Item 2.    MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The following discussion of our financial condition and results of operations should be read in conjunction with the condensed consolidated financial statements and the related notes appearing elsewhere in this report.

Overview

Curis, Inc. (“we”, “our” or “us”) is a therapeutic drug development company principally focused on the discovery, development and future commercialization of products that modulate key regulatory signaling pathways controlling the repair and regeneration of human tissues and organs. Our product development approach involves using small molecules, proteins or antibodies to modulate these regulatory signaling pathways. We have successfully developed several promising preclinical product candidates in the fields of cancer, kidney disease, neurological disorders, hair growth regulation and cardiovascular disease.

Since our inception, we have funded our operations primarily through license fees, research and development funding from our collaborative partners, the private and public placement of our equity securities, debt financings and the monetization of certain royalty rights. We have never been profitable and have incurred an accumulated deficit of $661,313,000 as of September 30, 2004. We expect to incur significant operating losses for the next several years as we devote substantially all of our resources to research and development of our product candidates. We will need to generate significant revenues to achieve profitability and do not expect to achieve profitability in the foreseeable future, if at all.

We currently have strategic license and collaboration agreements with Genentech, Ortho Biotech (a subsidiary of Johnson & Johnson) and Wyeth Pharmaceuticals (a subsidiary of Wyeth). Our strategic collaborations generally provide for certain of our research, development and commercialization programs to be either partially or wholly funded by our collaborators and provide us with the opportunity to receive additional payments if specified milestones are achieved, as well as royalty payments upon the successful commercialization of any products based upon the collaboration. These strategic license and collaboration agreements included $15,000,000 in up-front payments and potential future clinical development milestones in excess of $500,000,000 in the aggregate, assuming that all of the collaborations continue for their full terms and all milestone payments are received. These collaborations also include royalty rates on potential future product sales ranging from 6% to 10%.

In the future, we plan to continue to seek corporate partners for the further development and commercialization of some of our technologies. In some cases, we have retained development and commercialization rights in areas where we believe we can attain the greatest potential long-term value through the application of our own internal resources. For example, we currently expect to select at least one program that we will develop further on our own—most likely the Hedgehog small molecule agonist candidate for hair loss.

On October 14, 2004, we completed a registered direct offering of 5,476,559 shares of newly issued common stock, together with warrants to purchase 0.10 shares of common stock for each share of common stock purchased, at a purchase price of $3.67 per share to institutional and accredited investors. The warrants to purchase an aggregate of 547,656 shares of common stock expire on October 14, 2009 and are exercisable at $4.59 per share. The transaction provided us with approximately $18,868,000 in net proceeds (exclusive of any proceeds we may receive upon exercise of the warrants). The shares of common stock and warrants to purchase common stock offered by us in this transaction were registered under our existing shelf registration statement on Form S-3 which was declared effective by the Securities and Exchange Commission on January 7, 2004.

Financial Operations Overview

General.     Our future operating results will depend largely on the magnitude of payments from our current and potential future corporate partners and the progress of other product candidates currently in our research and

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development pipeline. The results of our operations will vary significantly from year to year and quarter to quarter and depend on, among other factors, the timing of our entry into new collaborations, the timing of the receipt of payments from collaborators and the cost and outcome of clinical trials. We believe that our existing capital resources at September 30, 2004, together with the $18,868,000 of net proceeds we received upon the closing of our registered direct common stock and warrant offering on October 14, 2004, should enable us to maintain current and planned operations into the second half of 2007, including spending related to the potential exercise of our co-development option with Genentech. Our ability to continue funding our planned operations is dependent upon the success of our collaborations, our ability to maintain or reduce our cash burn rate and our ability to raise additional funds through equity, debt or other sources of financing. A discussion of certain risks and uncertainties that could affect our liquidity and ability to raise additional funds is set forth below under the heading “Risk Factors that May Affect Results.”

Revenue.     We do not expect to generate any revenue from the sale of products for several years, if ever. Substantially all of our revenue to date has been derived from license fees, research and development payments, and other amounts that we have received from our strategic licensors and collaborators, including Genentech, Ortho Biotech, and Wyeth. In the future, we will seek to generate revenue from a combination of license fees, research and development funding and milestone payments in connection with strategic licenses and collaborations, and royalties resulting from the sale of products which incorporate our intellectual property. We expect that any revenue we generate will fluctuate from quarter to quarter as a result of the timing and amount of payments received under our strategic collaborations, and the amount and timing of payments we receive upon the sale of our products, to the extent that any are successfully commercialized.

Research and Development.     Research and development expenses consist of costs incurred to discover, research and develop product candidates. These expenses consist primarily of salaries and related expenses for personnel, outside service costs including chemistry, consulting and sponsored research collaborations and occupancy and depreciation charges. We expense research and development costs as incurred.

The following table summarizes our primary research and development programs, including the current development status of each program. In the table below, the term discovery means that we are seeking to identify compounds that may have therapeutic activities, early preclinical means we, and/or our collaborators, have observed initial demonstrations of therapeutic efficacy in a preclinical model of human disease, mid preclinical means we, and/or our collaborators, have achieved multiple demonstrations of efficacy in preclinical models of human disease, and late preclinical means we, and/or our collaborators, have multiple demonstrations of efficacy in preclinical models of human disease, as applicable, and are now seeking relevant toxicology and safety data required for an investigational new drug application filing with the FDA seeking to commence a phase I clinical trial to assess safety in humans. We have set forth below under “Results of Operations” the expenses incurred with respect to each product candidate for the three- and nine-month periods ended September 30, 2004 and 2003.

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There is a risk that any drug discovery and development program may not produce products or revenue. Due to uncertainties inherent in drug discovery and development, including those factors described below under “Risk Factors That May Affect Results,” we and our collaborative partners may not be able to successfully develop and commercialize any of the product candidates included in the table above.

Because substantially all of our product development initiatives are in various stages of preclinical testing, the successful development of our product candidates is highly uncertain. We cannot reasonably estimate or know the nature, timing and estimated costs of the efforts necessary to complete the development of, or the period in which material net cash inflows are expected to commence from any of our product candidates due to the numerous risks and uncertainties associated with developing drugs, including the uncertainty of:

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Any failure to complete the development of our product candidates in a timely manner could have a material adverse effect on our operations, financial position and liquidity. A discussion of risks and uncertainties associated with completing our projects on schedule, or at all, and some consequences of failing to do so, are set forth below in “Risk Factors That May Affect Results.”

General and Administrative .    General and administrative expense consists primarily of salaries and other related costs for personnel in executive, finance, accounting, business development, legal, information technology, corporate communications and human resource functions. Other costs include facility costs not otherwise included in research and development expense, insurance, and professional fees for legal, patent and accounting services.

Strategic Alliances and License Agreements .    Since inception, substantially all of our revenue has been derived from collaborations and other research and development arrangements with third parties. Our current strategic alliances and key license agreements are with Genentech, Ortho Biotech and Wyeth Pharmaceuticals. These strategic license and collaboration agreements included $15,000,000 in up-front payments and potential future clinical development milestones in excess of $500,000,000 in the aggregate, assuming that all of the collaborations continue for their full terms and all milestone payments are received. These collaborations also include royalty rates on potential future product sales ranging from 6% to 10%.

The collaborations and licenses are summarized as follows:

Genentech Collaboration.     In June 2003, we licensed our small molecule and antibody antagonists of the Hedgehog signaling pathway to Genentech on an exclusive, worldwide royalty-bearing basis with the primary focus of the research plan to develop applications in cancer therapy. Under the terms of the agreement, in June 2003 Genentech paid us an up-front license fee of $5,000,000 and purchased 1,323,835 shares of our common stock at a price of $2.644 per share for aggregate proceeds of $3,500,000. In addition, Genentech paid us a $2,000,000 maintenance fee in July 2004, and is obligated to pay us an additional $2,000,000 maintenance fee by July 2005. Genentech is also obligated to make cash payments to us upon the successful achievement of certain clinical development and drug approval milestones. In addition, Genentech will pay a royalty on potential future net product sales, which increases with increasing sales volume.

In March 2004, Genentech announced that it had added a new small molecule antagonist of the Hedgehog signaling pathway covered under our collaboration to its product candidate pipeline. This small molecule is under development for the treatment of basal cell carcinoma. We have retained the right to co-develop products in the field of basal cell carcinoma. If we elect to co-develop a basal cell carcinoma product candidate, we will forego development milestones and royalty payments on potential future sales and we will share in any costs and profits related to the basal cell carcinoma program based on the percentage that is equal to our co-development cost-sharing contribution. Genentech has publicly stated that it expects to file an investigational new drug application on this small molecule later this year or early in 2005. Under the terms of our agreement, Genentech is required to present a co-development plan and budget to us for the small molecule, at which point we will have 30 days to decide if we will participate in the co-development of the basal cell carcinoma product candidate. If we elect to participate, we will determine the applicable cost-sharing percentage. In the event that we elect not to participate in the co-development of the basal cell carcinoma product candidate, we will receive milestones and royalties on future sales, if any. We expect to receive the co-development plan and budget in late 2004 and to make a decision by the first quarter of 2005. We currently expect that we will exercise the co-development option.

As a result of our licensing agreements with various universities, we are obligated to make payments to these university licensors when certain payments are received from Genentech. These obligations total $510,000 for the $5,000,000 up-front license fee and the $4,000,000 maintenance fees. As of September 30, 2004, $310,000 has been paid to the university licensors. Of the remaining $200,000 obligation, $100,000 relates to a $2,000,000 license fee payment due in July 2005. The unpaid obligations are included in “Accrued liabilities” in our condensed consolidated balance sheet as of September 30, 2004.

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Ortho Biotech License.     In November 2002, we licensed our broad BMP technology portfolio to Ortho Biotech on an exclusive, worldwide royalty-bearing basis, for all non-orthopedic and non-dental therapeutic applications in exchange for a $3,500,000 fee, a series of cash milestones if specified clinical research objectives and regulatory approvals are achieved, including a $30,000,000 milestone payment upon U.S. regulatory approval of a product for the treatment of kidney disease, and a royalty on potential future product sales. Ortho Biotech has assumed all future costs and responsibility for BMP-based product development and has sole responsibility for deciding if and when human clinical trials of BMP-based product candidates will begin.

Wyeth Pharmaceuticals Collaboration.     Effective February 2004, we licensed our Hedgehog proteins and small molecule Hedgehog pathway agonists to Wyeth Pharmaceuticals on an exclusive worldwide, royalty-bearing basis for the development and commercialization of pharmaceutical products for therapeutic applications in the treatment of diseases and disorders in humans with the primary focus of the research program on the treatment of neurological disorders, including neurodegenerative diseases and neuropathies. Under the terms of the agreement, Wyeth paid us a license fee of $1,500,000 and purchased 315,524 shares of our common stock at a price of $4.754 per share for an aggregate purchase price of $1,500,000. Wyeth will also provide us with research funding for a minimum of two years. In addition, Wyeth is obligated to make cash payments to us upon the successful achievement of development and drug approval milestones and is obligated to pay a royalty on net product sales, if any, that escalates with increasing sales volume.

We are obligated to make payments to various university licensors when certain payments are received from Wyeth. These obligations total $125,000 for the $3,000,000 up-front license fee. As of September 30, 2004, the entire $125,000 had been paid to the university licensors.

Critical Accounting Policies and Estimates

The preparation of our consolidated financial statements in conformity with accounting principles generally accepted in the United States requires that we make estimates and assumptions that affect the reported amounts and disclosure of certain assets and liabilities at our balance sheet date. Such estimates and judgments include the carrying value of property and equipment and intangible assets, revenue recognition and the value of certain liabilities. We base our estimates on historical experience and on various other factors that are believed to be appropriate under the circumstances, the results of which form the basis for making judgments about the carrying value of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions.

We believe the following accounting policies to be critical to understanding the judgments and estimates we use in preparing our financial statements:

Long-Lived Assets .    Long-lived assets consist of goodwill, long-term receivables, equity securities held in privately held companies, capitalized patent costs, long-term deposits, and other long-term assets. We assess the impairment of identifiable intangibles and long-lived assets whenever events or changes in circumstances indicate that the carrying value may not be recoverable. If it were determined that the carrying value of intangible or long-lived assets may not be recoverable based upon the existence of one or more indicators of impairment, we would measure any impairment based on a projected cash flow method.

SFAS No. 142 requires us to perform an impairment assessment annually or whenever events or changes in circumstances indicate that our goodwill may be impaired. We completed our annual goodwill impairment test in December 2003, and determined that as of that date our fair value exceeded the carrying value of our net assets. Accordingly, no goodwill impairment was recognized in 2003. We plan to complete our next annual goodwill impairment test in December 2004. If, in connection with such impairment test, we determine that an impairment indicator exists it could result in a material impairment charge to our statement of operations.

Revenue Recognition .    Revenue is a key component of our results of operations. We follow the provisions of the Securities and Exchange Commission’s Staff Accounting Bulletin No. 104 (SAB No. 104), Revenue

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Recognition , and EITF 00-21, Accounting for Revenue Arrangements with Multiple Deliverables . In accordance with SAB No. 104, we recognize revenue related to research activities as they are performed, so long as there is persuasive evidence of an arrangement, the fee is fixed or determinable and collection of the related receivable is probable.

We analyze our multiple-element arrangements entered into since July 2003 to determine whether the elements can be separated and accounted for individually as separate units of accounting in accordance with EITF No. 00-21 . We recognize license payments as revenue when received if the license has stand-alone value and the fair value of the undelivered items can be determined. If the license is considered to have stand-alone value but the fair value on any of the undelivered items cannot be determined, the license payments are recognized as revenue over the period of performance for such undelivered items or services.

Amounts received for license fees are deferred and recognized as services are performed over the performance period of the contract. Any obligations related directly to the receipt of a license fee are also deferred and recognized as services are performed over the performance period of the contract. Amounts received for milestones are recognized upon achievement of the milestone, as long as the milestone is deemed to be substantive and we have no other performance obligations with respect to that milestone. In the event that we have remaining performance obligations, the portion of the milestone payment equal to the lesser of the non-refundable cash received or the percentage of the services performed through that date multiplied by the total milestone payment would be recognized as revenue.

Based upon the application of our revenue recognition policies and our related estimates and judgments, we recognized $611,000 and $1,556,000 in revenue related to our collaboration with Genentech for the three- and nine-month periods ended September 30, 2004. For the three- and nine-month periods ended September 30, 2004, of these amounts, $310,000 and $931,000, respectively, were recognized under the amortization of $7,000,000 in license and maintenance fees received from Genentech and future maintenance fees of $2,000,000 that Genentech is obligated to pay us by July 2005. We expect that the remainder of the license fees will be recognized proportionately through October 2010 as the remaining services are performed. We recognized expenses of $68,000 for the nine-month period ended September 30, 2004, for the amortization of obligations related to these license fees. In addition, we recognized revenues of $301,000 and $625,000, respectively, relating to research and development services performed under the collaboration agreement with Genentech for the three- and nine-month periods ended September 30, 2004. We recognized $346,000 in revenue related to the amortization of the Genentech license fee in the third quarter of 2003.

Based upon the application of our revenue recognition policies and our related estimates and judgments, we recognized $736,000 and $1,717,000, respectively, in revenue related to our collaboration with Wyeth for the three- and nine-month periods ended September 30, 2004. These amounts consist of revenue of $75,000 and $192,000, respectively, for the three- and nine- month periods ended September 30, 2004, recognized under the amortization of a $1,500,000 license fee payment received from Wyeth in February 2004. We expect that the remainder of the license fee will be recognized proportionately through February 2009 as the remaining services are performed. We recognized expenses of $6,250 and $16,000, respectively, for the three- and nine-month periods ended September 30, 2004, for the amortization of obligations related to the license fee. In addition, we recognized $661,000 and $1,525,000, respectively, relating to research and development services performed under the collaboration agreement with Wyeth for the three- and nine-month periods ended September 30, 2004. Since our collaboration with Wyeth was not effective until February 2004, no revenue related to Wyeth was recognized in 2003.

Although we follow detailed guidelines in measuring revenue, certain judgments affect the application of our revenue policy. For example, in connection with our collaboration agreements with Genentech and Wyeth, we have recorded on our balance sheet short- and long-term deferred revenue based on our best estimate of when such revenue will be recognized. We have recorded short-term deferred revenue of $1,900,000 and long-term deferred revenue of $7,166,000 as of September 30, 2004. Short-term deferred revenue consists of amounts that are expected to be recognized as revenue by September 30, 2005. Amounts that we expect will not be recognized

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prior to September 30, 2005 are classified as long-term deferred revenue. However, this estimate is based on our current operating plan as of September 30, 2004. If our operating plan should change in the future, we may recognize a different amount of deferred revenue over the twelve-month period from October 1, 2004, through September 30, 2005.

The estimate of deferred revenue reflects management’s estimate of the period of our involvement in the collaboration. Our period of involvement is largely determined by the time to commercialize clinical candidates that we may co-develop with Genentech and our estimate of time to reach clinical development for candidates under our collaboration with Wyeth. Since the timing of clinical development is difficult to estimate, our estimates may change in the future. Such changes to estimates would result in a change in revenue recognition amounts. If these estimates and judgments change over the course of these agreements, it may affect the timing and amount of revenue that we recognize and record in future periods.

Valuation of investments in privately held companies.     We have investments in Aegera, Micromet and ES Cell International with carrying values of $167,000, $400,000 and $150,000, respectively. These investments are included in the “Deposits and other assets” category of our consolidated balance sheets. At each balance sheet date, we review these investments to determine whether the fair value of these investments is less than the carrying value and, if so, whether we should write-down the investment. These companies are not publicly traded and, therefore, determining the fair value of our investments in these companies involves significant judgment. We consider available information in estimating the fair value of these investments and, as of September 30, 2004, believe that the fair value of our investments is not less than their carrying value.

In January 2004, Micromet announced that it terminated one-third of its workforce as the result of a contract dispute with a co-development partner that resulted in a significant decrease of previously budgeted cash inflows in 2004. Accordingly, we concluded that the carrying value of our investment in Micromet common stock had been impaired as of December 31, 2003, and we reduced the carrying value to the estimated fair value of $400,000. As of September 30, 2004, we believe our investment in Micromet has not been further impaired. If the financial condition or results of Aegera or ES Cell decline significantly or if Micromet’s financial condition continues to decline, the fair value of these investments would likely decline and, as a result, we may have to record an impairment charge to the extent such impairment is deemed other than temporary.

Results of Operations

Three-Month Periods Ended September 30, 2004 and September 30, 2003

Revenues.     Revenues decreased $7,823,000, or 84%, to $1,486,000 for the three-month period ended September 30, 2004 as compared to $9,309,000 for the three-month period ended September 30, 2003. Revenues for the three-month period ended September 30, 2004 were derived primarily from revenue recognized under our collaborations with Genentech and Wyeth of $611,000 and $736,000, respectively. In addition, we recognized revenue of $139,000 for the three-month period ended September 30, 2004 under our sponsored research agreement with the Spinal Muscular Atrophy Foundation.

Revenues for the three-month period ended September 30, 2003 were derived primarily from $8,555,000 in previously deferred revenue that we recognized upon the termination of our product development and target research agreements with Micromet during the quarter. In addition, we recognized $346,000 related to our collaboration with Genentech.

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Research and Development Expenses.     Research and development expenses are summarized as follows:

The increase of $124,000 in research and development expenses for the three-month period ended September 30, 2004 was primarily due to the net effect of changes in spending in our research programs. First, we decreased spending by $452,000, or 100%, on other programs. Included in other programs were expenses incurred for contract research and development services performed under our diabetes cell therapy program that was partnered with ES Cell International. The contract research component of this collaboration ended in December 2003 and, accordingly, we are no longer incurring costs related to this program. In addition, costs related to our nervous system disorders program were reduced as compared to 2003. This reduction in costs was primarily attributable to significant cost reductions related to personnel, chemistry and supplies. These decreases were partially offset by increases in spending under our new discovery research programs initiated in 2004. We incurred costs of $139,000 for our spinal muscular atrophy program, which is under collaboration with Spinal Muscular Atrophy Foundation. We incurred $932,000 in expenses related to our other discovery research programs during the three-month period ended September 30, 2004. We incurred no expenses for either of these programs during the same period in 2003.

General and Administrative Expenses.     General and administrative expenses are summarized as follows:

The increase of $461,000 in general and administrative expenses for the three-month period ended September 30, 2004 was primarily due to increases in personnel costs of $76,000, consulting services of $246,000, and professional service fees of $330,000. The increase principally resulted from an increase in patent-related legal expenses, costs associated with various technology acquisition evaluations and an increase in personnel. These increases were offset by a decrease in other spending of $159,000, principally from temporary help and bank-related expenses.

Stock-based Compensation.     Stock-based compensation for the three-month period ended September 30, 2004 was $368,000 as compared to $291,000 for the three-month period ended September 30, 2003, an increase

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of $77,000, or 26%. The increase was primarily attributable to an increase of compensation expense recorded on options held by non-employees.

Amortization of Intangibles.     Amortization of intangible assets was $19,000 for each of the three-month periods ended September 30, 2004 and 2003.

Interest Income.     Interest income was comparable for the three-month periods ended September 30, 2004 and 2003 at $116,000 and $115,000, respectively.

Other Income.     Other income was $40,000 for the three-month period ended September 30, 2004 as compared to $65,000 for the three-month period ended September 30, 2003. For the three-month period ended September 30, 2004, other income consisted of an adjustment to an estimate of an amount payable to a former collaborator. Other income for the third quarter of 2003 consisted of a gain recognized on currency rate fluctuations on a euro-denominated note receivable from a former collaborator.

Interest Expense.     Interest expense for the three-month period ended September 30, 2004 was $102,000 as compared to $156,000 for the three-month period ended September 30, 2003, a decrease of $54,000, or 35%. The decrease in interest expense was attributable to a decrease in interest expense accrued under our capital lease and debt obligations. We recorded $62,000, for the three-month period ended September 30, 2003 under our capital lease and debt obligations. We recorded $8,000 in interest expense under such agreements during the three-month period ended September 30, 2004.

Accretion on Series A Convertible Exchangeable Preferred Stock.     We recorded no accretion of preferred stock dividend for either of the three-month periods ended September 30, 2004 and September 30, 2003.

Net Income/Loss Applicable to Common Stockholders.     As a result of the foregoing, we incurred a net loss applicable to common stockholders of $3,906,000 for the three-month period ended September 30, 2004 as compared to net income applicable to common stockholders of $4,550,000 for the three-month period ended September 30, 2003.

Nine-Month Periods Ended September 30, 2004 and September 30, 2003

Revenues .    Total revenues for the nine-month period ended September 30, 2004 were $3,462,000 as compared to $10,293,000 for the nine-month period ended September 30, 2003, a decrease of $6,831,000, or 66%. Revenues for the nine-month period ended September 30, 2004 were primarily derived from revenue recognized under our collaborations with Genentech and Wyeth of $1,556,000 and $1,717,000, respectively. In addition, we recognized revenue of $139,000 for the nine-month period ended September 30, 2004 under our sponsored research agreement with the Spinal Muscular Atrophy Foundation.

Revenues for the nine-month period ended September 30, 2003 were derived primarily from $8,555,000 in previously deferred revenue that we recognized upon the termination of our product development and target research agreements with Micromet AG during the quarter. In addition, we recognized $1,277,000 in revenue under a former collaboration with ES Cell and $360,000 related to our collaboration with Genentech.

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Research and Development Expenses.     Research and development expenses are summarized as follows:

The decrease of $425,000 in research and development expenses for the nine-month period ended September 30, 2004 was primarily due to the net effect of changes in spending in our research programs. First, we decreased spending by $1,622,000, or 100%, on other programs. Included in other programs were expenses incurred for contract research and development services performed under our diabetes cell therapy program that was partnered with ES Cell International. The contract research component of this collaboration ended in December 2003 and, accordingly, we are no longer incurring costs related to this program. In addition, costs related to our nervous system disorders program were reduced as compared to 2003. These decreases were partially offset by increases in spending under our cancer program, which is under collaboration with Genentech. The increase in expenses was primarily attributable to a $586,000 increase in chemistry expenses related to potential small molecule antagonist product candidates for the treatment of various cancers as well as increases in license fees, personnel costs and related lab supplies. Genentech is obligated to reimburse us for all chemistry costs incurred under our collaboration for 2004. In addition, we initiated new discovery research programs in 2004. We incurred costs of $139,000 for our spinal muscular atrophy program, which is under collaboration with Spinal Muscular Atrophy Foundation. We incurred $2,301,000 in expenses related to our other discovery research programs during the nine-month period ended September 30, 2004. We incurred no expenses for these programs during the same period in 2003.

General and Administrative Expenses.     General and administrative expenses are summarized as follows:

The increase of $1,269,000 in general and administrative expenses for the nine-month period ended September 30, 2004 was primarily due to an increase in personnel costs of $327,000, consulting services of $515,000 and professional services of $693,000. The increase principally resulted from expenses associated with a planned equity financing that was not completed during the first half of 2004, costs associated with various technology acquisition evaluations, an increase in legal patent expenses and an increase in personnel.

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Stock-based Compensation.     Stock-based compensation for the nine-month period ended September 30, 2004 was $1,059,000 as compared to $1,210,000 for the nine-month period ended September 30, 2003, a decrease of $151,000, or 12%. The decrease was primarily attributable to a decrease of compensation expense recorded on options to purchase common stock that were issued to employees below fair market value on August 18, 2000. As of August 18, 2004, all of these options became fully vested; therefore, no related additional expense will be recognized.

Amortization of Intangibles.     Amortization of intangible assets was $56,000 for each of the nine-month periods ended September 30, 2004 and 2003.

Interest Income.     Interest income was comparable for the nine-month periods ended September 30, 2004 and 2003 at $333,000 and $313,000, respectively.

Other Income.     Other income for the nine-month period ended September 30, 2004 was $233,000 as compared to $550,000 for the nine-month period ended September 30, 2003. For the nine-month period ended September 30, 2004, other income primarily consisted of an adjustment to an estimate of an amount payable to a former collaborator. For the nine-month period ended September 30, 2003, other income consisted primarily of a gain recognized on currency rate fluctuations on a euro-denominated note receivable from a former collaborator.

Interest Expense.     Interest expense for the nine-month period ended September 30, 2004 was $307,000 as compared to $570,000 for the nine-month period ended September 30, 2003, a decrease of $263,000, or 46%. The decrease in interest expense was attributable to a decrease in interest expense accrued under our convertible note payable to Elan Pharma International Limited, or EPIL, an affiliate of Elan Corporation, and lower interest expense on capital lease and debt obligations. We recorded $137,000 and $211,000, respectively, for the nine-month periods ended September 30, 2004 and 2003 under the convertible note payable to EPIL. The decrease in interest expense under this note was due to a decrease in the average outstanding balance of this note payable for the nine-month period ended September 30, 2004 as compared to the nine-month period ended September 30, 2003. We recorded interest expense of $112,000 for the nine-month period ended September 30, 2003 under our debt obligations. We recorded $8,000 in interest expense under an outstanding letter of credit during the three-month period ended September 30, 2004. The decrease in interest expense was partially attributable to the full repayment in December 2003 of a note payable to the Boston Private Bank & Trust Company. In addition, interest expense recorded under our capital lease obligations decreased to $16,000 for the nine-month period ended September 30, 2004 from $102,000 for the nine-month period ended September 30, 2003.

Accretion on Series A Convertible Exchangeable Preferred Stock.     We recorded no accretion of preferred stock dividend for the nine-month period ended September 30, 2004 as compared to $271,000 for the nine-month period ended September 30, 2003. This charge relates to the accretion of a mandatory 6% dividend on shares of convertible exchangeable preferred stock issued to an affiliate of Elan Corporation. As part of our termination agreement with Elan Corporation, the preferred stock was cancelled on May 16, 2003. The accretion of preferred stock is included in the net loss applicable to common stockholders for nine-month period ended September 30, 2003.

Net Loss Applicable to Common Stockholders.     As a result of the foregoing, we incurred a net loss applicable to common stockholders of $12,245,000 for the nine-month period ended September 30, 2004 as compared to net loss applicable to common stockholders of $4,959,000 for the nine-month period ended September 30, 2003.

Liquidity and Capital Resources

We have financed our operations primarily through license fees, research and development funding from our collaborative partners, the private and public placement of our equity securities, debt financings and the monetization of certain royalty rights.

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At September 30, 2004, our principal sources of liquidity consisted of cash, cash equivalents and marketable securities of $30,934,000. Our cash and cash equivalents are highly liquid investments with a maturity of three months or less at date of purchase and consist of time deposits and investments in money market funds with commercial banks and financial institutions, short-term commercial paper, and government obligations. We also maintain cash balances with financial institutions in excess of insured limits. However, we do not anticipate any losses with respect to such cash balances. Our marketable securities are investments with original maturities of greater than three months, but less than twelve months, and consist of commercial paper, corporate debt securities, and government obligations.

The use of our cash flows for operations has primarily consisted of salaries and wages for our employees, facility and facility-related costs for our office and laboratory, fees paid in connection with preclinical studies, laboratory supplies, consulting fees, and legal fees. To date, the source of our cash flows from operations has been payments received from our collaborative partners. In general, our only source of cash flows from operations for the foreseeable future will be the up-front license payments, payments for the achievement of milestones, and funded research and development that we may receive under collaboration agreements. The timing of any new collaboration agreements and any payments under collaboration agreements cannot be easily predicted and may vary significantly from quarter to quarter.

Net cash used in operating activities was $7,447,000 for the nine-month period ended September 30, 2004 as compared to $6,076,000 for the nine-month period ended September 30, 2003. Cash used in operating activities during the nine-month period ended September 30, 2004 was primarily the result of our net loss for the period partially offset by non-cash charges including stock-based compensation, depreciation and non-cash interest expense. In addition, increases in operating cash as a result of changes in certain current assets and liabilities during the nine-month period ended September 30, 2004, including a $1,500,000 up-front payment received for a licensing agreement with Wyeth and a $2,000,000 maintenance fee payment received from Genentech, further offset our net loss. We expect that our cash used in operations will continue to increase as we continue to seek to develop our products toward clinical trials and advance new products into preclinical development. We also expect that the increase in cash used will be offset by anticipated payments made under our collaborations with Genentech, Wyeth and the Spinal Muscular Atrophy Foundation, assuming these collaborations continue in accordance with their terms.

Net cash used in operating activities during the nine-month period ended September 30, 2003 was primarily the result of our net loss for the period and an increase in long-term receivables related to Genentech, which were partially offset by non-cash charges including stock-based compensation, depreciation and non-cash interest expense.

Investing activities used cash of $7,243,000 for the nine-month period ended September 30, 2004 as compared to $1,427,000 provided in the nine-month period ended September 30, 2003. Cash used in investing activities resulted principally from $6,201,000 in net investment purchases and $1,043,000 in fixed asset purchases for the nine-month period ended September 30, 2004. We expect we will continue to use cash in our investing activities as we expand our infrastructure. For the nine-month period ended September 30, 2003, cash provided from investing activities resulted principally from $1,498,000 in net investment sales.

Financing activities provided approximately $3,531,000 of cash for the nine-month period ended September 30, 2004, resulting primarily from the sale of $3,272,000 of our common stock, including $1,500,000 from the sale of 315,524 shares to Wyeth and $1,567,000 in proceeds received upon stock option exercises. In addition, proceeds from the issuance of debt for the purchase of fixed assets provided $592,000 for the nine-month period ended September 30, 2004. These increases were offset by $332,000 in repayments of obligations under capital leases. We expect our cash flows provided by financing activities to increase for the remainder of 2004, as we continue to borrow against our loan agreement.

Financing activities provided approximately $11,736,000 of cash for the nine-month period ended September 30, 2003, resulting primarily from $14,367,000 received in issuances of common stock, including

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$9,829,000 in net proceeds from our August 2003 private placement of common stock, $3,500,000 in common stock purchased by Genentech as part of our collaboration and $1,006,000 received by the exercise of stock options. These cash inflows were partially offset by repayments of obligations under capital lease and debt arrangements of $2,609,000.

On October 14, 2004, we completed a registered direct offering of 5,476,559 shares of newly issued common stock, together with warrants to purchase 0.10 shares of common stock for each share of common stock purchased, at a purchase price of $3.67 per share to institutional and accredited investors. The warrants to purchase an aggregate of 547,656 shares of common stock expire on October 14, 2009 and are exercisable at $4.59 per share. The transaction provided us approximately $18,868,000 in net proceeds (exclusive of any proceeds we may receive upon exercise of the warrants). The shares of common stock and warrants to purchase common stock offered by us in this transaction were registered under our existing shelf registration statement on Form S-3 which was declared effective by the Securities and Exchange Commission on January 7, 2004.

Effective January 20, 2004, we entered into a loan agreement with the Boston Private Bank & Trust Company to finance up to $1,250,000 in purchases of equipment and facility leasehold improvements from December 1, 2003 until January 20, 2005. In June 2004, we financed $592,000 for purchases of equipment that accrue interest at a variable rate of 5.75% as of September 30, 2004. Under the terms of the loan agreement, we can request periodic financings for qualifying purchases of equipment and leaseholds through January 20, 2005. Until such time, we will pay interest only on any borrowings on a monthly basis in arrears. We then have the option to either repay the then outstanding balance in full or convert the then outstanding balance into a 36-month term note that bears interest at either a variable rate (5.75% as of September 30, 2004) or a fixed rate (6.46% as of September 30, 2004) for the repayment period. As of September 30, 2004, we consider this obligation to be short-term since we have not yet exercised the option to convert the balance to a term note. The loan is secured by any equipment and leaseholds purchased with the proceeds of the loan.

Effective September 23, 2004, we amended the loan agreement originally entered into with Boston Private Bank & Trust Company on January 20, 2004. The loan was amended to (i) increase the maximum facility amount from $1,250,000 to $2,250,000, (ii) extend the period under which we may finance purchases of equipment and leasehold improvements to February 28, 2005 from January 20, 2005, (iii) increase the allowable percentage of overall borrowings attributable to the purchase of leasehold improvements from 25% to 100%, and (iv) increase the security under the loan to all of our property, plant and equipment assets, except for those that are affixed to the property and those that are purchased after February 20, 2005 under purchase money arrangements with equipment lenders.

Effective September 7, 2004, we entered into a sponsored research agreement with the Spinal Muscular Atrophy Foundation. Under the agreement, the Foundation will grant to us up to $5,364,000 over a three-year period for identification of therapeutic compounds to treat spinal muscular atrophy. As of September 30, 2004, we had received $498,000 from the Foundation.

Effective February 2004, we licensed our Hedgehog proteins and small molecule Hedgehog pathway agonists to Wyeth for therapeutic applications in the treatment of diseases and disorders in humans with the primary focus of the research program on the treatment of neurological and other disorders pursuant to the terms of a collaboration, research, and license agreement. The collaboration agreement provides for cash payments from Wyeth, including a license fee of $1,500,000 which was received in February 2004, and milestone payments at various intervals during the regulatory approval process of Hedgehog proteins and small molecule Hedgehog pathway agonist candidates, assuming specified research objectives are met. Wyeth is also obligated to pay us a royalty on potential future product sales. We are recognizing revenue related to the $1,500,000 license fee over our estimated period of involvement related to the collaboration of five years. Under our current operating plan, we expect to recognize approximately $150,000 for the remainder of 2004 related to the license fee payment. Under the terms of the collaboration agreement, Wyeth is obligated to provide financial support of our research under the collaboration for a minimum of two years. For the nine-month period ended September 30, 2004, Wyeth has paid us $1,280,000 for research and development services.

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In June 2003, we licensed our small molecule and antibody Hedgehog pathway antagonists to Genentech for human therapeutic use with the primary focus of the research plan to develop applications in cancer therapy. The collaborative research, development and license agreement provides for cash payments from Genentech, including an up-front payment of $5,000,000, maintenance fee payments totaling $4,000,000 over the first two years of the collaboration and milestone payments at various intervals during the regulatory approval process of small molecule and antibody product candidates, assuming specified clinical development objectives are met. In July 2004, we received the first of two maintenance payments in the amount of $2,000,000. Genentech is also obligated to pay us a royalty on potential future product sales, if any. Under the terms of the collaboration agreement, we are required to commit eight employees to the small molecule and/or antibody Hedgehog pathway antagonist programs for a period of two years. We are recognizing revenue related to the $5,000,000 up-front payment and the $4,000,000 maintenance fee payments receivable over our estimated period of involvement related to the collaboration of seven and a quarter years. Under our current operating plan, we expect to recognize approximately $310,000 for the remainder of 2004 related to these payments.

On May 16, 2003, we and affiliates of Elan Corporation entered into a termination agreement to conclude the joint venture that was originally formed in July 2001. As part of the termination, we entered into an amended and restated convertible note payable with EPIL with the principal amount of $3,000,000. The terms of the amended and restated note were substantially the same as those under the original note, except that the interest rate was reduced from 8% to 6% and the conversion rate was increased from $8.63 to $10.00. As of September 30, 2004, there was approximately $3,252,000, including approximately $252,000 in accrued interest, outstanding under this convertible note payable.

On June 26, 2001, we received $2,000,000 from Becton Dickinson under a convertible subordinated note payable in connection with the exercise by Becton Dickinson of an option to negotiate a collaboration agreement. The note is repayable at any time up to its maturity date of June 26, 2006 by us, at our discretion, in either cash or upon issuance to Becton Dickinson of shares of our common stock. The note bears interest at 7%. As of September 30, 2004, there was approximately $2,457,000, including approximately $457,000 in accrued interest, outstanding under the note agreement.

In addition to our loan agreement, we also have contractual obligations related to our facility lease, research services agreements, consulting agreements, and license agreements. The following table summarizes our contractual obligations at September 30, 2004 and the effects such obligations are expected to have on our liquidity and cash flows for the remainder of 2004 and future periods:

We anticipate that existing capital resources at September 30, 2004, together with the proceeds of our registered direct offering which was completed in October 2004, should enable us to maintain current and planned operations into the second half of 2007, including spending related to the potential exercise of our co-development option with Genentech. We expect to incur substantial additional research and development and other costs, including costs related to preclinical studies and clinical trials for the foreseeable future. Our ability

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to continue funding planned operations beyond the second half of 2007 is dependent upon the success of our collaborations, our ability to maintain or reduce our cash burn rate and our ability to raise additional funds through equity or debt financings, or from other sources of financing. Our ability to generate sufficient cash flows depends on a number of factors, including the ability of either us, or our collaborators, to obtain regulatory approval to market and commercialize products to treat indications in major commercial markets. We are seeking additional collaborative arrangements and also expect to raise funds through one or more financing transactions, if conditions permit. Due to our significant long-term capital requirements, we intend to seek to raise funds through the sale of debt or equity securities when conditions are favorable, even if we do not have an immediate need for additional capital at such time. Additional financing may not be available or, if available, it may not be available on favorable terms. In addition, the sale of additional debt or equity securities could result in dilution to our stockholders. If substantial additional funding is not available, our ability to fund research and development and other operations will be significantly affected and, accordingly, our business will be materially and adversely affected.

Off-Balance Sheet Arrangements

We have no off-balance sheet arrangements as of September 30, 2004.

Risk Factors That May Affect Results

This Quarterly Report on Form 10-Q and certain other communications made by us contain forward-looking statements, including statements about our future operating results, discovery and development of products and current and potential strategic alliances. For this purpose, any statement that is not a statement of historical fact should be considered a forward-looking statement. We often use the words “believe,” “anticipate,” “plan,” “expect,” “intend” and similar expressions to help identify forward-looking statements.

There are a number of important factors that could cause our actual results to differ materially from those indicated or implied by forward-looking statements. Factors that could cause or contribute to such differences include those discussed below, as well as those discussed elsewhere in this Form 10-Q. We disclaim any intention or obligation to update or revise any forward-looking statements, whether as a result of new information, future events or otherwise.

RISKS RELATING TO OUR FINANCIAL RESULTS AND NEED FOR FINANCING

We have incurred substantial losses, we expect to continue to incur substantial losses and we may never achieve profitability.

We expect to incur substantial operating losses for the foreseeable future, and we have no current sources of material ongoing revenue. As of September 30, 2004, we had an accumulated deficit of approximately $661,313,000. Other than OP-1, which we and Stryker commercialized under a former collaboration, we have not commercialized any products to date, either alone or with a third party collaborator. If we are not able to commercialize any products, whether alone or with a collaborator, we will not achieve profitability. Even if our collaboration agreements provide funding for a portion of our research and development expenses for some of our programs, we expect to spend significant capital to fund our internal research and development programs for the foreseeable future. As a result, we will need to generate significant revenues in order to achieve profitability. We cannot be certain whether or when this will occur because of the significant uncertainties that affect our business. Our failure to become and remain profitable may depress the market price of our common stock and could impair our ability to raise capital, expand our business, diversify our product offerings or continue our operations.

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We will require additional financing, which may be difficult to obtain and may dilute your ownership interest in us.

We will require substantial funds to continue our research and development programs. We believe that our existing cash and working capital, together with the proceeds of our registered direct offering which closed October 2004, should be sufficient to fund our operations until the second half of 2007, however, our future capital requirements may vary from what we expect. There are factors that may affect our future capital requirements and accelerate our need for additional financing. Many of these factors are outside our control, including the following: