UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

FORM 10-Q

(Mark One)

For the quarterly period ended March 31, 2004

OR

For the transition period from ________________________to ______________________

Commission file number: 0-19825

SCICLONE PHARMACEUTICALS, INC.

(650) 358-3456
(Registrant’s telephone number, including area code)

Not Applicable

     Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

     Yes x                                    No o

     Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).

     Yes x                                    No o

     As of March 31, 2004, 44,583,412 shares of the registrant’s Common Stock, $0.001 par value, were issued and outstanding.

SCICLONE PHARMACEUTICALS, INC.

INDEX

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PART I. FINANCIAL INFORMATION

Item 1. Condensed Consolidated Financial Statements

SCICLONE PHARMACEUTICALS, INC.

See notes to condensed consolidated financial statements

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SCICLONE PHARMACEUTICALS, INC.

See notes to condensed consolidated financial statements

4

SCICLONE PHARMACEUTICALS, INC.

See notes to condensed consolidated financial statements

5

SCICLONE PHARMACEUTICALS, INC.

1.		Basis of Presentation
		SciClone was reincorporated in the State of Delaware on July 18, 2003. The accompanying unaudited condensed consolidated financial statements have been prepared in conformity with generally accepted accounting principles consistent with those applied in, and should be read in conjunction with, the audited financial statements for the year ended December 31, 2003 included in the Company’s Form 10-K as filed with the Securities and Exchange Commission. The interim financial information reflects all adjustments, consisting of only normal recurring adjustments, which are, in the opinion of management, necessary for a fair presentation of the results for the interim periods presented. The results of operations for the three months ended March 31, 2004 are not necessarily indicative of results for subsequent interim periods or for the full year. The condensed consolidated balance sheet data at December 31, 2003 is derived from the audited financial statements at that date, but does not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements.
2.		Significant Accounting Policies
		Revenue Recognition
		The Company recognizes revenue from product sales at the time of shipment. There are no significant customer acceptance requirements or post shipment obligations on the part of the Company. Sales to importing agents or distributors are recognized at time of shipment when title to the product is transferred to them, and they do not have contractual rights of return except under limited terms regarding product quality. However, the Company will replace products that have expired or are deemed to be damaged or defective when delivered. Payments by the importing agents and distributors are not contingent upon sale to the end user by the importing agents or distributors.
		Contract revenue for research and development is recorded as earned based on the performance requirements of the contract. Nonrefundable contract fees for which no further performance obligations exist, and there is no continuing involvement by the Company, are recognized on the earlier of when the payments are received or when collection is assured.

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		Revenue associated with substantive performance milestones is recognized based on the achievement of the milestones, as defined in the respective agreements and provided that (i) the milestone event is substantive and its achievement is not reasonably assured at the inception of the agreement, and (ii) there are no future performance obligations associated with the milestone payment.
		Net Loss Per Share
		Net loss per share is computed using the weighted average number of shares of common stock outstanding. Potentially dilutive common shares from convertible debt, stock options and warrants are excluded, as their effect is antidilutive.
		Accounting For Stock-Based Compensation
		The Company accounts for its stock option and employee stock purchase plans under the provisions of Accounting Principles Board Opinion 25 (“APB 25”) and related Interpretations. Accordingly, the Company does not recognize compensation expense in accounting for its stock option and employee stock purchase plans for awards to employees and directors granted with exercise prices at fair market value.
		Pro forma information regarding net loss and net loss per share is required by Statement of Financial Accounting Standards No. 123 “Accounting for Stock-Based Compensation” (“SFAS 123”) as amended by Statement of Financial Accounting Standards No. 148 “Accounting for Stock-Based Compensation-Transition and Disclosure” (“SFAS 148”) and has been determined as if the Company had accounted for its stock awards under the fair value method of that Statement. The fair value for the options was estimated at the date of grant using a Black-Scholes option pricing model with the following weighted-average assumptions for both the three-month period ended March 31, 2004 and the corresponding period in 2003: risk-free interest rate of 2.20% and 2.00%, respectively; dividend yield of 0%; volatility of 0.93 and 0.95, respectively, and a weighted average expected life of the option of 4.00 years.
		The Black-Scholes option 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. Because the Company’s employee stock awards have characteristics significantly different from those of traded options, and because changes in subjective input assumptions can materially affect the fair value estimate, in the Company’s opinion, the existing models do not necessarily provide a reliable single measure of the fair value of its employee and director stock options and stock purchases.
		The following table illustrates the Company’s pro forma net loss and net loss per share, had compensation expense for the Company’s option and employee purchase plans been determined based on the fair value at the grant date consistent with the provisions of SFAS 123, as amended by SFAS 148:

The effects of applying SFAS 123 for pro forma disclosures are not likely to be representative of the effects on reported net loss for future years due to the different number of options granted each year.

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3.		Comprehensive Loss
		For the three-month periods ended March 31, 2004 and 2003, the Company’s total comprehensive loss amounted to $3,077,000 and $2,883,000 respectively.
4.		Available-For-Sale Securities
		The following is a summary of available-for-sale securities at March 31, 2004 and December 31, 2003:

As of March 31, 2004, the available-for-sale securities are included as follows: $32,867,000 in cash            and cash equivalents, $694,000 in restricted short-term investments and $9,437,000 in other short-term investments. As of December 31, 2003, the available-for-sale securities are included as follows: $38,259,000 in cash and cash equivalents, $695,000 in restricted short-term investments and $9,380,000 in other short-term investments. As of March 31, 2004 and December 31, 2003 all available-for sale securities excluding the short-term municipal securities had maturities of 12 months or less. The short-term municipal securities are auction rate securities which have final maturities of 21-36 years, however, because they are highly rated, highly liquid and their interest rate is reset at auction every 30 days, our interest rate risk associated with these securities is limited due to this interest rate reset mechanism.

5.

Inventories

The following is a summary of inventories at March 31, 2004 and December 31, 2003:

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6.

Intangible Assets

The following is a summary of intangible assets:

		Acquired ZADAXIN product rights are being amortized on a straight-line basis beginning in September 1998. Amortization expense for each of the three-month periods ended March 31, 2004 and 2003 was $17,500. For the years ending December 31, 2004 through 2012, annual amortization expense is expected to be $70,000. Based upon the progress in the ZADAXIN clinical trials and the Company’s actual experience of product sales, the Company has assessed that the acquired product rights will be useful to the Company through 2012 when the European patent for the use of ZADAXIN in the treatment of hepatitis C expires. The Company’s policy is to identify and record impairment losses, as circumstances dictate, on intangible product rights when events and circumstances indicate that the assets might be impaired and the undiscounted cash flows estimated to be generated by those assets are less than the carrying amounts of those assets.
7.		Deferred Revenue
		In January 2002, the Company received $2,685,000 from its European partner, Sigma-Tau under the terms of its collaborative agreement announced in late December 2001. This receipt has been recorded as deferred revenue and is being recognized as contract revenue over the course of the ZADAXIN hepatitis C U.S. clinical program beginning in April 2002 and through the period of sharing the clinical data from this program with Sigma-Tau, the substantive performance requirements under the contract. For the three-month period ended March 31, 2004 and 2003, the Company recognized $134,000 and $224,000, respectively as contract revenue from this agreement.

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

Special Note Regarding Forward-Looking Statements

     This Quarterly Report on Form 10-Q contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. These forward-looking statements are based on our current expectations, estimates and projections about our business, industry, management’s beliefs and certain assumptions made by us. Words such as “anticipate,” “expect,” “intend,” “plan,” “believe” or similar expressions are intended to identify forward-looking statements including those statements we make regarding our future financial results; anticipated product sales and net sales and levels; the timing and outcome of clinical trials; ZADAXIN’s ability to complement existing therapies; prospects for ZADAXIN and our plans for its enhancement and commercialization; our ability to submit applications and obtain marketing and regulatory approvals for ZADAXIN; future financing plans; research and development and other expense levels; cash levels; levels of gross margin and cost of product sales and the allocation of financial resources to certain trials and programs. These statements are not guarantees of future performance and are subject to certain risks, uncertainties and assumptions that are difficult to predict. Therefore, our actual results could differ materially and adversely from those expressed in any forward-looking statements as a result of various factors including, but not limited to, those described under the caption “Risk Factors” in this Quarterly Report on Form 10-Q. We undertake no obligation to revise or update publicly any forward-looking statements for any reason.

Overview

     SciClone Pharmaceuticals, Inc. is a biopharmaceutical company engaged in the development and commercialization of therapeutics to treat life-threatening diseases. We are currently evaluating our lead product, ZADAXIN, in several late stage clinical trials for the treatment of patients with the hepatitis C virus, or HCV, the hepatitis B virus, or HBV, and certain types of cancer. Our primary focus is the successful completion of our two ongoing ZADAXIN phase 3 HCV clinical trials in the United States. We believe the worldwide market for HCV therapies was approximately $3 billion in 2003 and could exceed $8 billion in 2012. If approved by the U.S. Food and Drug Administration (FDA), we expect ZADAXIN to complement other HCV therapies and to expand the HCV market opportunity. In addition to the HCV trials in the United States, we are also evaluating ZADAXIN in a recently completed phase 3 HBV clinical trial in Japan, an ongoing phase 2 malignant melanoma clinical trial in Europe with our exclusive marketing partner for Western Europe, Sigma-Tau, two ongoing phase 2 pilot studies in the United States for the treatment of liver cancer, an ongoing HCV pilot clinical trial in Mexico and an ongoing HBV clinical trial in Taiwan. Our other principal drug development candidate is SCV-07, a potentially orally available therapeutic to treat viral and infectious diseases.

Results of Operations

     Total Revenue

     Product sales were $5,414,000 for the three-month period ended March 31, 2004 and $5,000,000 for the corresponding period in 2003. All product sales in each period were derived from sales of ZADAXIN. The increase was attributable to a higher volume of product sold as prices have remained stable. Sales to customers in China accounted for approximately 88% and 87% of this revenue for the three-month periods ended March 31, 2004 and 2003, respectively.

     For the three-month period ended March 31, 2004, sales to two importing agents in China accounted for approximately 50% and 38% of our product sales respectively. For the three-month period ended March 31, 2003, one importing agent accounted for 87% of our product sales; however, this importing agent accounted for only 38% of our product sales in the three-month period ended March 31, 2004. We rely on six

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importers to supply substantially all of our product in China, and our sales to any single importing agent can vary substantially from quarter to quarter depending on the size and timing of the orders. As of March 31, 2004, approximately $9,323,000, or 85%, of our accounts receivable were attributable to four customers in China. We perform on-going credit evaluations of our customers’ financial condition, and generally do not require collateral from our customers.

     Contract revenue was $228,000 and $224,000 for the three-month periods ended March 31, 2004 and 2003, respectively. We recognized $134,000 of contract revenue for the three-month period ended March 31, 2004, and all of the contract revenue for the corresponding period in 2003 in connection with the $2,685,000 payment we received from Sigma-Tau in January 2002. This revenue is recognized as contract revenue over the course of the ZADAXIN hepatitis C U.S. clinical program and the period of sharing the clinical data from this program with Sigma-Tau in accordance with the requirements under our contract with Sigma-Tau. We also recognized $94,000 of contract revenue in the three-month period ended March 31, 2004 in connection with a National Institutes of Health grant that we earned in the period.

     Cost of Product Sales and Gross Margin

     Gross margin on sales was 79% for the three-month period ended March 31, 2004, and 80% for the corresponding period in 2003. The decrease in gross margin percentage was primarily the result of temporarily higher product costs in connection with our use of a new manufacturer for ZADAXIN and foreign currency rate fluctuations, as purchases from one of our contract manufacturers are denominated in euros. We expect cost of product sales, and therefore gross margin, to vary from period to period, depending upon the level of ZADAXIN sales, the absorption of product-related fixed costs, and any charges associated with excess or expiring finished product inventory.

     Research and Development

     Research and development expenses were $3,931,000 for the three month-period ended March 31, 2004 and $3,783,000 for the corresponding period in 2003. The increase was primarily to support our ZADAXIN phase 3 clinical trials in the United States. The initiation and continuation of our current clinical development programs has had and will continue to have a significant effect on our research and development expenses. We expect a substantial increase in research and development expenses during the second quarter of 2004 compared to the first quarter of the current year and to the second quarter of 2003. The expected increase is primarily due to an anticipated increase in expenses relating to our phase 3 HCV clinical trials and other increases in research and development expenses. Due to the uncertain nature of the clinical trial process, and enrollment rates in particular, it is not possible to determine the timing of completion or total cost expected to be incurred for each trial. In general, we expect research and development expenses to increase significantly at least over the next two years and to vary substantially from quarter to quarter as we pursue our strategy of initiating additional preclinical and clinical trials and testing, acquiring product rights, and expanding regulatory activities.

     Sales and Marketing

     Sales and marketing expenses were $2,443,000 for the three-month period ended March 31, 2004 and $2,229,000 for the corresponding period in 2003. The increase was related to increased payroll expenses and expenses for advertising and conferences associated with the expansion of our markets for ZADAXIN. We expect sales and marketing expenses to increase in the next several quarters and years as we expand our commercialization and marketing efforts.

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     General and Administrative

     General and administrative expenses were $1,293,000 for the three-month period ended March 31, 2004 and $1,012,000 for the corresponding period in 2003. The increase was primarily attributable to greater general and administrative activities associated with increased securities regulation requirements. In the near term, we expect general and administrative expenses to vary quarter to quarter as we increase our general and administrative activities and resources to support increased expenditures on preclinical and clinical trials and testing, and regulatory, pre-commercialization and marketing activities.

     Interest and Investment Income and Expense

     Interest and investment income was approximately $116,000 for the three-month period ended March 31, 2004 and $53,000 for the corresponding period in 2003. The increase was primarily the result of larger cash balances earning interest in the 2004 period due to the proceeds we received from our follow-on public offering of common stock during the third quarter of 2003. Interest expense relating to $5,600,000 of convertible notes payable was $84,000 for each of the three-month periods ended March 31, 2004 and 2003.

     Liquidity and Capital Resources

     At March 31, 2004 and December 31, 2003, we had $58,253,000 and $62,975,000, respectively, in cash, cash equivalents and short-term investments. We currently estimate that cash, cash equivalents and short-term investments at December 31, 2004 will be lower than the balance at March 31, 2004. The expected decrease in this balance is attributable to an expected net loss and no plans for a financing during the current fiscal year. The short-term investments consist primarily of highly liquid marketable securities. We have two letters of credit each secured by a certificate of deposit. At March 31, 2004 and December 31, 2003, the letters of credit totaled $694,000, one for $633,000 under our lease agreement, the other for $61,000 to facilitate our value added tax filings in Europe.

     Net cash used in operating activities totaled $4,829,000 and $5,490,000 for the three-month periods ended March 31, 2004 and 2003, respectively. Net cash used in operating activities for the three-month period ended March 31, 2004 was more than the net loss primarily due to a $1,563,000 decrease in accounts payable.

     Net cash provided by financing activities totaled $70,000 and $1,948,000 for the three-month periods ended March 31, 2004 and 2003, respectively. Net cash provided by financing activities for the three-month period ended March 31, 2003 primarily consisted of approximately $1,800,000 generated from the issuance of common stock to Sigma-Tau.

     We intend to give priority use of our financial resources to ZADAXIN clinical programs in the United States. We believe our existing capital resources and funds from product sales are sufficient to complete our current U.S. phase 3 clinical trials and, if the trials are successful and we receive FDA approval, to begin commercialization of ZADAXIN in the United States. However, we cannot assure you that such funds will be sufficient, or that sales of ZADAXIN, if approved in the United States, will result in profitable operations. An expansion or significant extension of our clinical development programs may require us to seek additional capital resources. In the event we need to raise additional funds, the unavailability or the inopportune timing of any financing could prevent or delay our long-term product development and commercialization programs, either of which would severely hurt our business. The need, timing and amount of any such financing would depend upon numerous factors, including the level of ZADAXIN sales, the timing and amount of manufacturing costs related to ZADAXIN, the availability of complementary products, technologies and businesses, the initiation and continuation of preclinical and clinical trials and testing, the timing of regulatory approvals, developments in relationships with existing or future collaborative parties and the status of competitive products.

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Contractual Obligations

     There were no material changes to our contractual obligations in the three-month period ended March 31, 2004.

Off-Balance Sheet Arrangements

     There were no off-balance sheet arrangements in the three-month period ended March 31, 2004.

Risk Factors

     You should carefully consider the risks described below, in addition to the other information in this report on Form 10-Q and our report on Form 10-K for the year ended December 31, 2003, before making an investment decision. Each of these risk factors could adversely affect our business, financial condition, and operating results as well as adversely affect the value of an investment in our common stock.

If we are unable to commercialize ZADAXIN in various markets for multiple indications, particularly in the United States for the treatment of HCV, our business will be harmed.

     Our ability to achieve and sustain operating profitability depends in large part on our ability to commence, execute and complete clinical programs and obtain additional regulatory approvals, for ZADAXIN and other drug candidates, particularly in the United States, Europe and Japan. We are also dependent on our ability to increase ZADAXIN sales in existing markets and launch ZADAXIN in new markets. In particular, our ability to achieve and sustain profitability will depend in large part on our ability to commercialize ZADAXIN for the treatment of HCV in the United States. We cannot assure you that we will achieve significant levels of sales or that we will receive approval for ZADAXIN for the treatment of HCV in the United States or for the treatment of HCV or other indications in other countries. If we are unable to do so, our business will be harmed.

If we do not obtain regulatory approval for ZADAXIN for the intended indications that we are evaluating, our revenues will be limited and we will not become profitable.

     Our ability to execute on our business strategy requires that we obtain regulatory approval for the use of ZADAXIN, particularly for the treatment of HCV in the United States, both HBV and HCV in Japan and both HCV and malignant melanoma in Europe. If our current phase 3 trials in the United States and current and future trials in Europe yield favorable results, we intend to submit applications for marketing approval of ZADAXIN for the treatment of HCV in the United States and through our partner, Sigma-Tau, for the treatment of HCV and malignant melanoma in Europe. Based on the results of our recently completed phase 3 trial in Japan, we intend to submit a regulatory filing for the treatment of HBV in Japan. The regulatory approval processes in the United States, Europe and Japan are demanding and typically require 12 months or more in the United States and 18 months or more in Europe and Japan from the date of submission of a New Drug Application. We have committed significant resources, including capital and time, to develop ZADAXIN, particularly for HCV in the United States, with the goal of obtaining such approvals. If we do not obtain these approvals, we will be unable to achieve any substantial increase in our revenue.

     All new drugs, including our products, which have been developed or are under development, are subject to extensive and rigorous regulation by the FDA and comparable agencies in state and local jurisdictions and in foreign countries. These regulations govern, among other things, the development, testing, manufacturing, labeling, storage, pre-market approval, importation, advertising, promotion, sale and distribution of our products. These regulations may change from time to time and new regulations may be adopted.

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     Obtaining regulatory approval in developing countries is also time-consuming and expensive. In some countries where we are contemplating marketing and selling ZADAXIN, the regulatory approval process often relies on prior approvals obtained in the United States, Europe or Japan. Without such prior approvals, our ability to obtain regulatory approvals for ZADAXIN in these countries may be delayed or prevented. In addition, to secure these regulatory approvals, we will need, among other things, to demonstrate favorable results from additional clinical trials of ZADAXIN. Even if we are able to complete the clinical trials we have sponsored or are planning in a timely or cost-effective manner, these trials may not fulfill the applicable regulatory approval criteria, in which case we will not be able to obtain regulatory approval in these countries. We cannot assure you that we will ultimately obtain regulatory approvals in our targeted countries in a timely and cost-effective manner or at all. If we fail to obtain the required regulatory approvals to develop, market and sell our products in countries where we currently do not have such rights, our revenues will be limited.

     Satisfaction of government regulations may take several years and the time needed to satisfy them varies substantially based on the type, complexity and novelty of the pharmaceutical product. As a result, government regulation may cause us to delay the introduction of, or prevent us from marketing, our existing or potential products for a considerable period of time and impose costly procedures upon our activities. Even if we obtain regulatory approval for our products, such approval may impose limitations on the indicated uses for which our products may be marketed. Unsatisfactory data resulting from clinical trials may also adversely affect our ability to market and sell ZADAXIN in markets where it is approved for sale.

If the results of our clinical trials are not favorable, we will be unable to obtain regulatory approval for the intended indications we are evaluating.

     To obtain regulatory approvals, we must, among other requirements, complete carefully controlled and well-designed clinical trials demonstrating that a particular drug is safe and effective for the applicable disease. We cannot depend on data from prior trial results to predict or demonstrate that our drug products are safe and efficacious under regulatory guidelines to qualify for commercial sale. We cannot assure you, nor can you rely on our previous clinical trial results to predict, that our ongoing or future clinical trials will yield favorable results. Adverse or inconclusive clinical results would prevent us from filing for regulatory approval of ZADAXIN for the indications that we are evaluating, and our current programs in those areas would fail. In the past, Alpha 1 Biomedical, from which we acquired certain rights to thymosin alpha 1, conducted a phase 3 clinical trial of thymosin alpha 1 as a therapy for HBV that did not produce statistically significant results and Alpha 1 Biomedical did not submit a new drug application to the FDA.

     We are currently conducting phase 3 clinical trials based on the use of ZADAXIN in combination with pegylated interferon alpha for the treatment of HCV patients who did not previously respond to treatment. We cannot assure you that these phase 3 clinical trials will yield sufficient or adequate data to demonstrate appropriate safety and efficacy under FDA guidelines. Any failure to obtain sufficient or adequate data could delay or prevent us from securing FDA approval.

     Our two phase 3 HCV clinical trials in the United States have been designed to show that the combination of ZADAXIN and pegylated interferon alpha adds a significant clinical benefit when compared to the use of pegylated interferon alpha alone in non-responders. We cannot assure you that the results of this combination therapy will yield the favorable results we expect, or that the independent use of pegylated interferon alpha will not perform better than anticipated, which could reduce the chances that a new drug application, or NDA, will be approved. If the combination therapy of ZADAXIN and pegylated interferon alpha causes significant adverse side effects beyond those caused by pegylated interferon alpha alone, our clinical trials could be delayed, patients may drop out at a greater than anticipated rate, we may be forced to halt the trials or the FDA may reject an NDA due to safety issues. If any of the foregoing occurs, our efforts to

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market and sell ZADAXIN in the United States will be significantly impaired, our business will suffer and the price of our stock may decline.

     Our phase 3 HBV clinical trial in Japan was designed to demonstrate a clinical benefit measured by an analysis of a combination of safety and efficacy data points. We cannot assure that the results of this study will warrant favorable consideration by the Japanese Ministry of Health and Welfare or result in a marketing registration of ZADAXIN. If additional studies or other data are required for regulatory consideration, our efforts to market and sell ZADAXIN in Japan will be significantly impaired, our business will suffer and the price of our stock may decline.

If we experience delays in patient enrollment in our clinical trials, we may not be able to obtain regulatory approval in accordance with our anticipated timeline.

     Each of our two current phase 3 HCV clinical trials in the United States are designed to enroll 500 patients, one trial treating patients with no liver damage and the other trial treating patients with mild cirrhosis of the liver. The 500 patient enrollment is complete in the first trial, however if we are unable to enroll a sufficient number of patients in the second trial, if such enrollment is delayed or if patient drop out rates in either trial are higher than anticipated, our ability to proceed with our clinical trials and prepare an NDA would be adversely affected. In particular, we are experiencing competition for patients with mild cirrhosis of the liver, from trials sponsored by other commercial drug developers and from a trial sponsored by the National Institutes of Health. Competition for the enrollment of similar patients in other clinical trials or other delays in enrollment may prevent us from enrolling patients quickly enough to meet our current timing expectations for completing our phase 3 trials, which would delay the preparation of an NDA. If we are not able to fully enroll patients for both of these clinical trials or patient drop out rates are higher than anticipated, it could reduce the chances that our NDA will be approved.

We cannot predict the safety profile of the use of ZADAXIN when used in combination with other drugs.

     Many of our trials involve the use of ZADAXIN in combination with other drugs. Some of these drugs are known to cause adverse patient reactions. Even if ZADAXIN does not produce adverse side effects when used alone, we cannot predict how it will work with other drugs, including causing possible adverse side effects not directly attributable to the other drugs that could compromise the safety profile of ZADAXIN when used in certain combination therapies.

Due to the outbreak of SARS in China, sales of ZADAXIN in the second quarter of 2003 were significantly higher than expected and are not indicative of future sales.

     Our sales for the quarter ended June 30, 2003 were more than 200% greater than sales for any quarter in our history as a result of a previously unanticipated increase in sales of ZADAXIN to hospitals in China. This increase was related to the use of immune system enhancers, including ZADAXIN, in connection with the treatment of severe acute respiratory syndrome, or SARS. In future quarters, sales of ZADAXIN for the treatment of SARS could be affected by changes in treatment in China, changes in the rate of infection and the emergence of evidence as to the effectiveness or ineffectiveness of ZADAXIN or of other potential treatments for SARS.

     As a result of the containment of the SARS epidemic, we expect sales in future quarters to be more consistent with sales patterns of the third and fourth quarters of 2003 and the quarter ended March 31, 2004, each of which have significantly lower sales results than those of the second quarter in 2003. We could experience fluctuations in sales in future quarters as a result of similar factors.

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Our sales of ZADAXIN may fluctuate due to seasonality of product orders and sales in any quarter may not be indicative of future sales.

     Our sales for the quarter ended June 30, 2003 were greatly affected by the demand in China for ZADAXIN in connection with the treatment of SARS. It is not possible to predict at this time if SARS will re-emerge, like influenza, as a seasonal public health problem and what effect, if any, this would have on future sales of ZADAXIN. To the extent that ZADAXIN is purchased in connection with future outbreaks of SARS or other seasonal viral contagions, product sales could become more concentrated in certain quarters of the calendar year. Quarterly sales levels could fluctuate and sales in any quarter may not be indicative of sales in future periods.

Our revenue is dependent on the sale of ZADAXIN in foreign countries, particularly China, and if we experience difficulties in our foreign sales efforts, our financial condition will be harmed.

     Our product revenue in the near term is highly dependent on the sale of ZADAXIN in foreign countries. If we experience difficulties in our foreign sales efforts, our business will suffer and our financial condition will be harmed. Substantially all of our ZADAXIN sales are to customers in China. Sales of ZADAXIN in China may be limited due to the low average personal income, lack of patient cost reimbursement, poorly developed infrastructure and existing and potential competition from other products, including generics. Several local companies have introduced lower priced locally manufactured generic competitive products. If these sales continue, there could be a negative impact on the price and the volume of ZADAXIN sold in China and this would harm our business.

     In addition, our ZADAXIN sales and operations in other parts of Asia, as well as in Latin America and the Middle East, are subject to a number of risks, including difficulties and delays in obtaining registrations, permits, pricing approvals and reimbursement and unexpected changes in regulatory requirements. In addition, we experience other issues with managing foreign sales operations including long payment cycles, difficulties in accounts receivable collection and, especially from significant customers, fluctuations in the timing and amount of orders. Operations in foreign countries also expose us to risks relating to difficulties in enforcing our proprietary rights, currency fluctuations and adverse or deteriorating economic conditions.

     We do not have product sales in the United States with which to offset any decrease in our revenue from ZADAXIN sales in Asia, Latin America and the Middle East. In addition, some countries in these regions, including China, regulate pharmaceutical prices and pharmaceutical importation. These regulations may reduce prices for ZADAXIN to levels significantly below those that would prevail in an unregulated market, limit the volume of product which may be imported and sold or place high import duties on the product, any of which may limit the growth of our revenues or cause them to decline.

Because of China’s tiered method of importing and distributing finished pharmaceutical products, our quarterly results may vary substantially from one period to the next.

     China uses a tiered method to import and distribute finished pharmaceutical products. At each port of entry, and prior to moving the product forward to the distributors, government-licensed importing agents must process and evaluate each shipment to determine whether such shipment satisfies China’s quality assurance requirements. In order to efficiently manage this process, the importing agents typically place large, and therefore relatively few, orders within any six month period. Therefore, our sales to an importing agent can vary substantially from quarter to quarter depending on the size and timing of the orders, which has in the past and may in the future cause our quarterly results to fluctuate. We rely on six importers to supply substantially all of our product in China. Because we use a small number of importing agents in China, our

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receivables from any one importing agent are material, and if we were unable to collect receivables from any importer, our business and cash-flow would be adversely affected.

If we fail to protect our products, technologies and trade secrets, we may not be able to successfully use, manufacture, market or sell our products, or we may fail to advance or maintain our competitive position.

     Our success depends significantly on our ability to obtain and maintain meaningful patent protection for our products and technologies and to preserve our trade secrets. Our pending patent applications may not result in the issuance of patents in the future. Our patents or patent applications may not have priority over others’ applications. Our existing patents and additional patents that may be issued, if any, may not provide a competitive advantage to us or may be invalidated or circumvented by our competitors. Others may independently develop similar products or design around patents issued or licensed to us. Patents issued to, or patent applications filed by, other companies could harm our ability to use, manufacture, market or sell our products or maintain our competitive position with respect to our products. Although many of our patents relating to ZADAXIN have expired, including composition of matter patents, we have rights to other patents and patent applications relating to ZADAXIN and ZADAXIN analogues, including method of use patents with respect to the use of ZADAXIN for certain indications. If other parties develop generic forms of ZADAXIN for other indications, including conducting clinical trials for such indications, our patents and other rights might not be sufficient to prohibit them from marketing and selling such generic forms of ZADAXIN. If other parties develop analogues or derivatives of ZADAXIN, our patents and other rights might not be sufficient to prohibit them from marketing these analogues or derivatives.

     Pharmaceutical products are either not patentable or have only recently become patentable in some of the countries in which we market or may market ZADAXIN. Past enforcement of intellectual property rights in many of these countries, including China in particular, has been limited or non-existent. Future enforcement of patents and proprietary rights in many other countries will likely be problematic or unpredictable. We are aware that other companies are marketing generic thymosin alpha 1 in China, possibly in violation of our trademark or other rights, and we expect such violations of our rights to continue. Moreover, the issuance of a patent in one country does not assure the issuance of a similar patent in another country. Claim interpretation and infringement laws vary by nation, so the extent of any patent protection is uncertain and may vary in different jurisdictions.

If we are involved in intellectual property claims and litigation, the proceedings may divert our resources and subject us to significant liability for damages, substantial litigation expense and the loss of our proprietary rights.

     Our commercial success depends in part on us not infringing valid, enforceable patents or proprietary rights of third parties, and not breaching any licenses that may relate to our technologies and products. We are aware of a third-party patent that may relate to our products and may cover a method of action used by ZADAXIN. We cannot assure you that our mechanism of action does not infringe on their claim. In addition, we may not be aware of all patents or patent applications that may impact our ability to make, use or sell any of our potential products. For example, U.S. patent applications may be kept confidential for up to 18 months while pending in the Patent and Trademark Office, and patent applications filed in foreign countries are often first published six months or more after filing. It is possible that we may unintentionally infringe these patents or other patents or proprietary rights of third parties. We may in the future receive notices claiming infringement from third parties as well as invitations to take licenses under third-party patents. Any legal action against us or our collaborative partners claiming damages and seeking to enjoin commercial activities relating to our products and processes affected by third-party rights may require us or our collaborative partners to obtain licenses in order to continue to manufacture or market the affected products and processes. Our efforts to defend against any of these claims, regardless of merit, would require us to devote resources and attention that could have been directed to our operations and growth plans. In addition, these actions may

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subject us to potential liability for damages. We or our collaborative partners may not prevail in a patent action and any license required under a patent may not be made available on commercially acceptable terms, or at all. Any conflicts resulting from the patent rights of others could significantly reduce the coverage of our patents and limit our ability to obtain meaningful patent protection.

     If other companies obtain patents with conflicting claims, we may be required to obtain licenses to those patents or develop or obtain alternative technology to manufacture or market the affected products and processes. We may not be able to obtain any such licenses on acceptable terms or at all. Any failure to obtain such licenses could delay or prevent us from pursuing the development or commercialization of our potential products. Our efforts to defend against any of these claims would require us to devote resources and attention that could have been directed to our operations and growth plans.

     We may need to initiate litigation, which could be time-consuming and expensive, to enforce our proprietary rights or to determine the scope and validity of others’ rights. If litigation results, a court may find our patents o