costs associated with collaborative agreements are included in research and development expenses. The Company expects that the revenue from Novo Nordisk may trend down over the coming quarters due to the expected level of activity in support of the ongoing Phase 3 clinical program.

         Research and Development Expenses: Research and development expenses for the three months ended June 30, 2004 decreased to $11.4 million from $14.0 million for the same period in 2003. The decrease in research and development expenses is due to the decrease in Novo Nordisk program activities and continued cost saving efforts.

        These expenses represent proprietary research expenses as well as costs related to contract revenues and include salaries and benefits of scientific and development personnel, laboratory supplies, consulting services and expenses associated with the development of manufacturing processes. We expect research and development spending to increase over the next few years as we continue to expand our development activities to support current and potential future collaborations, increase development expense to support Intraject subcutaneous delivery technology, and initiate commercial manufacturing of the AERx systems. The increase in research and development expenditures cannot be predicted accurately as it depends in part upon the future success of, and funding levels supported by, our existing development collaborations, as well as obtaining new collaborative agreements.

        Our lead development program is developing pulmonary delivery systems to manage diabetes using insulin with our partner Novo Nordisk. Since Novo Nordisk and we successfully initiated Phase 3 clinical trials in September 2002, we have been focused on supporting our partner in the existing and planned additional Phase 3 clinical trials that will be needed for their regulatory submission and commercial scale-up activities.

         General and Administrative Expenses: General and administrative expenses for the three months ended June 30, 2004 increased by 11.4% to $3.2 million from $2.8 million for the same period in 2003 due to an increase in cost associated with increased marketing and legal expenses, which were slightly offset by lower depreciation.

         Interest Income: Interest income for the three months ended June 30, 2004 decreased to $49,000 from $86,000 for the same period in 2003. The decrease is due to lower average investment portfolio balances and lower yields.

         Interest Expense: Interest expense for the three months ended June 30, 2004 decreased to $5,000 from $39,000 for the same period in 2003. The decrease is primarily due to the pay off of the outstanding capital lease and equipment loan balances under various equipment and lease lines of credit.

         Net Loss: Net loss for the three months ended June 30, 2004 increased by 0.5% to $7.5 million from $7.4 million for the same period in 2003, reflecting lower Novo Nordisk contract revenues and primarily offset by reduced associated development expense.

Six Months Ended June 30, 2004 and 2003

         Contract Revenues: Contract revenues for the six months ended June 30, 2004 decreased by 19.6% to $13.7 million from $17.1 million for the same period in 2003. Revenue from Novo Nordisk was $13.6 million for the six months ended June 30, 2004 and $16.8 million for the same period in 2003. The decrease in revenue is related to lower budgeted Novo Nordisk activities for clinical supply and product

 

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development activities for the ongoing phase 3 clinical program and by lower revenue from other funded programs. Costs associated with collaborative agreements are included in research and development expenses. The Company expects that the revenue from Novo Nordisk may trend down over the coming quarter(s) due to the expected level of activity in support of the ongoing phase 3 clinical program.

         Research and Development Expenses: Research and development expenses for the six months ended June 30, 2004 decreased to $23.3 million from $27.0 million for the same period in 2003. The decrease in research and development expenses is due to the decrease in Novo Nordisk program activities and continued cost saving efforts.

         General and Administrative Expenses: General and administrative expenses for the six months ended June 30, 2004 increased by 3.5% to $5.7 million from $5.5 million for the same period in 2003. The increase is primarily due to higher marketing, insurance, legal and consulting costs.

         Interest Income: Interest income for the six months ended June 30, 2004 decreased to $115,000 from $194,000 for the same period in 2003. The decrease is due to lower invested balances.

         Interest Expense: Interest expense for the six months ended June 30, 2004 decreased to $15,000 from $95,000 for the same period in 2003. The decrease is primarily due to the pay off of the outstanding capital lease and equipment loan balances under various equipment and lease lines of credit.

         Net Loss: Net loss for the six months ended June 30, 2004 decreased to $15.2 million from $15.3 million for the same period in 2003 reflecting lower Novo Nordisk contract revenues and primarily offset by reduced associated development expense.

Liquidity and Capital Resources

        We have financed our operations since inception primarily through private placements and public offerings of capital stock, proceeds from equipment lease financing, contract revenues and interest earned on investments. As of June 30, 2004, we had cash, cash equivalents and short-term investments of approximately $18.9 million.

        In January and April 2004, the Company received net proceeds of approximately $786,000 and issued an aggregate of 813,297 shares of Common Stock in connection with the exercise of options and warrants, and the sale of common stock under the Employee Stock Purchase Plan.

        Net cash used in operating activities for the six months ended June 30, 2004 decreased to $10.4 million from $14.3 million for the same period in 2003. As the net loss for the two periods was similar, the significant decline in net cash used in operating activities was primarily the result of the timing of cash payments and receipts for accounts payable and deferred revenue. The accounts payable balance at the end of the second quarter of 2004 was lower than in 2003 due to lower research and development activities. The amortization of deferred revenue decreased in 2004 relative to 2003 due to the significantly higher deferred balance held at year-end 2003 that was recognized as revenue in the first six months of 2004.

        Investing activities for the six months ended June 30, 2004 provided cash of $2.2 million, compared to $0.6 million for the same period in 2003. Higher capital expenditures in 2003 related to the acquisition of certain assets and the intellectual property of related Intraject subcutaneous delivery technology from Weston Medical Group.

        Net cash provided by financing activities for the six months ended June 30, 2004 was $0.4 million, compared to $15.2 million for the same period in 2003. Net cash provided in the six months ended June 30, 2003 was higher as a result of the completion of a private placement financing in March 2003.

        The development of our technology and proposed products, including the Intraject development program, will require a commitment of substantial funds to conduct the costly and time-consuming research, preclinical studies and clinical trial activities necessary to develop and refine the technology and proposed products and bring such products to market. Our future capital requirements will depend on many factors, including continued progress and results from research and development for the technology and drug delivery systems, the ability to establish and maintain favorable collaborative arrangements with others, progress with preclinical studies and clinical trials and the results thereof, the time and costs

 

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involved in obtaining regulatory approvals, the cost of development and the rate of scale-up for the required production technologies, the costs involved in preparing, filing, prosecuting, maintaining and enforcing patent claims and the need to acquire licenses or other rights to new technology.

        We continue to review our planned operations through the end of 2004 and beyond. We particularly focus on capital spending requirements to ensure that capital outlays are not expended sooner than necessary. We expect our total annual capital outlays for 2004 will be from $5.0 to $8.0 million. In January 2004, we amended the operating lease for one of our facilities. Effective January 1, 2004, the new agreement reduces the aggregate annual lease payments by $1.1 million through 2006 and increases the aggregate annual payments by $1.1 million from 2007 through 2010. We believe that our existing cash balances at June 30, 2004, funding commitments from corporate development partners and interest earned on our investments should be sufficient to meet our needs for at least the next 12 months. There can be no assurance that our funding commitments from corporate development partners will not be amended or terminated, and if they are amended or terminated, we will need to obtain additional sources of capital sooner than would otherwise be the case.

        If our development programs, including the Intraject development program, continue to progress, we would expect our cash requirements for capital spending and operations to increase in future periods. We will need to raise additional capital to fund our capital spending and operations before we become profitable. We may seek additional funding through collaborations, borrowing arrangements or through public or private equity financings. There can be no assurance that additional financing can be obtained on acceptable terms, or at all. Dilution to shareholders may result if funds are raised by issuing additional equity securities. If adequate funds are not available, we may be required to delay, to reduce the scope of, or to eliminate one or more of our research and development programs, or to obtain funds through arrangements with collaborative partners or other sources that may require us to relinquish rights to certain of our technologies or products that we would not otherwise relinquish.