CollaGenex Pharmaceuticals (CGPI)

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, DC 20549

FORM 10-Q

(MARK ONE)

For the transition period from     to    

Commission File Number 0-28308

(Exact Name of Registrant as Specified in Its Charter)

(215) 579-7388

(Registrant’s Telephone Number, Including Area Code)

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.

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).

Indicate the number of shares outstanding of each of the issuer’s classes of common stock as of November 1, 2007:

COLLAGENEX PHARMACEUTICALS, INC.

Oracea®, Periostat®, Metastat®, Dermostat®, Nephrostat®, Osteostat®, Arthrostat®, Rheumastat®, Corneostat®, Gingistat®, IMPACS™, PS20®, The Whole Mouth Treatment®, Restoraderm®, Dentaplex®, Lytra®, Periostat-MR™, SansRosa®, Unorthodoxy™, Unorthodoxycycline™, Aprecin®, Zedara™, Optistat®, Xerostat®, Periocycline®, Periostatus®, CollaGenex®, Dermastat®, Periostan®, Periostat-SR®, “C” Logo® and “The Whole Mouth Treatment” Logo®, Esteemax™, Rubazil™, Lytrazine™, Palytra™, Lytrazac™, Presteme™, Erubatin™, Rosoral™, Reveeril™, Cycavin™, Zyclinil™, and Impaken™.

Marks listed as registered herein may be registered in the United States or in other jurisdictions. All other trade names, trademarks or service marks appearing in this Quarterly Report on Form 10-Q are the property of their respective owners and are not property of CollaGenex Pharmaceuticals, Inc. or any of our subsidiaries.

2

COLLAGENEX PHARMACEUTICALS, INC.

Condensed Consolidated Balance Sheets

September 30, 2007 and December 31, 2006

(dollars in thousands, except share data)

(unaudited)

See accompanying notes to unaudited condensed consolidated financial statements.

3

COLLAGENEX PHARMACEUTICALS, INC.

Condensed Consolidated Statements of Operations

For the Three Months Ended September 30, 2007 and 2006

(amounts in thousands, except share and per share data)

(unaudited)

See accompanying notes to unaudited condensed consolidated financial statements.

4

COLLAGENEX PHARMACEUTICALS, INC.

Condensed Consolidated Statements of Operations

For the Nine Months Ended September 30, 2007 and 2006

(amounts in thousands, except share and per share data)

(unaudited)

See accompanying notes to unaudited condensed consolidated financial statements.

5

COLLAGENEX PHARMACEUTICALS, INC.

Condensed Consolidated Statements of Cash Flows

For the Nine Months Ended September 30, 2007 and 2006

(dollars in thousands)

(unaudited)

See accompanying notes to unaudited condensed consolidated financial statements.

6

COLLAGENEX PHARMACEUTICALS, INC.
AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
September 30, 2007 and 2006
(dollars in thousands, except per share data)
(unaudited)

The unaudited condensed consolidated financial statements included herein have been prepared by CollaGenex Pharmaceuticals, Inc. and subsidiaries, or the Company, pursuant to the rules and regulations of the Securities and Exchange Commission and in accordance with accounting principles generally accepted in the United States of America, or U.S. GAAP. Certain information and footnote disclosures normally included in the annual consolidated financial statements prepared in accordance with U.S. GAAP, have been condensed or omitted pursuant to such rules and the regulations of the Securities and Exchange Commission. These unaudited condensed consolidated financial statements should be read in conjunction with the Company’s 2006 audited consolidated financial statements and footnotes included in its Annual Report on Form 10-K for the year ended December 31, 2006.

The accompanying unaudited condensed consolidated financial statements include the results of operations of the Company and its majority-owned subsidiaries. All intercompany accounts and transactions have been eliminated in consolidation.

In the opinion of the Company’s management, the accompanying unaudited condensed consolidated financial statements have been prepared on a basis substantially consistent with the audited consolidated financial statements for the year ended December 31, 2006 and contain adjustments, all of which are of a normal, recurring nature necessary to present fairly the Company’s consolidated financial position at September 30, 2007, the results of operations for the three and nine months ended September 30, 2007 and 2006, and the cash flows for the nine months ended September 30, 2007 and 2006. Interim results are not necessarily indicative of results anticipated for the full fiscal year.

The preparation of consolidated financial statements in conformity with U.S. GAAP requires management to make estimates and assumptions that affect the amounts reported in the consolidated financial statements and accompanying notes. Actual results could differ from those estimates.

