UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

FORM 10-Q

(MARK ONE)

þ	QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

FOR THE QUARTERLY PERIOD ENDED MARCH 31, 2005

OR

o	TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

FOR THE TRANSITION PERIOD FROM                      TO                     .

COMMISSION FILE NUMBER                     

ANADYS PHARMACEUTICALS, INC.

3115 Merryfield Row
San Diego, California 92121
(Address of principal executive offices)

Company’s telephone number, including area code: 858-530-3600

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 þ No o

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

Yes o No þ

The number of shares of common stock outstanding as of the close of business on May 1, 2005:

ANADYS PHARMACEUTICALS, INC.

INDEX

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PART I. FINANCIAL INFORMATION

Item 1. Unaudited Condensed Consolidated Financial Statements

Anadys Pharmaceuticals, Inc.

See accompanying notes to unaudited condensed consolidated financial statements.

Note: The balance sheet at December 31, 2004, has been derived from audited financial statements at that date but does not include all of the disclosures required by accounting principles generally accepted in the United States for complete financial statements.

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Anadys Pharmaceuticals, Inc.

See accompanying notes to unaudited condensed consolidated financial statements.

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Anadys Pharmaceuticals, Inc.

See accompanying notes to unaudited condensed consolidated financial statements.

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Anadys Pharmaceuticals, Inc.

1. Basis of Presentation

     The accompanying unaudited condensed consolidated financial statements of Anadys Pharmaceuticals, Inc. (together with its wholly owned subsidiary Anadys Pharmaceuticals Europe GmbH, the “Company”) should be read in conjunction with the audited financial statements and notes thereto as of and for the year ended December 31, 2004 included in the Company’s Annual Report on Form 10-K filed with the Securities and Exchange Commission (the “SEC”) on March 30, 2005. The accompanying financial statements have been prepared in accordance with accounting principles generally accepted in the United States (“GAAP”) for interim financial information and in accordance with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, since they are interim statements, the accompanying financial statements do not include all of the information and notes required by GAAP for complete financial statements. The accompanying financial statements reflect all adjustments, consisting of normal recurring adjustments, that are, in the opinion of management, necessary for a fair statement of the results of operations for the interim periods presented. Interim results are not necessarily indicative of results for a full year.

     The preparation of financial statements in accordance with GAAP requires management to make estimates and assumptions that affect amounts reported in the financial statements and notes thereto. A discussion of the Company’s critical accounting policies and management estimates is described in the “Management’s Discussion and Analysis of Financial Condition and Results of Operations” included elsewhere in this quarterly report on Form 10-Q.

2. Net Loss Per Share

     The Company calculates basic and diluted net loss per share for all periods presented in accordance with the Statement of Financial Accounting Standards (“SFAS”) No. 128, Earnings Per Share. Basic net loss per share was calculated by dividing the net loss for the period by the weighted-average number of common shares outstanding during the period, without consideration for common stock equivalents. Diluted net loss per share was calculated by dividing the net loss for the period by the weighted-average number of common share equivalents outstanding during the period determined using the treasury-stock method. For purposes of this calculation, common stock subject to repurchase by the Company, options, and warrants are considered to be common stock equivalents and are only included in the calculation of diluted earnings per share when their effect is dilutive.

     The net loss per share for the three months ended March 31, 2005 includes the full effect of the 13.3 million shares of our common stock issued upon conversion of our redeemable and convertible preferred stock in conjunction with our initial public offering. As a result of the issuance of these common shares on March 31, 2004, there is a lack of comparability in the basic and diluted net loss per share amounts for the three months ended March 31, 2005 and 2004. In order to provide a more relevant measure of our operating results, the following unaudited pro forma net loss per share calculation has been provided. The shares used to compute unaudited pro forma basic and diluted net loss per share represent the weighted average common shares used to calculate actual basic and diluted net loss per share, increased to include the assumed conversion of all outstanding shares of preferred stock into shares of common stock using the as-if converted method as of the beginning of each period presented or the date of issuance, if later.

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3. Comprehensive Loss

     Comprehensive loss is comprised of net loss adjusted for changes in market values in available-for-sale securities. Below is a reconciliation of net loss to comprehensive loss for the periods presented.

4. Stock-based Compensation

     The Company accounts for stock-based compensation in accordance with the provisions of Accounting Principles Board Opinion (“APB”) No. 25, Accounting for Stock Issued to Employees and its related Interpretations, which state that no compensation expense is recorded for stock options or other stock-based awards to employees and directors that are granted with an exercise price equal to or

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above the fair value per share of the Company’s common stock per share on the grant date. In the event that stock options are granted with an exercise price below the fair value of the Company’s common stock on the grant date, the difference between the fair value of the Company’s common stock and the exercise price of the stock option is recorded as deferred compensation. Deferred compensation is amortized to compensation expense over the vesting period of the stock option. For stock options granted to its employees and directors, the Company has adopted the disclosure-only requirements of SFAS No. 123, Accounting for Stock-Based Compensation, which require compensation expense to be disclosed in the notes to the financial statements based on the fair value of the options granted at the date of the grant. Compensation expense for options granted to non-employees other than directors has been determined in accordance with SFAS No. 123 and Emerging Issue Task Force (“EITF”) Issue No. 96-18, Accounting for Equity Instruments that are Issued to Other than Employees for Acquiring, or in Conjunction with Selling Goods or Services. Such expense is based on the fair value of the options issued using the Black-Scholes method and is periodically remeasured as the underlying options vest in accordance with EITF Issue No. 96-18. Deferred compensation for restricted stock granted to employees has been determined as the quoted market value on the date the restricted stock was granted.

     The following pro forma information regarding net loss and net loss per share has been determined as if the Company had accounted for its employee and director stock options under the fair value method prescribed by SFAS No. 123. The fair value of options was estimated at the date of grant using a Black-Scholes option valuation model using the assumptions stated below.

     The effects of applying SFAS No. 123 for providing pro forma disclosures may not be representative of the effect on reported net loss for future years.

5. Recent Accounting Pronouncement

     In December 2004, the Financial Accounting Standards Board issued Statement No. 123 (revised 2004), Share Based Payment (“SFAS No. 123R”), which is a revision of S FAS No. 123. This statement supercedes APB No. 25, and amends SFAS No. 95, Statement of Cash Flows. Generally, the approach in SFAS No. 123R is similar to the approach described in SFAS No. 123; however, SFAS No. 123R requires all share-based payments to employees, including grants of employee stock options, to be recognized in the income statement based on their fair values. Pro forma disclosure is no longer an alternative.

     SFAS No. 123R permits companies to adopt its requirements using either a “modified prospective” method or a “modified retrospective” method. Under the “modified prospective” method, compensation cost is recognized in the financial statements beginning with the effective date, based on the requirements of SFAS No. 123R for all share-based payments granted after that date, and based on the requirements for SFAS No. 123 for all unvested awards granted prior to the effective date of SFAS No. 123R. Under the “modified retrospective” method, the requirements are the same as under the “modified prospective” method, but also permits companies to restate financial statements of previous periods based on pro forma disclosures made in accordance with SFAS No. 123. The Company currently utilizes the Black-Scholes model to measure the fair value of stock options granted to employees under the pro forma disclosure requirements of SFAS No. 123. While SFAS No. 123R permits companies to continue to use such model, it also permits the use of a “lattice” model. The Company has not yet determined which method or model it will use to measure the fair value

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of employee stock options under the adoption for SFAS No. 123R. The new standard is effective for annual periods beginning after June 15, 2005, and the Company expects to adopt SFAS No. 123R on January 1, 2006.

     The Company currently accounts for share-based payments to employees using APB No. 25’s intrinsic value method and, as such, recognizes no compensation cost for employee stock options granted with exercise prices equal to or greater than the fair value of our common stock on the date of the grant. Accordingly, the adoption of SFAS No. 123R’s fair value method is expected to result in significant non-cash charges which will increase the Company’s reported cost of revenues and operating expenses, however, it will have no impact on the Company’s cash flows. The impact of adoption of SFAS No. 123R cannot be predicted at this time because it will depend on the level of share-based payments granted in the future and the model the Company chooses to use. However, had the Company adopted SFAS No. 123R in prior periods, the impact of that standard would have approximated the impact of SFAS No. 123 as described in the disclosure of pro forma net loss above.

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

     This discussion and analysis should be read in conjunction with our financial statements and notes thereto included in this quarterly report on Form 10-Q (this “Quarterly Report”) and the audited financial statements and notes thereto as of and for the year ended December 31, 2004 included with the Company’s Annual Report on Form 10-K filed with the Securities and Exchange Commission (the “SEC”) on March 30, 2005. Operating results are not necessarily indicative of results that may occur in future periods.

     This Quarterly Report contains forward-looking statements. These forward-looking statements involve a number of risks and uncertainties. Such forward-looking statements include statements about our strategies, objectives, discoveries, collaborations, clinical trials, internal programs, and other statements that are not historical facts, including statements which may be preceded by the words “intend,” “will,” “plan,” “expect,” “anticipate,” “estimate,” “aim,” “believe,” “hope” or similar words. For such statements, we claim the protection of the Private Securities Litigation Reform Act of 1995. Readers of this Quarterly Report are cautioned not to place undue reliance on these forward-looking statements, which speak only as of the date on which they are made. We undertake no obligation to update publicly or revise any forward-looking statements. Actual events or results may differ materially from our expectations. Important factors that could cause actual results to differ materially from those stated or implied by our forward-looking statements include, but are not limited to, the risk factors identified in our SEC reports, including this Quarterly Report.

Overview

     We are a biopharmaceutical company committed to advancing patient care by discovering, developing and commercializing novel small molecule, anti-infective medicines for the treatment of hepatitis C virus, hepatitis B virus and certain bacterial infections. To date we have devoted substantially all of our resources to the development of our proprietary drug discovery technologies, general research and development and preclinical and clinical testing of isatoribine, ANA975, which is an oral prodrug of our proprietary compound isatoribine, a Toll-Like Receptor 7 agonist, and our other product candidates. We have incurred significant operating losses since our inception in 1992 and our commencement of operations in 1994 and, as of March 31, 2005 our accumulated deficit was $174.2 million. We expect to incur substantial and increasing losses for at least the next several years as we:

	•	Continue the development of ANA975 for the treatment of HCV and HBV;
	•	Fund our portion of the global development costs of ANA380;
	•	Continue the development of our other HCV, HBV and antibacterial product candidates;
	•	Develop and scale-up products for clinical trials and potential commercialization;
	•	Further our research and development programs;
	•	Advance our preclinical candidates into clinical development;
	•	Establish a commercial infrastructure;
	•	Commercialize any product candidates that receive regulatory approval; and
	•	Potentially in-license technology and acquire or invest in businesses, products or technologies that are synergistic with our own.

Critical Accounting Policies

     Our discussion and analysis of our financial condition and results of operations are based on our condensed consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the U.S. (“GAAP”). The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities and expenses and related disclosure of contingent assets and liabilities. We review our estimates on an on-going basis. We base our estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities. Actual results may differ from these estimates under different assumptions or conditions.

     Revenue Recognition. Our revenue recognition policies are in accordance with the SEC, Staff Accounting Bulletin (“SAB”), No. 104, Revenue Recognition, which provides guidance on revenue recognition in financial statements, and is based on the interpretations and practices developed by the SEC, and Emerging Issues Task Force (“EITF”) Issue 00-21, Revenue Arrangements with Multiple Deliverables. Many of our collaboration agreements contain multiple elements, including technology access fees, research funding, milestones and royalty obligations. As of March 31, 2005, we do not have any revenue from royalties or significant milestone payments.

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     Revenue from milestones is recognized when earned, as evidenced by written acknowledgment from the collaborator or other persuasive evidence that the milestone has been achieved, provided that (i) the milestone event is substantive and its achievability was not reasonably assured at the inception of the agreement, (ii) our performance obligations after the milestone achievement will continue to be funded by the collaborator at the comparable level to before the milestone achievement and (iii) the milestone is not refundable or creditable. If both of these criteria are not met, the milestone payment is recognized over the remaining minimum period of our performance obligations under the agreement. Upfront fees under our collaborations, such as technology access fees, are recognized over the period the related services are provided. Non-refundable upfront fees not associated with our future performance are recognized when received. Amounts received for research funding are recognized as revenues as the services are performed. Amounts received for research funding for a specific number of full time researchers are recognized as revenue as the services are provided, as long as the amounts received are not refundable regardless of the results of the research project.

     Drug Development Costs. We account for certain compound manufacturing costs, clinical trial site costs, joint development costs and drug development costs by estimating the services incurred but not reported. We review and accrue drug development costs based on work performed, which relies on estimates of total costs incurred based on patient enrollment, completion of studies and other events. These costs and estimates vary based on the type of clinical trial, the site of the clinical trial and the length of treatment period for each patient as well as other factors. Drug development costs are subject to revisions as trials and studies progress to completion. Revisions are charged to expense in the period in which the facts that give rise to the revision become known.

     Stock-based compensation. As permitted by the Statement of Financial Accounting Standards (“SFAS”), No. 123, Accounting for Stock-Based Compensation, we account for stock options granted to employees using the intrinsic value method in accordance with Accounting Principles Board (“APB”), Opinion No. 25, Accounting for Stock Issued to Employees, and the Financial Accounting Standards Board (“FASB”), Interpretation No. 44, Accounting for Certain Transactions Involving Stock Compensation — An Interpretation of APB 25. Pursuant to these guidelines, we measure the intrinsic value of the option or restricted stock award on its grant date as the difference between the purchase price of the restricted stock or the exercise price of employee stock options and the fair market value of our stock on the date of issuance or grant, and expense the difference, if any, over the vesting period of the option or restricted stock award.

     SFAS No. 123 requires stock-based compensation to be accounted for under the fair value method. If we adopted SFAS No. 123 to account for options granted to employees under our stock-based compensation plans, our loss would have been materially impacted.

     Options or stock awards issued to non-employees are recorded at their fair value in accordance with SFAS No. 123 and periodically remeasured in accordance with EITF No. 96-18, Accounting for Equity Instruments That Are Issued to Other Than Employees for Acquiring or in Conjunction with Selling Goods or Services, and recognized over the related service period.

     The above listing is not intended to be a comprehensive list of all of our accounting policies. In many cases, the accounting treatment of a particular transaction is specifically dictated by GAAP. There are also areas in which our management’s judgment in selecting any available alternative would not produce a materially different result. See our audited consolidated financial statements and notes thereto included elsewhere in this Annual Report, which contains accounting policies and other disclosures required by GAAP.

Recent Accounting Pronouncements

     In December 2004, the FASB issued SFAS No. 123R, Share-Based Payment, that addresses the accounting for share-based payment transactions in which a Company receives employee services in exchange for either equity instruments of the Company or liabilities that are based on the fair value of the Company’s equity instruments or that may be settled by the issuance of such equity instruments. The statement eliminates the ability to account for share-based compensation transactions using the intrinsic method that we currently use and requires that such transactions be accounted for using a fair-value-based method and recognized as expense in our consolidated statement of operations. The effective date of the standard is for annual periods beginning after June 15, 2005. Upon adoption of this standard we expect that it will have a significant impact on our consolidated statement of operations as we will be required to expense the fair value of our stock option grants and stock purchases under our employee stock purchase plan.

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Results of Operations

Three Months Ended March 31, 2005 and 2004

     Revenue. We recorded revenues of $563,000 for the three months ended March 31, 2005 compared to $683,000 for the three months ended March 31, 2004. Revenue for the three months ended March 31, 2005 was attributable to revenues derived from our collaboration with Roche and to a lesser extend our Phase II SBIR grant with the National Institutes of Health and our collaboration with Daiichi. Revenue for the three months ended March 31, 2004 was attributable to our collaborations with Roche, Daiichi and Amgen. Fluctuations in our collaboration-related revenue from period to period are expected, as amounts recognized are dependent upon a number of factors including, but not limited to, the timing of agreements, the timing of the workflow under the agreements and our collaborators’ abilities to provide us with the materials and information necessary for us to conduct our portion of the collaboration effort. We expect our revenues to continue to fluctuate in future periods as we continue to enter into new agreements and perform activities under existing agreements.

     Research and Development Expenses. Research and development expenses were $6.8 million for the three months ended March 31, 2005 compared to $4.7 million for the three months ended March 31, 2004. The increase in research and development expenses during the quarter ended March 31, 2005 was the result of increased costs associated with the development of ANA975 including costs associated with compound manufacturing and toxicology studies. In addition, research and development expenses for the quarter ended March 31, 2005 included costs associated with our Phase I clinical trial for ANA975, which was initiated during the quarter. The clinical trial was initiated in January 2005 and is designed to evaluate the safety, tolerability and pharmacokinetics of ANA975 in healthy volunteers.

     The following summarizes our research and development expenses for the three months ended March 31, 2005 and 2004:

     General and Administrative Expenses. General and administrative expenses were $1.7 million for the three months ended March 31, 2005 compared to $1.0 million for the three months ended March 31, 2004. The $700,000 increase from the three months ended March 31, 2004 to the three months ended March 31, 2005 was primarily related to an increase in our Directors and Officers insurance premium as a result of our initial public offering which was completed on March 31, 2004 and an increase in personnel expenses.

     Stock-based Compensation. Deferred compensation for stock options and stock awards granted has been determined as the difference between the exercise price and the fair value of our common stock on the date of grant. Options or awards issued to non-employees are recorded at their fair value in accordance with SFAS No. 123 and periodically remeasured in accordance with EITF 96-18 and recognized over the service period. In connection with the grant of stock options to employees, we recorded deferred stock-based compensation as a non-cash charge to operations over the vesting period of the options. We recorded stock-based compensation of $617,000 for the three months ended March 31, 2005 compared to $2.3 million for the three months ended March 31, 2004.

     Interest Income and Other, net. Interest income was $252,000 for the three months ended March 31, 2005 compared to $18,000 for the three months ended March 31, 2004. The Company received $43.7 million during March and April 2004 as a result of our initial public offering. The proceeds from our initial public offering were invested in short-term marketable securities. The increase in interest income was the result of the overall increase in our average short-term marketable securities for the three months ended March 31, 2005 compared to the three months ended March 31, 2004. Our ending cash, cash equivalents, and securities available-for-sale balance was $27.6 million at March 31, 2005.

     Interest Expense. Interest expense was $97,000 for the three months ended March 31, 2005, which was relatively consistent with the interest expense of $60,000 for the three months ended March 31, 2004.

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Liquidity and Capital Resources

     As of March 31, 2005, we had cash, cash equivalents, and securities available-for-sale of $27.6 million. To date, we have funded our operations primarily through the sale of equity securities as well as through equipment financing. Through March 31, 2005, we had received approximately $171.2 million from the sale of equity securities. In addition, as of March 31, 2005, we had financed through loans the purchase of equipment totalling approximately $9.7 million, of which $2.2 million in loans was outstanding at that date. These obligations are secured by the purchased equipment and leasehold improvements, bear interest at rates ranging from approximately 8.6% to 10.0% and are due in monthly installments through October 2008.

     Cash Flows from Operating Activities and Investing Activities:

     Our condensed consolidated statements of cash flows are summarized as follows: