UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q

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  ý No  o

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).  Yes  ý No  o

Applicable Only to Corporate Issuers

The number of outstanding shares of the registrant’s Common Stock, $0.0001 par value, was 83,966,223 on October 29, 2004.

NEKTAR THERAPEUTICS

INDEX

Forward-Looking Statements

This report includes “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933, as amended (the “1933 Act”) and Section 21E of the Securities Exchange Act of 1934, as amended (the “1934 Act”). All statements other than statements of historical fact are “forward-looking statements” for purposes of this report, including any projections of earnings, revenues or other financial items, any statements of the plans and objectives of management for future operations, any statements concerning proposed new products or services, any statements regarding future economic conditions or performance and any statement of assumptions underlying any of the foregoing. In some cases, forward-looking statements can be identified by the use of terminology such as “may,” “will,” “expects,” “plans,” “anticipates,” “estimates,” “potential,” or “continue,” or the negative thereof or other comparable terminology. Although we believe that the expectations reflected in the forward-looking statements contained in this report are reasonable, there can be no assurance that such expectations or any of the forward-looking statements will prove to be correct and actual results could differ materially from those projected or assumed in the forward-looking statements. Our future financial position and results of operations, as well as any forward-looking statements, are subject to inherent risks and uncertainties, including but not limited to the cautionary factors set forth in this report and for the reasons described elsewhere in this report. All forward-looking statements and reasons why results may differ included in this report are made as of the date hereof and we do not intend to update any forward-looking statements except as required by law or applicable regulations.

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PART I:  FINANCIAL INFORMATION

Item 1. Condensed Consolidated Financial Statements – unaudited:

NEKTAR THERAPEUTICS

CONDENSED CONSOLIDATED BALANCE SHEETS

(In thousands, except per share information)

(*)                                 The balance sheet at December 31, 2003 has been derived from the audited financial statements at that date, which are included in our Form 10-K, as amended, for the year ended December 31, 2003 as filed with the Securities and Exchange Commission. This balance sheet does not include all the information and footnotes required by accounting principles generally accepted in the United States for complete financial statements.

See accompanying notes.

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NEKTAR THERAPEUTICS

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(In thousands, except per share information)

(unaudited)

See accompanying notes.

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NEKTAR THERAPEUTICS

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(In thousands)

(unaudited)

See accompanying notes.

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NEKTAR THERAPEUTICS

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

September 30, 2004

(unaudited)

Note 1—Organization and Summary of Significant Accounting Policies

Organization and Basis of Presentation

Nektar Therapeutics was originally incorporated in California in July 1990 under the name Inhale Therapeutic Systems, Inc.  We were reincorporated in Delaware in 1998.  On January 15, 2003 we changed our name from Inhale Therapeutic Systems, Inc. to Nektar Therapeutics. 

We are working to become one of the world’s leading drug delivery products based companies by providing a portfolio of technologies and expertise that is intended to enable us and our pharmaceutical and biotechnology partners to improve drug performance throughout the drug development process.  We are focused on three main technologies: Nektar Advanced PEGylation Technology, Nektar Pulmonary Technology, and Nektar Supercritical Fluids Technology. 

We prepared the condensed consolidated financial statements following the requirements of the Securities and Exchange Commission (“SEC”) for interim reporting.  As permitted under those rules, certain footnotes or other financial information that are normally required by generally accepted accounting principles in United States of America (“U.S. GAAP”) can be condensed or omitted.  In the opinion of management, the financial statements include all normal and recurring adjustments that are considered necessary for the fair presentation of our financial position and operating results.  Certain reclassifications have been made to prior year amounts to conform to current period presentation.

Revenues, expenses, assets and liabilities can vary during each quarter of the year. Therefore, the results and trends in these interim financial statements may not be the same as those for the full year. The information included in this quarterly report on Form 10-Q should be read in conjunction with the consolidated financial statements and accompanying notes included in our Annual Report on Form 10-K, as amended, for the year ended December 31, 2003.

Use of Estimates

The preparation of financial statements in conformity with U.S. GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period.  Actual results could differ from those estimates. 

Principles of Consolidation

Our consolidated financial statements include the financial position and results of operations and cash flows of our wholly-owned subsidiaries: Nektar Therapeutics AL, Corporation (“Nektar AL”), formerly Shearwater Corporation (“Shearwater”); Nektar Therapeutics UK, Ltd. (“Nektar UK”), formerly Bradford Particle Design Ltd.  (“Bradford”); and Inhale Therapeutic Systems Deutschland GmbH (“Inhale Germany”).  As of December 31, 2003 our consolidated financial statements also included the financial statements of Inhale 201 Industrial Road, L.P., a real estate partnership in San Carlos, California and Shearwater Polymers, LLC, a real estate partnership in Alabama.  As of September 30, 2004, these real estate partnerships were dissolved and are no longer included in our consolidated financial statements (see notes 8 and 9).

Our consolidated financial statements are denominated in U.S. dollars.  Accordingly, changes in exchange rates between the applicable foreign currency and the U.S. dollar will affect the translation of each foreign subsidiary’s financial results into U.S. dollars for purposes of reporting our consolidated financial results.  The process by which each foreign subsidiary’s financial results are translated into U.S. dollars is as follows: income statement accounts are translated at average exchange rates for the period; balance sheet asset and liability accounts are translated at end of period exchange rates; and equity accounts are translated at historical exchange rates.  Translation of the balance sheet in this manner results in an accumulated other comprehensive gain/loss of the stockholders’ equity section.  To date, such cumulative translation adjustments have not been material to our consolidated financial position. 

Significant Concentrations

Cash equivalents and short-term investments are financial instruments that potentially subject us to concentration of risk to the extent of the amounts recorded in the consolidated balance sheet.  We limit our concentration of risk by limiting the credit risk, term, and

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dollar amount of each of our individual investments.  Our professional portfolio managers adhere to our investment policy as approved by our Board of Directors.

Our customers are primarily pharmaceutical and biotechnology companies that are typically located in the U.S. and Europe. All of our accounts receivable are denominated in U.S. dollars.  Our accounts receivable balance contains trade receivables from product sales and collaborative research agreements.  At September 30, 2004, four customers represented approximately 77% of our accounts receivable, and at December 31, 2003, one customer represented approximately 63% of our accounts receivable.  We have not experienced significant credit losses from our accounts receivable or collaborative research agreements, and none is currently expected.  We perform a regular review of our customers’ payment history and credit risks and do not require collateral from our customers. 

In addition, we are dependent on our partners, vendors and contract manufacturers to provide raw materials, drugs and devices of appropriate quality and reliability and to meet applicable regulatory requirements.  Consequently, in the event that supplies are delayed or interrupted for any reason, our ability to develop our products could be impaired, which could have a material adverse effect on our business, financial condition and results of operation. 

We are dependent on Pfizer Inc. for a significant source of our revenue.  Revenue from Pfizer represented 59% of our revenue for both the three-month and nine-month periods ended September 30, 2004, and 59% and 62% for the three-month and nine-month periods ended September 30, 2003, respectively. 

If terminated, of our collaboration with Pfizer, under which we develop and manufacture Exubera® (inhaled insulin) for Pfizer, could have a material adverse effect on our financial position and results of operation.  Should the Pfizer collaboration be discontinued prior to any commercial launch of Exubera®, we would need to find alternative funding sources to replace the collaboration revenue we currently receive from them and we would need to reassess the realizability of our capitalized assets.  Additionally, we may have to reimburse our device contract manufacturers for their capital outlay to the extent that they cannot re-deploy their assets.  At the present time, it is not possible to estimate the potential loss that could occur as a result of these obligations.

Recent Accounting Pronouncements

In March 2004 the Financial Accounting Standards Board’s (“FASB”) Emerging Issues Task Force (“EITF”) reached a consensus on EITF 03-01, The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments.  EITF 03-01 provides guidance regarding disclosures about unrealized losses on available-for-sale debt and equity securities accounted for under Statement of Financial Accounting Standard (“SFAS”) No. 115, Accounting for Certain Investments in Debt and Equity Securities. The guidance for evaluating whether an investment is other-than-temporarily impaired should be applied in other-than-temporary impairment evaluations made in reporting periods beginning after June 15, 2004.  In September 2004, the EITF delayed the effective date for the measurement and recognition guidance.  We are in the process of evaluating the effect of adopting EITF 03-1.

Cash, Cash Equivalents and Investments

We consider all highly liquid investments with a maturity at the date of purchase of three months or less to be cash equivalents.  Cash and cash equivalents include demand deposits held in banks, interest bearing money market funds, commercial paper, and repurchase agreements.  All other investments are classified as short-term investments.  Short-term investments consist of federal and municipal government securities, corporate bonds and commercial paper with A1, F1, or P1 short-term ratings and A or better long-term ratings with remaining maturities at date of purchase of greater than 90 days and less than two years. 

At September 30, 2004, we held British Pounds valued at approximately $2.6 million in a U.S. bank account, using the exchange rate as of period end.  During the three-month period ended September 30, 2004, an immaterial amount of losses resulting from revaluing British Pounds at the current exchange rate were included in other income/(expense).

At September 30, 2004, all short-term investments are designated as available-for-sale and are carried at fair value, with unrealized gains and losses reported in stockholders’ equity as accumulated other comprehensive income/(loss).  Short-term investments are adjusted for amortization of premiums and accretion of discounts to maturity.  Such amortization is included in interest income.  Realized gains and losses and declines in value judged to be other-than-temporary on available-for-sale securities, if any, are included in other income/(expense).  The cost of securities sold is based on the specific identification method.  Interest and dividends on securities classified as available-for-sale are included in interest income. 

Inventories

Inventories consist primarily of raw materials, work-in-process and finished goods of Nektar AL.  Inventories are stated at the lower of cost (first-in, first-out method) or market.  Cost is computed using standard cost, which approximates actual costs on a

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first-in, first-out basis.  Inventories are reflected net of a reserve of $3.1 million and $1.6 million as of September 30, 2004 and December 31, 2003, respectively.  Reserves are determined using specific identification plus an estimated reserve against finished goods for potential defective or excess inventory based on historical experience. 

Inventories consist of the following (in thousands):

Property and Equipment

Property and equipment are stated at cost.  Major improvements are capitalized, while maintenance and repairs are expensed when incurred.  Laboratory and other equipment are depreciated using the straight-line method over estimated useful lives of three to seven years.  Leasehold improvements and buildings are depreciated using the straight-line method over the shorter of the estimated useful life or the remaining term of the lease.  Certain amounts have been expensed for plant design, engineering and validation costs based on our evaluation that it is unclear whether such costs are ultimately recoverable.   These assets may become fully recoverable only if and when Exubera® is approved by the appropriate regulatory agencies and commercial production commences.

Goodwill

Goodwill is tested for impairment at least annually, or on an interim basis if an event occurs or circumstances change that would more-likely-than-not reduce the fair value below our carrying value.  Goodwill is tested for impairment using a two-step approach.  The first step is to compare our fair value to our carrying amount, including goodwill.  If the fair value is greater than the carrying amount, goodwill is not considered impaired and the second step is not required.  If the fair value is less than the carrying amount, the second step of the impairment test measures the amount of the impairment loss, if any.  The second step of the impairment test is to compare the implied fair value of goodwill to its carrying amount.  If the carrying amount of goodwill exceeds its implied fair value, an impairment loss is recognized equal to that excess.  The implied fair value of goodwill is calculated in the same manner that goodwill is calculated in a business combination, whereby the fair value is allocated to all of the assets and liabilities (including any unrecognized intangible assets) as if they had been acquired in a business combination and the fair value was the purchase price.  The excess “purchase price” over the amounts assigned to assets and liabilities would be the implied fair value of goodwill. 

We perform our annual test as of October 1st of each year, which, to date, has not resulted in an impairment charge.  We will perform this test annually or more frequently if indicators of potential impairment exist.  

Other Intangible Assets

Acquired technology and other intangible assets with definite useful lives are amortized on a straight-line basis over their estimated useful lives which we currently estimate to be a period of five to seven years.  Acquired technology and other intangible assets are tested for impairment whenever events or changes in circumstances indicate the carrying amount of the assets may not be recoverable from future undiscounted cash flows.  If impaired, asset values are adjusted to fair value.  Acquired technology and other intangible assets include proprietary technology, intellectual property, and supplier and customer relationships acquired from third parties or in business combinations. 

We periodically evaluate whether changes have occurred that would require revision of the remaining estimated useful lives of these assets or otherwise render the assets unrecoverable.  If such an event occurred, we would determine whether the other intangibles are impaired.  To date, no such impairment losses have been recorded. 

Interest Rate Swap

In September 2004, we retired a bank loan with a remaining principal balance of $5.6 million.  The loan had been secured by one of our Nektar AL facilities in Alabama.  This loan originally had a variable rate of interest tied to the LIBOR index.  In November 2003, we entered into an interest rate swap agreement to limit our exposure to fluctuations in U.S. interest rates.  We retired this interest rate swap agreement by paying $0.3 million to the lender, representing the fair value of this instrument on that date which was equal to the swap liability recorded on our books.

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Comprehensive Loss

Comprehensive loss is comprised of net loss and other comprehensive gain/(loss).  Other comprehensive loss includes unrealized gains/(losses) on available-for-sale securities and translation adjustments.  The comprehensive loss consists of the following components (in thousands):

The components of accumulated other comprehensive income is as follows (in thousands):

Stock-Based Compensation

We apply the recognition and measurement principles of APB Opinion No. 25, Accounting for Stock Issued to Employees, and related Interpretations in accounting for those plans.  Under this opinion, no stock-based employee compensation expense is charged for options that were granted at an exercise price that was equal to the market value of the underlying common stock on the date of grant.  Pro forma information regarding net income and earnings per share is required by SFAS No. 123, Accounting for Stock Based Compensation, as amended by SFAS No. 148, which also requires that the information be determined as if we had accounted for our employee stock options and shares granted through our employee stock purchase plan under the fair value method of that statement.  The fair value for these options was estimated at the date of grant using a Black-Scholes option-pricing model with the following weighted-average assumptions:

The Black-Scholes options valuation model was developed for use in estimating the fair value of traded options, which have no vesting restrictions and are fully transferable.  In addition, option valuation models require the input of highly subjective assumptions including the expected stock price volatility.  We have presented the pro forma net loss and pro forma basic and diluted net loss per common share using the assumptions noted above. 

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The following table illustrates the effect on net income and earnings per share if we had applied the fair value recognition provisions of SFAS Nos. 123 and 128 to stock-based employee compensation (in thousands, except per share information):

Stock compensation expense for options granted to non-employees has been determined in accordance with SFAS No. 123 and EITF No. 96-18 as the fair value of the consideration received or the fair value of the equity instruments issued, whichever is more reliably measured. The fair value of options granted to non-employees is re-measured as the underlying options vest and are included in our reported net loss.

Revenue Recognition

Our research revenue is derived primarily from customers in the pharmaceutical and biotechnology industries and consists of reimbursement of development costs, reimbursement of certain expenses, payment for clinical supplies, and amortization of milestones.

Revenue is recognized when there is persuasive evidence that an arrangement exists, delivery has occurred, the price is fixed and determinable, and collectability is reasonably assured.  Allowances, if any, are established for uncollectible amounts, estimated product returns, and discounts.  Payments received for milestones achieved are deferred and recorded as revenue ratably over the next period of continued development.   Contract revenue from collaborative research agreements is recorded when earned based on the performance requirements of the contract.   Advance payments for research and development revenue received in excess of amounts earned are classified as deferred revenue until earned.  Revenue from grants and feasibility arrangements are recognized as the related costs are incurred.  Costs of contract research revenue approximate such revenue and are included in research and development expenses.

Consideration received for revenue arrangements with multiple deliverables is allocated among these deliverables based on objective and reliable evidence of each deliverable’s fair value using available internal or third party evidence.  Revenue from non-refundable upfront license fees and certain guaranteed payments where we have continuing involvement through collaborative development efforts are deferred and recognized as revenue over the period of continuing involvement.  

Research and Development

Research and development expenses are associated with three general categories: (i) collaborative agreements under which spending is reimbursed by our partners; (ii) spending attributed to internally funded programs; and (iii) commercial readiness and infrastructure costs associated with commercial operations for our drug and third-party device manufacturing.  Research and development costs are expensed as incurred and include salaries, benefits, and other operating costs. 

Net Loss Per Share

Basic net loss per share is calculated based on the weighted-average number of common shares outstanding during the periods presented.  Diluted earnings per share would give effect to the dilutive impact of common stock equivalents which consist of convertible preferred stock and convertible subordinated debt (using the as-if converted method), and stock options and warrants (using the treasury stock method).  Potentially dilutive securities have been excluded from the diluted earnings per share computations in all years presented as such securities would have an anti-dilutive effect on net loss per share due to our net loss for all periods presented.

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Accounting for Income Taxes

We account for income taxes under SFAS No. 109, Accounting for Income Taxes.  Under SFAS No. 109, the liability method is used in accounting for income taxes.  Under this method, deferred tax assets and liabilities are determined based on differences between financial reporting and tax reporting bases of assets and liabilities and are measured using enacted tax rates and laws that are expected to be in effect when the differences are expected to reverse.  Realization of deferred tax assets is dependent upon future earnings, if any, the timing and amount of which are uncertain. Because of our lack of earnings history, the net deferred tax assets have been fully offset by a valuation allowance. 

Note 2 - Segment, Significant Customer and Geographic Information

We report segment information in accordance with SFAS No. 131, Disclosures About Segments of an Enterprise and Related Information.  The Company is managed as one business segment.  The entire business is comprehensively managed by a single management team that reports to the Chief Executive Officer.  We have multiple technologies, all of which are marketed to a common customer base (pharmaceutical and biotechnology companies which are typically located in the U.S. and Europe). 

Our research revenue is derived primarily from customers in the pharmaceutical and biotechnology industries.  Revenue from Pfizer represented 59% of our revenue for both the three-month and nine-month periods ended September 30, 2004, and 59% and 62% for the three-month and nine-month periods ended September 30, 2003, respectively.  Product sales relate to the sale of our manufactured Advanced PEGylation Technology products by Nektar AL.

Our accounts receivable balance contains trade receivables from product sales and collaborative research agreements.  All of our accounts receivable are denominated in U.S. dollars.  At September 30, 2004, four customers represented approximately 77% of our accounts receivable, and at December 31, 2003 one customer represented approximately 63% of our accounts receivable. 

We primarily receive contract research revenue from, and provide product sales to, customers located within the United States and Europe.  Revenues are from the following geographic areas (in thousands):

Note 3 – Financial Instruments

As of September 30, 2004, we held a portfolio exclusively of debt securities.  Certain of these securities have a fair value less than their amortized cost.  In accordance with SFAS No. 115, Accounting for Certain Investments in Debt and Equity Securities and EITF 03-01, we have recorded the difference between the amortized cost and fair value as a component of accumulated other comprehensive income.  Management has concluded that no impairment should be recognized related to these investments because the unrealized losses incurred to date are not considered other than temporary.  Management has reached this conclusion based upon its intention to generally hold all debt investments to maturity at which point they are redeemed at full par value and our strategy of aligning of the maturity of our debt investments to meet our cash flow needs.  Therefore, we will, in most cases, have the ability to hold all of our debt investments to maturity.

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The following is a summary of operating cash and available-for-sale securities as of September 30, 2004 (in thousands):

The following is a summary of operating cash, held-to-maturity, and available-for-sale securities as of December 31, 2003 (in thousands):

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Note 4 - Other Intangible Assets

The components of our other intangible assets at September 30, 2004, are as follows (in thousands, except for years):

Amortization expense related to other intangible assets totaled $1.1 million for both of the three-month periods ended September 30, 2004 and 2003 and $3.4 million for both the nine-month periods ended September 30, 2004 and 2003.  The following table presents expected future amortization expense for other intangible assets until they are fully amortized (in thousands):

Note 5 - Commitments and Contingencies

On September 3, 2004, a purported securities class action entitled Rhodes v. Nektar Therapeutics et al., Case No. C 04 3735, was filed in the United States District Court for the Northern District of California against us, as well as our Chairman, Chief Executive Officer, and our President, Nektar AL.  The complaint alleges that the defendants made certain material misrepresentations to the market in violation of the federal securities laws, specifically Sections 10(b) and 20(a) of the Securities Exchange Act of 1934, and Rule 10b-5.  The named plaintiff seeks unspecified damages on behalf of a purported class of purchasers of our common stock during the period from March 4, 2004 through August 4, 2004.  No class has been certified in the above actions and no trial date has been scheduled.

This litigation may be costly and could prove to be time consuming and disruptive to normal business operations. There can be no assurance that we will prevail or that the cost of defending these lawsuits will be covered by our insurance policies. While it is not possible to predict accurately or to determine the eventual outcome of this litigation, an unfavorable outcome or settlement of this litigation could have a material adverse effect on our financial position, liquidity or results of operations. 

From time to time, we may be involved in other lawsuits, claims, investigations and proceedings, consisting of intellectual property, commercial, employment and other matters, which arise in the ordinary course of business. In accordance with the SFAS No. 5, Accounting for Contingencies, we make a provision for a liability when it is both probable that a liability has been incurred and the amount of the loss can be reasonably estimated. These provisions are reviewed at least quarterly and adjusted to reflect the impact of negotiations, settlements, ruling, advice of legal counsel, and other information and events pertaining to a particular case. Litigation is inherently unpredictable. If any unfavorable ruling were to occur in any specific period, there exists the possibility of a material adverse impact on the results of operations of that period or on our cash and/or liquidity.

Note 6 – Guarantees and Indemnifications

The following is a summary of our agreements, which we have determined are within the scope of FASB Interpretation (“FIN”) No. 45.  The guarantees presented below are not subject to the initial recognition and measurement provisions of FIN No. 45 and accordingly, we have not recorded any liability for these agreements as of September 30, 2004, except as noted below.

Indemnification of Directors, Executive Officers, Other Officers, Employees and Other Agents

As permitted under Delaware law, and as set forth in our Certificate of Incorporation and our Bylaws, we indemnify our directors, executive officers, other officers, employees, and other agents for certain events or occurrences that arose while in such capacity.  The maximum potential amount of future payments we could be required to make under this indemnification is unlimited; however, we have insurance policies that may limit our exposure and may enable us to recover a portion of any future amounts paid.  Assuming the applicability of coverage, the willingness of the insurer to assume coverage, and subject to certain retention, loss limits and

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other policy provisions, we believe any obligations under this indemnification are not material, other than an initial $500,000 per incident retention deductible per our insurance policy.  However, no assurances can be given that the covering insurers will not attempt to dispute the validity, applicability, or amount of coverage without expensive litigation against these insurers, in which case we may incur substantial liabilities as a result of these indemnification obligations. 

Lease Restoration

We currently lease certain facilities.  In the event that we do not exercise our option to extend the term of these leases, we guarantee certain costs to restore the property to certain conditions in place at the time of each lease.  We believe the estimated fair value of these guarantees is minimal. 

Strategic Alliance—Enzon

In January 2002, we announced a broad strategic alliance with Enzon Pharmaceuticals, Inc. that included a collaboration to develop up to three products using our Pulmonary Technology and/or Supercritical Fluids Technology.  Under the terms of the agreement, we are responsible for the development of drug formulations for the agreed upon pharmaceutical agents.  We are required to self-fund a portion of these costs.  As of September 30, 2004, we are required to fund up to an incremental $5.3 million in the coming years without reimbursement for research and development expenses.  To date these costs, amounting to $11.7 million, have been included in our research and development expenses.  After our funding requirement has been met, Enzon would have an option to license the products and if they exercise this option, they would be required to provide research and development funding as well as milestone payments should the products progress through clinical testing. 

Manufacturing and Supply Agreement with Contract Manufacturers

In August 2000, we entered into a Manufacturing and Supply Agreement with our contract manufacturers to provide for the manufacturing of our pulmonary inhaler device for Exubera®.  Under the terms of the Agreement, we may be obligated to reimburse the contract manufacturers for the actual unamortized and unrecovered portion of any equipment procured or facilities established and the interest accrued for their capital overlay in the event that Exubera® does not gain FDA approval to the extent that the contract manufacturers cannot re-deploy the assets.  While such payments may be significant, at the present time, it is not possible to estimate the loss that will occur should Exubera® not be approved.  We have also agreed to defend, indemnify and hold harmless the contract manufacturers from and against third party liability arising out of the agreement, including product liability and infringement of intellectual property.  There is no limitation on the potential amount of future payments we could be required to make under these indemnification obligations.  We have never incurred costs to defend lawsuits or settle claims related to these indemnification obligations.  If any of our indemnification obligations is triggered, we may incur substantial liabilities. 

Security Agreement with Pfizer Inc.

In connection with the Collaboration, Development, and License Agreement (“CDLA”) dated January 18, 1995 that we entered into with Pfizer Inc., for the development of Exubera®, we entered into a Security Agreement pursuant to which our obligations under the CDLA and certain Manufacturing and Supply Agreements related to the manufacture and supply of powdered insulin and pulmonary inhaler devices for the delivery of powdered insulin, are secured.  Our default under any of these agreements triggers Pfizer’s rights with respect to property relating solely to, or property used or which will be used solely in connection with, the development, manufacture, use and sale of Exubera®, including proceeds from the sale or other disposition of the property. 

Collaboration Agreements for Products Based on our Pulmonary Technology

As part of our collaboration agreements with our partners for the development, manufacture, and supply of products based on our Pulmonary Technology, we generally agree to defend, indemnify, and hold harmless our partners from and against third party liabilities arising out of the agreements, including product liability and infringement of intellectual property.  The term of these indemnification obligations is generally perpetual any time after execution of the agreements.  There is no limitation on the potential amount of future payments we could be required to make under these indemnification obligations.  We have never incurred costs to defend lawsuits or settle claims related to these indemnification obligations.  If any of our indemnification obligations is triggered, we may incur substantial liabilities. 

License, Manufacturing and Supply Agreements for Products Based on our Advanced PEGylation Technology

As part of our license, manufacturing and supply agreements with our partners for the development and/or manufacture and supply of PEG reagents based on our Advanced PEGylation Technology, we generally agree to defend, indemnify and hold harmless our partners from and against third party liabilities arising out of the agreements, including product liability and infringement of intellectual

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property.  The term of these indemnification obligations is generally perpetual any time after execution of the agreements.  There is no limitation on the potential amount of future payments we could be required to make under these indemnification obligations.  We have never incurred costs to defend lawsuits or settle claims related to these indemnification obligations.  If any of our indemnification obligations is triggered, we may incur substantial liabilities. 

Note 7 – Deferred Compensation

During the three-month period ended March 31, 2004, we issued restricted stock unit awards covering 206,666 shares of our common stock to certain officers.  The restricted stock unit awards are settled by delivery of shares of our common stock on or shortly after the date the awards vest.  The Purchase price of these restricted stock unit awards is $0.01 per share, whereas the fair market value of our common stock on the dates of grant ranged between $18.46 per share and $19.54 per share.  The restricted stock unit awards become fully vested over a period of 35 months.  In connection with these restricted stock unit awards, we recorded deferred compensation of $3.9 million, which represents the difference between the fair market value of our stock on the day of grant and the purchase price of $0.01 per share.  We are ratably expensing the deferred compensation on a monthly basis over the vesting term of 35 months.  For the three-month and nine-month periods ended September 30, 2004, we recognized expense related to these restricted stock unit awards of approximately $0.3 million and $0.9 million, respectively.

Note 8 – Redemption of Interest in Inhale 201 Partnership

In connection with a Contribution Agreement dated September 14, 2000 by and between Nektar and Bernardo Property Advisors, Inc., Nektar had contributed certain property located at 201 Industrial Road, San Carlos, CA to the Partnership in exchange for a limited partnership interest in the Partnership.  In addition, Nektar entered into a Build-to-Suit Lease with the Partnership (the “Lease”) with respect to the property contributed to the Partnership and the building subsequently built on such property, now occupied by Nektar as its headquarters (the “Building”).

Effective June 23, 2004, Nektar, SciMed Prop III, Inc. (the “General Partner”), Bernardo Property Advisors, Inc., and Inhale 201 Industrial Road Partnership (the “Partnership”) entered into a Redemption Agreement (the “Redemption Agreement”) with respect to Nektar’s limited partnership interest in the Partnership.  The Redemption Agreement provides for the redemption of Nektar’s limited partnership interest in the Partnership in exchange for a cash payment of $19.5 million from Bernardo Property Advisors, Inc. to Nektar, the repayment from Bernardo Property Advisors, Inc., to Nektar of a $3.0 million outstanding loan from Nektar to the Partnership, and a modification of the Lease.  The redemption contemplated by the Redemption Agreement and related transactions were subject to certain closing conditions which were met on August 18, 2004, resulting in the dissolution of the Partnership on that date.  As of September 30, 2004, we are no longer consolidating the Partnership as part of our consolidated financial statements.

Pursuant to the Redemption Agreement, Nektar and Bernardo Property Advisors, Inc., entered into an Amended and Restated Build-to-Suit Lease (the “Amended Lease”).  The Amended Lease provides for, among other things, a decrease in the term of Nektar’s obligations with respect to a portion of the Building not currently occupied by Nektar from 12 years to 3 years and the elimination of Nektar’s rights to occupy certain other space in the Building.

In accordance with FAS 98, Accounting for Leases, we recorded a capital lease asset and obligation equal to the fair market value of the leased asset of $25.5 million.  We also recorded a deferred gain on the sale-leaseback transaction of $12.7 million which is included in other long-term liabilities on the balance sheet.  In accordance with FAS 66, Accounting for Sales of Real Estate, this deferred gain was recorded as an other long-term liability and will be amortized over the term of the lease as a reduction to depreciation expense. 

Note 9 – Purchase of Nektar, AL Facility

On September 30, 2004, we purchased our Church Street facility in Alabama from Shearwater Polymers, LLC (“the LLC”) for $2.9 million.  The land and building were recorded as fixed assets at their fair market value as of the purchase date of $0.7 million and $2.2 million, respectively.

Nektar AL paid $0.1 million during each of the three-month periods ended September 30, 2004 and 2003, and $0.3 million during each of the nine-month periods ended September 30, 2004 and 2003, as rent to the LLC. The LLC was 4% owned by Nektar AL with the remaining 96% owned by Dr. J. Milton Harris.  Prior to March 4, 2004, Dr. Harris was one of our executive officers.  Both Nektar AL and Dr. Harris had jointly guaranteed a bank loan on the Nektar AL facility,  and the lease income from Nektar AL was the sole source of revenue for the LLC.  We had fully consolidated this entity in our consolidated financial statements since December 31, 2003, in accordance with FIN 46, Consolidation of Variable Interest Entities.  On September 30, 2004, the LLC paid the principal balance owed on the bank loan of $1.7 million, and Nektar was relieved of its guarantee. As of September 30, 2004, the LLC was dissolved and we are no longer consolidating the LLC as part of our consolidated financial statements.

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

The following discussion contains forward-looking statements that involve risks and uncertainties. Our actual results could differ materially from those discussed here. Factors that could cause or contribute to such differences include, but are not limited to, those discussed in this section as well as factors under the heading “Risk Factors” at the end of this section.

Overview

We are working to become one of the world’s leading drug delivery products based companies by providing a portfolio of technologies and expertise that will enable us and our pharmaceutical and biotechnology partners to improve drug performance throughout the drug development process.  To date the revenues we have received from the sales of our products and in connection with our collaborative arrangements have been insufficient to meet our operating and other expenses and we believe this will continue to be the case for several years.  To date, except for sales from certain products using Nektar Advanced PEGylation Technology, we have not sold any commercial products and do not anticipate receiving significant revenue from product sales or royalties in the near future.  The development of a successful product is dependent upon several factors that are outside of our control.   These include, among other things, the need to obtain regulatory approval to market these products and our dependence upon our collaborative partners.   As a result of these or other risks, potential products for which we have invested substantial amounts in research and development may never produce revenues or income.

We have generally been compensated for research and development expenses during initial feasibility work performed under collaborative arrangements for all three of our technologies: Nektar Advanced PEGylation Technology, Nektar Pulmonary Technology, and Nektar Supercritical Fluid Technology.  Prior to commercialization of pulmonary delivery and Advanced PEGylation products, we receive revenues from our partners for partial or full funding of research and development activities and progress payments upon achievement of certain developmental milestones.  In a typical Advanced PEGylation Technology collaboration, we manufacture and supply the polyethylene glycol (“PEG”) reagents and receive manufacturing revenues and possible royalties from sales of the commercial product.  In a typical Pulmonary Technology collaboration, our partner will provide the active pharmaceutical ingredient (the majority of which are already approved by the U.S. Food and Drug Administration (“FDA”) in another delivery form), fund clinical and formulation development, obtain regulatory approvals, and market the resulting commercial product.  We may manufacture and supply the drug delivery approach or drug formulation, and may receive revenues from drug manufacturing, as well as royalties from sales of most commercial products.  In addition, for products using our Pulmonary Technology, we may receive revenues from the supply of our device for the product along with revenues for any applicable drug processing or filling.  In addition to our partner-funded programs, we are applying our technologies independently through internal early-stage proprietary product development efforts.  To achieve and sustain profitable operations, we, alone or with others, must successfully develop, obtain regulatory approval for, manufacture, introduce, market, and sell products using our drug delivery and other drug delivery systems.  There can be no assurance that we can generate sufficient product or contract research revenue to become profitable or to sustain profitability. 

To fund the substantial expense related to our research and development activities, we have raised significant amounts of capital through the sale of equity and convertible debt.  Our ability to meet the repayment obligations of our outstanding convertible debt, which as of September 30, 2004 totaled approximately $173.9 million in outstanding principal, is dependent upon our ability to develop successful products without unexpected significant delay or expense.  Even if we are successful in this regard, we may require additional capital to repay the debt obligations.  

Because of the magnitude of the revenues and resulting gross margins we receive, we do not expect that sales of our currently marketed products will be sufficient for us to achieve profitability.  Our ability to achieve profitability is dependent on the approval of and successful marketing of products with significant markets, and for which we realize relatively higher royalties.

Recent Developments

On August 27, 2004, we reported that Eyetech and Pfizer announced the FDA Dermatologic & Ophthalmic Drugs Advisory Committee met and reviewed the clinical submission for Macugen™ for the treatment of neovascular age-related macular degeneration (AMD).  In addition, on September 20, 2004, Pfizer and Eyetech announced that the European Medicines Agency (EMEA) accepted the filing of their marketing authorization application for Macugen™ in Europe, and they have begun clinical trials in Japan.  We provide Eyetech with PEGylation technology for use in Macugen™.  If approved, Macugen™ would be the sixth product marketed in the U.S., and the seventh in Europe, using Nektar Advanced PEGylation Technology.

On September 3, 2004, a purported securities class action entitled Rhodes v. Nektar Therapeutics et al., Case No. C 04 3735, was filed in the United States District Court for the Northern District of California against us, as well as our Chairman, Chief Executive Officer, and our President, Nektar AL.  The complaint alleges that the defendants made certain material misrepresentations to the market in violation of the federal securities laws, specifically Sections 10(b) and 20(a) of the Securities Exchange Act of 1934, and Rule 10b-5.  The named plaintiff seeks unspecified damages on behalf of a purported class of purchasers of our common stock

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during the period from March 4, 2004 through August 4, 2004.  No class has been certified in the above actions and no trial date has been scheduled.  This litigation may be costly and could prove to be time consuming and disruptive to normal business operations. There can be no assurance that we will prevail or that the cost of defending these lawsuits will be covered by our insurance policies. While it is not possible to predict accurately or to determine the eventual outcome of this litigation, an unfavorable outcome or settlement of this litigation could have a material adverse effect on our financial position, liquidity or results of operations. 

On September 7, 2004, Pfizer and Aventis announced that new data showed that Exubera® was effective and well tolerated in controlling blood glucose levels over a two-year period in patients with type 2 diabetes.  The results were from trials extended from six months to up to an additional 18 months where the primary objective was to assess long-term pulmonary safety.  Pfizer and Aventis submitted Exubera® for review by the European Medicines Agency (“EMEA”) for marketing approval in the European Union in February 2004.  Interactions with the European regulatory authorities are ongoing.  We develop and provide the inhalers and the powdered insulin for the Exubera® product.

In October 2004, Chiron Corporation and Nektar announced data from the final study report of a Phase I clinical trial of tobramycin powder for inhalation (TPI) presented at the 18^th Annual North American Cystic Fibrosis Conference.  This inhaled antibiotic is being developed for the treatment of cystic fibrosis patients with Pseudomonas aeruginosa infection.  The trial data suggest that TPI, a formulation of tobramycin, a drug with a proven efficacy and safety profile, may significantly reduce the treatment burden for cystic fibrosis patients while offering a short administration time and portability.  We provide the formulation and device technologies for this product.

Recent Accounting Pronouncements

In March 2004 the Financial Accounting Standards Board’s (“FASB”) Emerging Issues Task Force (“EITF”) reached a consensus on EITF 03-01, The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments.  EITF 03-01 provides guidance regarding disclosures about unrealized losses on available-for-sale debt and equity securities accounted for under Statement of Financial Accounting Standard (“SFAS”) No. 115, Accounting for Certain Investments in Debt and Equity Securities. The guidance for evaluating whether an investment is other-than-temporarily impaired should be applied in other-than-temporary impairment evaluations made in reporting periods beginning after June 15, 2004.  In September 2004, the EITF delayed the effective date for the measurement and recognition guidance.  We are in the process of evaluating the effect of adopting EITF 03-1.

Critical Accounting Estimates

On March 31, 2004, the Financial Accounting Standards Board (“FASB”) issued an exposure draft of a statement titled Share-Based Payment, that addresses the accounting for share-based payment transactions in which an enterprise receives employee services in exchange for (a) equity instruments of the enterprise or (b) liabilities that are based on the fair value of the enterprise’s equity instruments or that may be settled by the issuance of such equity instruments. The statement would eliminate the ability to account for share-based compensation transactions using APB Opinion No. 25, Accounting for Stock Issued to Employees, and generally would require instead that such transactions be accounted for using a fair-value-based method. 

We currently apply the recognition and measurement principles of APB Opinion No. 25.  Under this opinion, no stock-based employee compensation expense is charged for options that were granted at an exercise price that was equal to the market value of the underlying common stock on the date of grant.  Pro forma information regarding net income and earnings per share is required to be disclosed in the footnotes to our financials statements by Statement of Financial Accounting Standards (“SFAS”) No. 123, as amended by SFAS No. 148, as if we had accounted for our employee stock options under the fair value method of that statement. 

On October 13, 2004, the FASB concluded that the statement would be effective for public companies for interim or annual periods beginning after June 15, 2005.  The FASB currently plans to issue a final statement on or around December 15, 2004.  When we adopt the new statement, if approved by the FASB as anticipated, we will have to recognize substantially more compensation expense. This could have a material adverse impact on our results of operations.

Results of Operations

Three-Months and Nine-Months Ended September 30, 2004 and 2003

Revenue

Contract research revenue for the three-month period ended September 30, 2004 was approximately $23.6 million compared to approximately $19.6 million for the three-month period ended September 30, 2003, an increase of approximately 20%.  This increase was primarily due to recognition of milestone revenue of approximately $0.8 million with regard to the filing of a marketing authorization application for Exubera® with the European Medicines Evaluation Agency as well as a total of approximately $3.6 million of increased development revenue from two of our collaborative partners.  Contract research revenue for the nine-month

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period ended September 30, 2004, was approximately $67.2 million compared to approximately $59.2 million for the nine-month period ended September 30, 2003, an increase of approximately 13%.  This increase was primarily due to project termination fees from Aventis-Behring totaling approximately $2.0 million, recognition of milestone revenue of approximately $2.0 million with regard to the filing of a marketing authorization application for Exubera® with the European Medicines Evaluation Agency, as well as a total of approximately $2.8 million in increased development revenue from two of our collaborative partners.  Contract research revenue includes reimbursed research and development expense as well as the amortization of deferred up-front signing and progress payments received from our collaborative partners.  Contract revenues are expected to fluctuate from year to year, and future contract revenue cannot be predicted accurately.  The level of contract revenues depends in part upon future success in new collaborations, the continuation of existing collaborations, and achievement of milestones under current and future agreements. 

Product pricing is dependent on the manufacturing agreement specific to each partner.  Product revenue for the three-month period ended September 30, 2004, was approximately $5.0 million compared to approximately $7.7 million for the three-month period ended September 30, 2003, a decrease of approximately 35%.  Product revenue for the nine-month period ended September 30, 2004, was approximately $15.7 million compared to approximately $21.4 million for the nine-month period ended September 30, 2003, a decrease of approximately 26%.  The decrease in product revenue for both the three-month and nine-month periods ended September 30, 2004 was primarily due to production problems during the three month-periods ended June 30, 2004 and September 30, 2004 (see discussion below under Cost of Goods Sold) as well as lower customer demand for certain PEG products. Based on discussion with our customers, management believes that the decrease in demand experienced during the nine-month period ended September is temporary and that demand should increase over the next several quarters.

Cost of Goods Sold

Cost of goods sold is associated with product sales and was approximately $4.5 million for the three-month period ended September 30, 2004 based on product sales of approximately $5.0 million, representing a gross margin of approximately 10%.  Cost of goods sold for the three-month period ended September 30, 2003 was approximately $3.5 million based on product sales of approximately $7.7 million, representing a gross margin of approximately 54%.  Cost of goods sold was approximately $13.7 million for the nine-month period ended September 30, 2004 based on product sales of approximately $15.7 million, representing a gross margin of approximately 13%.  Cost of goods sold for the nine-month period ended September 30, 2003 was approximately $11.9 million based on product sales of approximately $21.4 million, representing a gross margin of approximately 45%. 

The decrease in gross margin for both the three-month and nine-month periods ended September 30, 2004 was primarily due to the expensing of excess overhead not absorbed by overhead absorption due to lower-than-normal production and higher inventory reserves resulting from production problems with our PEG products during the three-month periods ended June 30, 2004 and September 30, 2004. During the period from March 2004 through July 2004, we encountered production problems, which led to a temporary shut down of part of our manufacturing operations.  Because of the shutdown, production during this period was lower than production during the same period in 2003, resulting in lower than usual overhead absorption.  The excess overhead not absorbed was expensed to Cost of Goods Sold.  As of September 30, 2004, we are in the process of confirming that the manufacturing problems are being satisfactorily addressed.  We plan to reprocess the impacted inventory, which we expect will result in saleable inventory.  Inventory reserves increased $1.5 million during the nine-month period ended September 30, 2004 from $1.6 million at December 31, 2003 to $3.1 million at September 30, 2004.  The decrease in gross margin for both the three-month and nine-month periods ended September 30, 2004 was also caused in part by a refinement in our methodology to allocate operating expenses to inventory production.

Research and Development Expenses

Research and development expenses are associated with three general categories: (i) collaborative agreements under which spending is reimbursed by our partners; (ii) spending attributed to internally funded programs; and (iii) commercial readiness and infrastructure costs associated with commercial operations for our drug and third-party device manufacturing.  Research and development expenses were approximately $37.4 million and approximately $31.8 million for the three-month periods ended September 30, 2004 and 2003, respectively, an increase of approximately 18%.  Research and development expenses were approximately $107.9 million and approximately $96.3 million for the nine-month periods ended September 30, 2004 and 2003, respectively, an increase of approximately 12%.  The increases in research and development expenses during the three-month and nine-month periods ended September 30, 2004 were primarily due to increased expenditures relating to commercial readiness of Exubera® as well as increased spending on our proprietary products.  We intend to increasingly fund significant development expenses associated with the development and commercialization of new proprietary products, including clinical trials, developed through our Proprietary Products Group prior to seeking collaborative relationships with pharmaceutical and biotechnology partners.  While we believe this strategy may result in improved economics for any products ultimately developed and approved, it will require us to invest significant funds in developing these products without reimbursement from a collaborative partner.  Currently we have four such programs underway, two of which have entered the clinic.

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General and Administrative Expenses

General and administrative expenses are associated with administrative staffing, business development, and marketing efforts.  General and administrative expenses were approximately $4.7 million and approximately $5.2 million for the three-month periods ended September 30, 2004 and 2003, respectively, a decrease of approximately 9%.  General and administrative expenses were approximately $14.6 million and approximately $15.5 million for the nine-month period ended September 30, 2004 and 2003, respectively, a decrease of approximately 6%.  The decreases in general and administrative expenses during the three-month and nine-month periods ended September 30, 2004 were primarily due to a refinement in our methodology to allocate general and administrative expenses to inventory production. 

Loss on Debt Extinguishment

During the nine-month period ended September 30, 2004, we recognized a loss on debt extinguishment in connection with two privately negotiated transactions to convert our outstanding convertible subordinated notes into shares of our common stock.  In January 2004, certain holders of our outstanding 3.5% convertible subordinated notes due October 2007 completed an exchange and cancellation of $9.0 million in aggregate principal amount of the notes for the issuance of 575,605 shares of our common stock in a privately negotiated transaction.  In February 2004, certain holders of our outstanding 3% convertible subordinated notes due June 2010 converted approximately $36.0 million in aggregate principal amount of such notes for approximately 3.2 million shares of our common stock and a cash payment of approximately $3.1 million in the aggregate in privately negotiated transactions.  As a result of these transactions, we recognized losses on debt extinguishment of approximately $7.8 million and $1.5 million, respectively, in accordance with SFAS No. 84, Induced Conversions of Convertible Debt. 

During the nine-month period ended September 30, 2003, we recognized a $4.3 million gain on the debt extinguishment in connection with the cash payment of approximately $16.2 million to repurchase $20.5 million in aggregate principal amount of 3.5% convertible notes due in 2007 in privately negotiated transactions. 

Interest Income

Interest income was approximately $1.8 million for the three-month period ended September 30, 2004, as compared to approximately $1.3 million for the three-month period ended September 30, 2003.  Interest income was approximately $4.6 million for the nine-month period ended September 30, 2004, as compared to approximately $4.1 million for the nine-month period ended September 30, 2003.   The increase in interest income was primarily due to higher average cash, cash equivalent, and short-term investment balances during the three-month and nine-month periods ended September 30, 2004 as compared to the three-month and nine-month periods ended September 30, 2003. 

Interest Expense

Interest expense is related to our outstanding convertible subordinated notes and debentures, capital lease obligations, other equipment loans and lines of credit, and the mark-to-market impact of our interest rate swap.  Interest expense was approximately $3.1 million and $4.8 million for the three-month periods ended September 30, 2004 and 2003, respectively.  The approximate $1.7 million decrease in interest expense was due to the lower balance of convertible subordinated notes outstanding at September 30, 2004 as compared to September 30, 2003.  Interest expense was approximately $21.9 million and approximately $13.1 million for the nine-month periods ended September 30, 2004 and 2003, respectively.  The approximate $8.8 million increase in interest expense was due primarily to the payment of approximately $12.7 million in “make-whole” payments made to certain holders of our outstanding 3.0% convertible subordinated notes due June 2010 in connection with the conversion of $169.3 million in aggregate principal amount of the notes held by such holders for the issuance of approximately 14.9 million shares of our common stock following our call for the redemption of such notes during the three-month period ended March 31, 2004.  This was partially offset by a decrease in interest expense due to the lower average balance of convertible subordinated notes outstanding during the nine-month period ended September 30, 2004 as compared to the nine-month period ended September 30, 2003. 

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Liquidity and Capital Resources

We have financed our operations primarily through public and private placements of our debt and equity securities, revenue from development contracts, product sales and short-term research and feasibility agreements, financing of equipment acquisitions and tenant improvements, and interest income earned on our investments of cash.  At September 30, 2004 we had cash, cash equivalents and short-term investments of approximately $426.9 million.

The $70.7 million used by operating activities for the nine-month period ended September 30, 2004 was primarily due to the net loss of $82.6 million offset by non-cash expenses of $11.9 million.  The $63.6 million used by operating activities for the nine-month period ended September 30, 2003 was primarily due to the net loss of $50.2 million and non-cash expenses of $13.4 million. 

The $101.3 million used by investing activities for the nine-month period ended September 30, 2004 and the $15.2 million used by investing activities for the nine-month period ended September 30, 2003 were primarily due to the net cash used to purchase short-term investments.  During the three-month period ended September 30, 2004 we received $22.5 million in connection with the redemption of Nektar’s limited partnership interest in the Inhale 201 Industrial Road Partnership.  The increase in capital expenditures during the nine-month period ended September 30, 2004 compared to the nine-month period ended September 30, 2003 of $9.6 million was primarily due to the purchase of our Church Street facility for approximately $2.9 million and approximately $8.6 million related to the expansion of our manufacturing facility in Alabama partially offset by lower non-real estate capital expenditures. 

The $200.4 million in cash provided by financing activities for the nine-month period ended September 30, 2004 was primarily due to the sale of 9.5 million shares of our common stock in March 2004 at a price of $20.71 per common share for proceeds of approximately $196.4 million, net of issuance costs; cash received from employee exercises of stock options of approximately $8.8 million; and a loan received from Pfizer of approximately $3.7 million; partially offset by the repayment of bank loans and capital lease obligations of approximately $9.4 million  The $95.4 million in cash provided by financing activities for the nine-month period ended September 30, 2003 resulted from the sale of $110 million in aggregate principal amount of our 3% convertible subordinated notes due in 2010 for aggregate proceeds of $106.1 million, net of issuance costs, and a loan received from Pfizer of approximately $3.7 million.  This was offset by cash payments of $16.2 million for the repurchase of $20.5 million aggregate principal amount of our 3.5% convertible subordinated notes due in 2007 in privately negotiated transactions. 

In April 2004, we called for redemption of all of our outstanding 6¾% convertible subordinated notes due October 2006.  Holders of all but $10,000 in principal amount converted their notes prior to the redemption date, resulting in the issuance of approximately 0.5 million shares of our common stock.  We redeemed the $10,000 in principal amount not converted into equity for cash in the amount of $10,000.  The aggregate amount of notes converted was approximately $7.8 million.

In March 2004, we called for the full redemption of our outstanding 3% convertible subordinated notes due June 2010. The aggregate principal amount outstanding of the notes at the time of the call for redemption was $133.3 million, all of which was converted into approximately 11.7 million shares of common stock prior to the redemption date.  In connection with the conversion, we agreed to pay $75.00 per $1,000 of the notes to be converted, for an aggregate payment of approximately $10.0 million.  This payment was recorded as interest expense.

In February 2004, certain holders of our outstanding 3% convertible subordinated notes due June 2010 converted approximately $36.0 million in aggregate principal amount of such notes for approximately 3.2 million shares of our common stock and a cash payment of approximately $3.1 million in the aggregate in privately negotiated transactions.

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In January 2004, certain holders of our outstanding 3.5% convertible subordinated notes due October 2007 completed an exchange and cancellation of $9.0 million in aggregate principal amount of the notes for the issuance of approximately 0.6 million shares of our common stock in a privately negotiated transaction. 

As a result of the transactions related to convertible subordinated debt during the nine-month period ended September 30, 2004, our total contractual obligation with regard to convertible subordinated debt has decreased from $360.0 million at December 31, 2003 to $173.9 million at September 30, 2004.  All of our outstanding convertible subordinated debt as of September 30, 2004 will mature in 2007.  

Given our current cash requirements, we forecast that we will have sufficient cash to meet our net operating expense requirements for at least the next two years.  We plan to continue to invest in our growth and the need for cash will be dependent upon the timing of these investments.  Our capital needs will depend on many factors, including continued scientific progress in our research and development arrangements, progress with preclinical and clinical trials of our proprietary and partnered products, the time and costs involved in obtaining regulatory approvals, the costs of developing and scaling up each manufacturing operation of our technologies, the timing and cost of our clinical and commercial production facilities, the costs involved in preparing, filing, prosecuting, maintaining and enforcing patent claims, the need to acquire licenses to new technologies, and the status of competitive products.  The entire outstanding balance of convertible subordinated debt as of September 30, 2004 of $173.9 million will mature in 2007.  We are not likely to be able to satisfy this entire obligation through cash flow generated by our operations.  To satisfy our long-term needs, we intend to seek additional funding, as necessary, from corporate partners and from the sale of securities.  Because we are an early stage biotechnology company, we do not qualify to issue investment grade debt or have access to certain credit facilities.  As a result, any financing we undertake will likely involve the issuance of equity, convertible debt instruments or high-yield debt to fund our working capital.  To date we have been primarily dependent upon equity and convertible debt financings for capital and have incurred substantial debt as a result of our issuances of subordinated notes and debentures that are convertible into our common stock.  Our substantial debt, the market price of our securities and the general economic climate, among other factors, could have material consequences for our financial position and could affect our sources of short-term and long-term funding.  There can be no assurance that additional funds, if and when required, will be available to us on favorable terms, if at all. 

On October 27, 2004, we filed a prospectus as part of a registration statement that we filed with the SEC using a “shelf” registration process. Under this shelf registration process, we may sell common stock, preferred stock, debt securities and/or warrants in one or more offerings up to a total dollar amount of $250,000,000. The prospectus provides you with a general description of the securities we may offer. Each time we sell common stock, preferred stock, debt securities and/or warrants, we will provide a prospectus supplement that will contain more specific information.

The following is a summary of our contractual obligations as of September 30, 2004 (in thousands):