The Company generally recognizes revenues for product sales upon shipment to wholesale customers, net of estimated returns and estimates for chargebacks, sales discounts and applicable wholesale distribution fees and rebates provided that collection is probable and no significant obligations remained. However, following the launch of a third party generic competitor to Periostat^® in May 2005 and commencing with the second quarter of 2005, the Company began recognizing Periostat sales revenue based on product sales to end-users. For all other products sold, the Company records sales discounts, allowances, rebates and returns upon the recognition of product sales. The Company only accepts returns of damaged or expired products. The return allowance, when estimatable, is based on an analysis of the historical returns of the product and the Company considers current end user demand and wholesale and retail inventory levels. If product returns are not estimatable, the Company defers revenue recognition for all outstanding products in the wholesale and retail channel that are subject to return. Chargebacks, wholesale distribution fees and rebates are based on an analysis of the applicable agreements and historical experience. In addition, the Company also considers the volume and price of the product in the channel, trends in wholesaler and retailer inventory levels, conditions that might affect end-user demand (such as generic competition) and other relevant factors.

The Company currently utilizes a patient rebate program for Oracea® prescriptions. The Company accounts for these patient rebates as a reduction of net product sales.

7

Non-refundable, up-front contract and license fees are deferred and amortized to revenue over the related performance period. The Company estimates the performance period based on the specific terms of each of the license or contract agreements. The Company recognizes periodic payments over the period that the Company performs the related activities under the terms of the agreements. Revenue resulting from the achievement of milestone events stipulated in the agreements is recognized when the milestone is achieved if reliable, verifiable and objectively determinable evidence of fair value is established. If such evidence of fair value cannot be established, the total revenue resulting from any such agreement will be recognized over the total performance period of such agreement.

Pursuant to the Company’s Promotion and Cooperation Agreement, or the Promotion Agreement, with Primus Pharmaceuticals, Inc., or Primus, contract revenues for Alcortin^™, a prescription topical antifungal steroid combination and Novacort^™, a prescription topical steroid and anesthetic, are fee-based arrangements where contract revenue is earned as prescriptions are filled and recognized as a percentage of the gross profit earned by Primus. The Company does not take title to the inventory sold by Primus under the Promotion Agreement.

During 2005, the Company received a grant from the National Institutes of Health, or NIH, to fund additional research by the Company and its collaborators on the anti-inflammatory effects of incyclinide. The Company expenses such research expenditures as they are incurred and recognizes grant revenue when earned for the portion of the expenditures that are reimbursable by the NIH. The Company recognized $60 and $211 in grant revenues for the three and nine months ended September 30, 2007 and $211 and $377 in grant revenues for the three and nine months ended September 30, 2006.

Research and product development costs are expensed as incurred. Research and development expenses consist primarily of personnel costs and funds paid to third parties for the provision of services and materials for drug development, manufacturing and formulation enhancements, clinical trials (including clinical trials conducted after FDA approval of a product), statistical analysis and report writing and regulatory compliance costs, including governmental filing fees.

As described above, some of the Company’s research and development is conducted by third parties, including contract research and development service providers. At the end of each quarter, the Company compares the payments made to each service provider to the estimated progress toward completion of the research or development objectives. Such estimates are subject to change as additional information becomes available. Depending on the timing of payments to the service providers and the progress that the Company estimates has been made as a result of the service provided, the Company may record net prepaid or accrued expense relating to these costs.

Costs to acquire in-process research and development projects and technologies which have not achieved technical feasibility at the date of acquisition are expensed as research and development expense as incurred. The Company expensed $2,182 of in-process research and development for the nine months ended September 30, 2007 and $300 for the nine months ended September 30, 2006.

Inventories are stated at the lower of cost or market. Cost is determined using the first-in, first-out method. Critical accounting estimates and assumptions related to inventory carrying values are evaluated periodically and consider the saleable quantities of inventory versus quantities of inventory on-hand.

The Company classifies costs relating to the manufacture of product inventory and samples in advance of a new product launch as research and development expense until the product is approved by the Food and Drug Administration, or FDA. Following FDA approval, the Company’s policy is to capitalize any inventory costs that were not previously recognized as a research and development expense.

8

The Company recognizes the fair value of stock-based compensation awards in the Company’s consolidated financial statements using the modified prospective method. The Company applies the Black-Scholes option pricing model to determine the fair value of stock options on the date of grant and estimates key assumptions that are important elements in the model, such as the expected stock-price volatility and expected stock option life. The Company’s estimates of these key assumptions and expected forfeiture rates are based on historical data and judgment regarding market trends and factors. These estimates are not intended to predict actual future events or the value ultimately realized by individuals who receive equity awards.

The Company considers all highly liquid investments with an original maturity of three months or less at the date of acquisition to be cash equivalents. Cash equivalent investments are held at amortized cost, which approximates fair value. All short-term investments have original maturity dates of between three months and one year. The Company’s short-term investments are primarily composed of commercial paper, certificates of deposit and government notes. At September 30, 2007, all of the Company’s short-term investments, carried at fair value, were classified as available-for-sale with unrealized gains and losses included as a separate component of stockholders’ equity.

The accumulated net unrealized gain on short-term investments at September 30, 2007 was $2. The accumulated net unrealized gain on short-term investments was $7 at December 31, 2006.

(1) U.S. Agency notes are comprised of Fannie Mae, Freddie Mac, Farmer Mac, Federal Farm Credit and Federal Home Loan bank. If held to maturity, these holdings allow the issuer to settle the securities at a price no less than the amortized cost.

On January 1, 2007, the Company adopted the Financial Accounting Standards Board, or FASB, Interpretation No. 48, Accounting for Uncertainty in Income Taxes, or FIN 48. FIN 48 clarifies the accounting for uncertainty in income taxes recognized in an enterprise’s financial statements in accordance with SFAS No. 109, Accounting for Income Taxes. FIN 48 prescribes a recognition threshold and measurement for financial statement recognition and measurement of a tax position reported or expected to be reported on a tax return. FIN 48 also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure, and transition. Prior to the adoption of FIN 48, the Company’s policy was to recognize tax benefits of uncertain tax positions only if it was “probable” that the position would be sustained. FIN 48 requires application of a “more likely than not” threshold to the recognition and derecogntion of tax positions. As a result of the adoption of FIN 48, retained earnings increased in the amount of $945 and accrued expenses decreased by the same amount as of January 1, 2007 (see Note 10).

9

The Company and its subsidiaries file income tax returns in the U.S. federal jurisdiction and in various states. The Company has tax net operating loss and credit carryforwards that are subject to examination for a number of years beyond the year in which they are utilized for tax purposes. Since a portion of these carryforwards will be utilized in the future, many of these attribute carryforwards may remain subject to examination. The Company’s policy is to record interest and penalties on uncertain tax positions as income tax expense. At September 30, 2007, the Company has no amounts recorded for uncertain tax positions, interest or penalties in the accompanying consolidated financial statements.

In September 2006, the FASB issued Statement of Financial Accounting Standards, or SFAS, Statement No. 157, “Fair Value Measurements”, or SFAS 157. SFAS 157 clarifies the definition of fair value, establishes a framework for measuring fair value and expands the disclosures on fair value measurements. SFAS 157 is effective for the Company beginning January 1, 2008. The Company is currently evaluating the impact, if any, of SFAS 157 adoption on its consolidated financial statements.

In February 2007, the FASB issued SFAS No.159, The Fair Value for Financials Assets and Financial Liabilities or SFAS No. 159. SFAS No. 159 permits entities to choose to measure financial assets and liabilities, with certain exceptions, at fair value at specified election dates. A business entity shall report unrealized gains and losses on items for which the fair value option has been elected in earnings at each subsequent reporting date. SFAS No. 159 is effective as of the beginning of an entity’s first fiscal year that begins after November 15, 2007. The Company is currently evaluating the impact, if any, SFAS No. 159 will have on its consolidated financial statements.

In June 2007, the Emerging Issues Task Force (“EITF”) reached a final consensus on EITF Issue No. 07-3, “Accounting for Nonrefundable Advance Payments for Goods or Services to Be Used in Future Research and Development Activities” (“EITF 07-3”). EITF 07-3 is effective for fiscal years beginning after December 15, 2007.  EITF 07-3 requires that non-refundable advance payments for future research and development activities should be capitalized until the goods have been delivered or related services have been performed.  Adoption is on a prospective basis and could impact the timing of expense recognition for agreements entered into after December 31, 2007.  The Company does not expect the adoption of EITF 07-3 to have a significant impact on the consolidated financial statements.

Note 2 — Concentration of Credit and Segment Information

The Company invests its excess cash in money market funds with major U.S. financial institutions, commercial paper, certificates of deposit and government notes, based on its investment guidelines designed to protect the safety and liquidity of these investments.

The Company currently contracts with a single source for the manufacturing of Oracea capsules and Periostat tablets and has an agreement with a single company to supply the active ingredient in Oracea and Periostat. A single company also provides all warehousing and logistics services to the Company.

As indicated in the table below, three customers accounted for 92% and 87%, respectively of net product sales for the three months ended September 30, 2007 and 2006. The same three customers accounted for 91% and 88% of net product sales during the nine months ended September 30, 2007 and 2006.

10

As indicated in the table below three customers accounted for 94% of gross trade accounts receivable balance at September 30, 2007 and at December 31, 2006.

The Company operates as one business that is managed by a single management team reporting to the chief executive officer. The Company does not prepare discrete financial information with respect to separate product or product candidate areas or by location and does not have separately reportable segments. During each of the three and nine months ended September 30, 2007 and 2006, the Company’s total net revenues were comprised of the following:

At September 30, 2007, the Company had one active stock-based employee compensation plan. Stock option awards to employees are granted with an exercise price equal to the fair market value of the Company’s common stock on the date of grant. The option awards typically have a term of ten years and generally vest over a period ranging from two to five years. Certain options are subject to accelerated vesting if there is a change in control (as defined in the plan and change of control agreements, if applicable).

Stock-based compensation for the three and nine months ended September 30, 2007 and 2006 are as follows:

11

No amount of stock-based compensation cost has been capitalized into inventory or other assets during the three and nine months ended September 30, 2007 and 2006.

Certain options granted in 2003 have been amortized at an accelerated rate versus the contractual vesting period of such options as these options are performance-based and it was anticipated that the performance criteria would be met prior to straight-line vesting. Such options were fully amortized at December 31, 2006.

In May 2006, the Company accelerated the vesting of certain options held by a former member of the Company’s Board of Directors. Accordingly, a charge of $92 was recorded during the nine months ended September 30, 2006 to reflect the fair value of such options on the date of modification.

The following table summarizes activity under all stock option plans.

At September 30, 2007, the value of the unvested portion of all outstanding stock-related awards was $7,617 which the Company expects to amortize and recognize as compensation expense over the weighted-average service period of approximately two years.

The amount of cash received during the nine months ended September 30, 2007 and 2006 from the exercise of options was $2,133 and $1,734, respectively. No related tax benefit from the exercise of such options was realized as a result of the Company’s net operating loss carryforwards and full valuation allowance.

The Company received $376 in cash during the nine months ended September 30, 2007 as a result of the exercise of 40,000 warrants on June 28, 2007. As of September 30, 2007, the Company had no outstanding warrants.

The fair values of the options granted during the nine months ended September 30, 2007 and 2006 were determined using the Black-Scholes option pricing model, which incorporates various assumptions. The risk-free rate of interest for the average contractual life of the option is based on U.S. Government Securities Treasury Constant Maturities. Expected volatility is based on the historical daily volatility of the Company’s common stock. The expected life is determined using the short-cut method permitted under Staff Accounting Bulletin No. 107, Share-Based Payment. The expected dividend rate yield is zero because the Company currently does not pay or expect to pay dividends to common stockholders.

The following are the weighted average assumptions used during the respective periods:

12

Stock option activity during the nine months ended September 30, 2007 was as follows:

(1)             The aggregate intrinsic value was calculated based on the positive difference between the closing sales price of the Company’s common stock ($8.98 per share) on September 28, 2007 and the exercise prices of the underlying options.

Inventories at September 30, 2007 and December 31, 2006 consist of the following:

The Company recorded a charge of $37 to cost of product sales related to excess inventories of the Atrix and Pandel products during the three months ended September 30, 2007. During the three and nine months ended September 2006, the Company recorded a charge to cost of product sales of $160 and $250 related to excess inventories. During the three months ended September 30, 2007, the Company recorded a charge of $180 to cost of product sales related to validation costs from the manufacturer of the Company’s inventory.

13

Intangible assets, net at September 30, 2007 and December 31, 2006 consist of the following:

In August 2001, the Company signed a license agreement with Atrix Laboratories, Inc. (now known as Tolmar Inc., a subsidiary of Technofarma, S.A.), for the rights to market Atridox^®, Atrisorb FreeFlow^® and Atrisorb-D^® in the United States. On May 14, 2007, the Company received written notice of termination effective November 14, 2007 of the Company’s License Agreement with Tolmar Inc. The amortization of acquired product rights has been adjusted to coincide with the termination date of the contract.

Oracea milestone fees represent the unamortized component of Oracea formulation milestones paid post-FDA approval of Oracea and are being amortized on a straight-line basis over a fifteen year period commencing in July 2006.

Amortization expense, which is included in cost of product sales, was $105 and $300 for the three and nine months ended September 30, 2007 and $83 and $284 for the three and nine months ended September 30, 2006.

On October 9, 2006, the Company entered into a Sixth Loan Modification Agreement with Silicon Valley Bank. Pursuant to the terms of this agreement, the expiration date of the amended credit facility has been extended to October 9, 2008. Under the amended credit facility, the Company may borrow up to the lesser of (i) $10,000 or (ii) 80% of eligible receivables plus certain specified amounts, subject to reduction during the period October 9, 2006 through December 31, 2007. The amount available to the Company is reduced by any outstanding letters of credit that may be issued under the amended credit facility in amounts totaling up to $2,000. As the Company pays down amounts under any letter of credit, the amount available to it under the credit facility increases. The Company is not obligated to draw down any amounts under the amended credit facility and any borrowings shall bear interest, payable monthly, at Silicon Valley Bank’s prime rate, or 7.75%, at September 30, 2007. Under the Sixth Loan Modification Agreement, the Company is charged an unused line credit fee of 0.25% per annum. In addition, under the amended credit facility, the Company is subject to financial covenants that require the Company to maintain certain minimum liquidity and tangible net worth levels on a quarterly basis. During the nine months ended September 30, 2007 and 2006, the Company’s unused line of credit fee was $45 and $18, respectively. As of September 30, 2007 the Company had no borrowings outstanding.

14

The Company recorded contract and license revenues of $314 and $826 for the three and nine months, ended September 30, 2007, respectively, and $431 and $1,084 for the three and nine months ended September 30, 2006, respectively. In June 2005, the Company entered into the Promotion Agreement with Primus, under which the Company promotes Alcortin, a prescription topical antifungal steroid combination, and Novacort, a prescription topical steroid and anesthetic. Under the Promotion Agreement, the Company receives a percentage of the gross profit arising from prescriptions written by dermatology professionals (or offices) that result in sales of the products in the United States. Through June 30, 2006, the majority of marketing expenses, excluding sales force compensation and sample product costs, related to the promotion of the Primus products were funded by Primus and the majority of product sample costs and all sales force compensation were funded by the Company. Effective July 1, 2006, the Company and Primus amended the Promotion Agreement. As a result of the amendment, sample expenses and marketing costs, excluding sales force compensation, are funded 60% by the Company and 40% by Primus.

On December 18, 2006, the Company executed a License and Supply Agreement with MediGene AG, or MediGene, a corporation existing under the laws of Germany, that became effective on January 1, 2007. Under this agreement, MediGene has the right to manufacture, register, market and sell Oracea in the European Union, certain contiguous countries and Russia. MediGene may exercise its right to manufacture Oracea at any time during the term of the agreement upon twelve months notice to the Company. During the nine months ended September 30, 2007, the Company classified the up front non-refundable fee of $5,000 as non-current deferred licensing revenue. In accordance with the Company’s revenue recognition policy, the Company would begin amortizing this deferred revenue to revenue over the term of the agreement once EU approval for Oracea has been received. Additionally, the Company may be entitled to an additional $7,500 in milestone payments upon the achievement of certain annual sales thresholds achieved by MediGene. In addition, the Company will receive an agreed upon transfer price and a royalty of 12% of annual net sales up to $10,000 and 15% of annual net sales in excess of $10,000 in the specified territories. The Company’s application for European marketing authorization for Oracea was recently referred to the Committee for Medicinal Products for Human Use, or CHMP. Referral to the CHMP may be a lengthy process and the Company cannot predict when, or if, this body will approve the Company’s application.

In October 2002, the Company announced the execution of a license agreement with Medtronic, Inc., or Medtronic, involving the Company’s IMPACS^™ compounds, pursuant to which Medtronic obtained an exclusive, worldwide license to use the compounds and certain related patent technology to treat aortic aneurysms and other forms of vascular disease with medical devices. This program is still active. In an amendment to the Medtronic License dated January 27, 2007, the Company agreed to narrow the scope of Medtronic’s rights, to provide that the license shall become non-exclusive if certain milestones are not timely met, and to accelerate the timing of the first milestone payment of $250 upon execution of the amendment. During the nine months ended September 30, 2007, the Company received the $250 milestone payment and has classified this in non-current deferred licensing revenue in the accompanying condensed consolidated balance sheet. Further milestone payments of $500 and $2,000 respectively, become due upon first human use and first commercial sale, of a product incorporating IMPACS technology. Medtronic must also pay royalties based on a percentage of net sales of such a product. Neither the Company nor Medtronic have developed a timetable for clinical development or commercial launch of any product.

The Company is involved in, or has been involved in, arbitrations or various other legal proceedings that arise from the normal course of business. The Company cannot predict the timing or outcome of these claims and other proceedings. At September 30, 2007, the Company is not involved in any arbitration and/or other legal proceedings that it expects to have a material adverse effect on the business, financial condition, results of operations or liquidity of the Company. All legal costs are expensed as incurred.

Under the Company’s license agreement with The State University of New York at Stony Brook, or SUNY, covering Periostat and Oracea, the Company is entitled to deduct costs incurred to defend its patents from current and future royalties due to SUNY on net sales of Oracea and Periostat. The cumulative legal patent defense, litigation and settlement costs incurred during the litigation period through September 30, 2007 currently exceeds the amount of the royalties earned by SUNY, since the inception of litigation, by $2,902. This excess amount, which has been previously expensed, may be available to offset future royalties earned by SUNY, if any, on sales of products based on the SUNY technology. The Company recorded $215 and $764 in product royalty expense and credited legal expense for $215 and $764 related to previously expensed legal fees for the three and nine months ended September 30, 2007. Accordingly, $215 and $764 were deducted from royalty payments earned by SUNY during the three and nine months ended September 30, 2007. The

15

Company recorded $183 and $335 in product royalty expense and credited legal expense for $183 and $335 related to previously expensed legal fees for the three and nine months ended September 30, 2006. Accordingly, $183 and $335 were deducted from royalty payments earned by SUNY during the three and nine months ended September 30, 2006.

Accrued expenses at September 30, 2007 and December 31, 2006 consist of the following:

(1)             In November 2004, the Company sold its U.K. and European dental assets to Alliance Pharma plc, a U.K. specialty pharmaceuticals company. As part of this sale in 2004, the Company recorded a liability of $945 within accrued expenses for anticipated U.K. income taxes due on this sale. As described in Note 1, the Company adopted FIN 48 on January 1, 2007. As a result of the adoption, this liability was reversed on January 1, 2007, as the threshold for this tax uncertainty was above more-likely-than not. On January 19, 2007, the Company received a notice from the U.K. taxing authorities stating that no amendments were needed to the Company’s previously filed tax return. Accordingly, no additional income taxes were due related to this transaction.

On July 17, 2007, the Company entered into a capital lease for certain telecommunication equipment. The lease term is thirty-six months with annual payments of $22. At September 30, 2007, the gross amount of equipment related to this capital lease amounted to $54.

In November 2006, the Company raised $42,500 in a public offering, net of placement agency fees and all related offering expenses. In December 2005 and January 2006, the Company raised $15,500 and $11,600 respectively, in a public offering, net of placement agency fees and all related offering expenses.

16

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

Our management’s discussion and analysis of our financial condition and results of operations include the identification of certain trends and other statements that may predict or anticipate future business or financial results. There are important factors that could cause our actual results to differ materially from those indicated. See “Part II, Item 1A., Risk Factors.”

CollaGenex Pharmaceuticals, Inc. and subsidiaries is a specialty pharmaceutical company currently focused on developing and marketing innovative proprietary medical therapies to the dermatology market. We currently market four prescription pharmaceutical products to the dermatology market through our professional dermatology sales force and generate revenues from four other prescription pharmaceutical products that we continue to sell to the dental market. In May 2006, the U.S. Food and Drug Administration, or the FDA, granted us marketing approval for Oracea® for the treatment of inflammatory lesions (papules and pustules) of rosacea in adult patients. Oracea is the first FDA approved, orally-administered, systemically-delivered drug to treat rosacea. In July 2006, we launched Oracea to the U.S. dermatology community.

Our strategy is to become a leading developer and marketer of innovative prescription pharmaceutical products to the dermatology market. We intend to continue to market our current products, including Oracea, and develop and launch new products based on our proprietary platform technologies as well as other technologies. Our lead development candidates are: COL-118, a topical compound that we are developing for the treatment of erythema (skin redness) associated with dermatological conditions. We recently reported favorable results from a Phase II clinical trial of this compound and we are in discussions with FDA concerning the conclusion of Phase II and the design and timing of Phase III clinical trials, which we expect to initiate in the middle of 2008; becocalcidiol, a recently licensed vitamin D analogue for the topical treatment of psoriasis; and Restoraderm®, a foam-based, topical dermal drug delivery system, which is currently in formulation development.

Our marketed dermatology products are: Oracea; Pandel®, a prescription corticosteroid we licensed in 2002 from Altana Inc., a member of the Nycomed Group; Alcortin™, a prescription topical antifungal steroid combination; and Novacort™, a prescription topical steroid and anesthetic. In June 2005, we executed a Promotion and Cooperation Agreement with Primus Pharmaceuticals Inc., or Primus, to market Alcortin and Novacort to dermatologists. On February 1, 2007, we received written notice of termination of the Sublicense Agreement relating to Pandel. Effective November 1, 2007, we will no longer generate sales from the Pandel product.

Our original dental product, Periostat®, is an orally-administered, prescription pharmaceutical product that was approved by the FDA in September 1998 for the treatment of adult periodontitis. On May 20, 2005, we terminated our dental sales force and promotional activities for Periostat following the introduction of a third party generic version of the product. We also discontinued the promotion of our other dental products on May 20, 2005. We continue to generate sales from Periostat and three other dental products, which include Atridox®, Atrisorb FreeFlow® and Atrisorb-D®, also referred to as the Atrix Products, each of which is licensed from Tolmar Inc., a subsidiary of Tecnofarma, S.A. Effective November 14, 2007, our License Agreement with Tolmar, Inc. will terminate and we will no longer generate sales from the Atrix Products.

In addition to our marketed products, we have a pipeline of product candidates in clinical and preclinical development. These products are based on our proprietary platform technologies, SansRosa® and Restoraderm, or are licensed from third parties.

We were founded in 1992 and completed an initial public offering of our common stock in 1996. Although we achieved net income for the years ended December 31, 2004, 2003 and 2002, we have incurred losses in every other year since inception and have an accumulated deficit of $134.4 million at September 30, 2007. We do not expect to generate a profit for the year ending December 31, 2007.

IMPACS^™ (Inhibitors of Multiple Proteases And CytokineS) are a group of compounds that demonstrate a range of anti-inflammatory activities as well as the ability to inhibit the breakdown of connective tissue. Periostat and Oracea are our first FDA-approved IMPACS products. Our IMPACS technology is licensed on a perpetual basis from the Research

17

Foundation of the State University of New York at Stony Brook, or SUNY. SUNY also conducts research and development on other potential applications of this technology on a project basis.

Our SansRosa technology, which we acquired in connection with the acquisition of SansRosa Pharmaceutical Development Inc., or SansRosa, in December 2005, is a class of compounds that have shown promise in reducing the redness associated with rosacea, and we intend to formulate and develop a topical treatment for erythema based on one or more of these compounds.

Our Restoraderm technology is a proprietary, foam-based, topical drug delivery technology that originated from a Swedish collaborator. We have acquired all rights, title and interest to the Restoraderm technology. We have formulated various prescription and over the counter products based on the Restoraderm technology. We do not currently have a timetable for either the initiation of clinical development or the launch of any Restoraderm products.

Our becocalcidiol product candidate uses technology covered by various patents and patent applications licensed from QuatRx Pharmaceuticals Company, or QuatRx, pursuant to a Sub-License Agreement, or the Sub-License Agreement.

On August 23, 2007, we announced results of a Phase II dose-finding study designed to evaluate the safety and efficacy of COL-118 for the treatment of erythema. The Phase II clinical study demonstrated a highly statistically significant dose-response relationship of COL-118 in the reduction of erythema with a side effect profile similar to placebo. We are in discussions with FDA concerning the conclusion of Phase II and the design and timing of Phase III clinical trials, which we expect to initiate in the middle of 2008.

On March 29, 2007, we announced that we had commenced enrollment of patients in a 40 mg cohort of our Phase II double-blinded, placebo-controlled, dose-finding clinical trial to determine the appropriate dose for Phase III testing of incyclinide in the treatment of acne. On May 2, 2007, we learned that one patient had experienced apparent significant photo-toxicity, a known side effect of tetracyclines, while participating in the 40 mg cohort and we suspended enrollment of all new patients in this study. On May 7, 2007, we learned of another patient who had experienced apparent photo-toxicity and we announced that we had discontinued treatment of all enrolled patients.

On September 26, 2007, we announced results of a Phase II dose-finding study designed to evaluate the safety and determine the therapeutic range of incyclinide for the treatment of rosacea. The study demonstrated that incyclinide was well tolerated with most adverse events being mild to moderate. However, the patients administered incyclinide did not demonstrate greater reduction in inflammatory lesions than the patients on placebo at any time point during the study and we discontinued all development work on incyclinide for a rosacea indication.

On November 6, 2007, we announced that, following a detailed cost, benefit and risk analysis in the fourth quarter of 2007, we had decided to discontinue all development work on incyclinide for an acne indication in order to focus our resources and energies on those projects in our pipeline that we believe have the greatest potential.

18

Results of Operations

Comparison of the Three Months Ended September 30, 2007 and September 30, 2006

During the three months ended September 30, 2007, total net product sales which included net sales of Oracea, Pandel, Periostat and the Atrix Products, increased $10.6 million, or 211.7%, as compared to the three months ended September 30, 2006, due primarily to sales from Oracea, which was launched in July 2006. Net revenues from dermatological products were 92.3% of total net revenues in the three months ended September 30, 2007 compared to 66.3% for the three months ended September 30, 2006. Total deductions from gross sales for estimated product returns, trade cash discounts, managed care rebates, government and patient rebates and wholesale distribution fees for Oracea were approximately 14.7% of gross sales during the three months ended September 30, 2007 compared to 37.8% during the three months ended September 30, 2006. Prescriptions for Oracea as reported by an independent industry data source were approximately 100,504 during the three months ended September 30, 2007, representing a 252% increase in prescriptions compared to 28,545 prescriptions during the three months ended September 30, 2006. At September 30, 2007, Oracea wholesaler inventory level was approximately 4.1 weeks of sales as compared to approximately 3.3 weeks of sales at June 30, 2007.

Effective November 1, 2007, our Sublicense Agreement with Altana Inc., will terminate and we will no longer generate other net product sales from the Pandel product. Effective November 14, 2007, our License Agreement with Tolmar, Inc. will terminate and we will no longer generate sales from the Atrix Products.

Cost of product sales for the three months ended September 30, consist of the following:

Manufacturing costs include contract manufacturing costs (Periostat and Oracea), transfer price (Pandel and the Atrix Products), manufacturing facility FDA validation costs, costs associated with excess inventories, overhead costs and internal costs.

19

Under our license agreement with SUNY, covering Periostat and Oracea, we are entitled to deduct prior legal costs incurred to defend SUNY’s patents from current and future royalties due SUNY on net sales of products based on SUNY technology. During the three months ended September 30, 2007, we recorded $215 in product royalty expense and credited legal expense for $215 related to previously expensed legal fees. Accordingly, $215 was deducted from royalty payments earned by SUNY during the three months ended September 30, 2007. During the three months ended September 30, 2006, we recorded $183 in product royalty expense and credited legal expense for $183 related to previously expensed legal fees. Accordingly, $183 was deducted from royalty payments earned by SUNY during the three months ended September 30, 2006. (see Note 9)

Cost of product sales increased $1.0 million during the three months ended September 30, 2007 compared to the three months ended September 30, 2006 due primarily to a significant increase in Oracea sales as well as approximately $180,000 in manufacturing development costs incurred during the three months ended September 30, 2007. Cost of product sales as a percent of net product sales was 15.2% for the three months ended September 30, 2007 and 26.6% for the three months ended September 30, 2006. The decrease in the cost of product sales as a percent of net product sales during the three months ended September 30, 2007 is primarily due to the addition of Oracea sales, which have higher gross margins than our other products.

Effective November 1, 2007, our Sublicense Agreement with Altana Inc. will terminate and we will no longer generate other net product sales from the Pandel product. As part of the termination agreement, we expect to receive $1.7 million from Altana Inc. that will be credited to cost of product sales during the fourth quarter of 2007.

Research and Development

Research and development for the three months ended September 30, consist of the following: