General
From its inception in 1987 through 1994, Noven engaged primarily in the development of advanced transdermal and transmucosal drug delivery systems. During this period, Noven’s revenues consisted primarily of amounts paid to Noven under license agreements with Novartis Pharmaceuticals Corporation (f/k/a Ciba Geigy Corporation) ("Novartis") and Rhône-Poulenc Rorer Inc. ("RPR"). In 1995, after receipt of regulatory approvals for its first generation transdermal estrogen delivery system, a significant portion of Noven’s revenues was derived from the sale of this product to Novartis and RPR. In 1996, revenues from the sale of this product increased substantially as Novartis and RPR purchased product to supply their distribution channels and build their own inventory positions. In 1997, although retail sales of the products increased over 1996, Noven experienced lower sales as Novartis, RPR and their distributors reduced inventories.

In May 1998, Noven and Novartis formed a joint venture company called Vivelle Ventures LLC (the "Joint Venture") to market and sell women’s healthcare products, with the initial focus on marketing Noven’s first generation estrogen delivery system, Vivelle^®. The Joint Venture is managed by a committee consisting of 5 members, 3 of which are appointed by Novartis and 2 of which are appointed by Noven. Noven contributed $7.5 million in return for a 49% equity interest in the Joint Venture. The Joint Venture modified the prior relationship in which Noven had licensed Novartis the exclusive right to market Vivelle^® in the United States and Canada, and had received royalties from Novartis based upon Novartis’ sales. Novartis contributed its rights to Vivelle^® to the Joint Venture and also licensed the right to use the Vivelle^® trademark in return for a 51% equity interest in the Joint Venture. In January 1999, Noven received FDA approval for its second generation estrogen delivery system, Vivelle-Dot™. Noven expects that Vivelle-Dot™ will be launched by the Joint Venture in the United States in the first half of 1999. Under the terms of the agreements, Noven manufactures Vivelle^® and Vivelle-Dot™, performs marketing, sales and promotional activities, and receives royalties from the Joint Venture based on the Joint Venture’s sales of the products. Novartis distributes Vivelle^® and Vivelle-Dot™ and provides certain other services to the Joint Venture, including marketing to the managed care sector.

The agreement provides for an annual preferred return of $6.1 million to Novartis and then an allocation of income between Novartis and Noven according to a contractual formula depending upon sales levels attained. Noven’s share of income increases as product sales increase, subject to a cap of 50%. The Joint Venture did not produce sufficient income in 1998 under the established formula for Noven to recognize income from the Joint Venture. Under the terms of the agreement, however, the Joint Venture did generate sufficient income to meet Novartis’ preferred return. Subject to the approval of the Joint Venture’s management committee, cash may be distributed quarterly to Novartis and Noven based upon a contractual formula. Noven expects that a substantial majority of its earnings for the next several years will be generated from profits to be allocated by the Joint Venture, and no assurance can be given regarding the amount or timing of any such allocations.

Noven expects that revenues from product sales to its licensees will fluctuate from quarter to quarter and year to year depending upon various factors not in Noven’s control, including, but not limited to, the timing of the launch of Vivelle-Dot™, the inventory requirements of each licensee, and possible special selling efforts undertaken by each licensee.

In 1998, RPR received regulatory approval from the FDA and from certain European regulatory authorities to market Noven’s transdermal combination estrogen/progestogen delivery system. RPR is presently marketing the product in the United States and Sweden.

Noven is dependent on sales of its transdermal estrogen and combination estrogen/progestogen delivery systems to the Joint Venture and RPR, and royalties generated from such parties’ retail sales of these products, for substantially all of its revenues. RPR is presently engaged in a merger transaction, and there can be no assurance that RPR’s marketing efforts will not diminish following consummation of the merger. A failure by either of such parties to actively and successfully market Noven’s products would have a material adverse effect on Noven’s business and results from operations.

Results of Operations

1998 Compared to 1997
Total revenues increased 53% from $14.3 million in 1997 to $21.8 million in 1998. The increase in revenues was primarily a result of the increase in sales of Vivelle^®, Noven’s first generation transdermal estrogen delivery system, and the launch of Noven’s CombiPatch™ transdermal combination estrogen/progestogen delivery system. Royalties from transdermal estrogen delivery systems are included in product sales.

License revenues decreased 8% from $1.9 million in 1997 to $1.7 million in 1998. License revenues were primarily attributable to milestone payments received from licensees. Noven does not expect any significant licensing revenue or milestone payments in 1999 from existing contracts.

Cost of products sold increased 82% from $5.2 million in 1997 to $9.4 million in 1998. The gross margin percentage on product sales was 53% in 1998 and 58% in 1997. The decrease in gross margins resulted primarily from a decrease in manufacturing efficiency caused by initial manufacturing costs associated with CombiPatch™ and to a lesser extent from a shift in product mix.

Research and development expenses decreased 30% from $9.7 million in 1997 to $6.8 million in 1998. The decrease was attributable to a reduction in process development activity and reduced costs for validation of manufacturing equipment and facilities. Research and development expenses for new products were flat. New product development in 1998 included transdermal delivery systems for hormone deficiency, nonsteroidal anti-inflammatory agents, and central nervous system and cardiovascular drugs. The future level of research and development expenditures will depend on, among other things, the status of products under development and the outcome of clinical trials, strategic decisions by management, the consummation of new license agreements and Noven’s liquidity.

Marketing, general and administrative expenses increased 3% from $9.8 million in 1997 to $10.1 million in 1998 due to increases in staffing and associated office expenses.

Interest income decreased 51% from $893,000 in 1997 to $439,000 in 1998 due to lower average cash and cash equivalents balances.

1997 Compared to 1996
Total revenues decreased 30% from $20.5 million in 1996 to $14.3 million in 1997. The decrease in revenue was a result of the decrease in product sales of Noven’s first generation transdermal estrogen delivery system to its licensees. Royalties from transdermal estrogen delivery systems are included in product sales.

License revenues increased 130% from $815,000 in 1996 to $1.9 million in 1997, reflecting an increase in milestone payments received pursuant to license agreements.

Cost of products sold decreased 48% from $10.0 million in 1996 to $5.2 million in 1997. Gross margin percentage was 58% in 1997 and 49% in 1996. The gross margins increase was the result of a shift in the product sold to each licensee and manufacturing efficiencies, including those relating to higher production volumes.

Research and development expenses increased 11% from $8.7 million in 1996 to $9.7 million in 1997. The increase was attributable to new product development and manufacturing process development activity. New product development included work related to transmucosal delivery systems in the areas of dental therapeutics and larger molecular entities and transdermal delivery systems for hormone deficiency, nonsteroidal anti-inflammatory agents, central nervous system and cardiovascular drugs.

Marketing, general and administrative expenses increased 102% from $4.9 million in 1996 to $9.8 million in 1997, due to initial marketing support of the DentiPatch^® system and an increase in staffing and office expenses.

Interest income decreased 24% from $1.2 million in 1996 to $893,000 in 1997 due to lower average cash and cash equivalent balances.

Year 2000 Compliance
Noven believes that its Year 2000 project is proceeding on schedule. The project is addressing potential problems in certain computer programs and embedded chips, which represent the calendar year with only the last two digits. There is a risk that, with respect to the change in calendar year from 1999 to 2000, some programs or chips could interpret "00" as "2000", "1900", or some other input. The project addresses issues in critical business areas related to information technology ("IT") systems and non-IT systems with embedded technology.

Status
Noven initiated its Year 2000 project in early 1998 and engaged an independent consulting company to assist in coordinating its Year 2000 project. The initial inventory, assessment and prioritization and planning phases were completed by May 1998. Noven has completed the testing and remediation of its IT systems and anticipates that the remediation and testing of internal non-IT systems will be completed by mid-1999. None of Noven’s other IT projects have been materially delayed or impacted by the Year 2000 project. The book value of computers, software and equipment that will need to be written off as a result of not being Year 2000 compliant is immaterial.

Noven has commenced efforts to determine the extent to which it may be affected by Year 2000 issues of third parties, including suppliers, customers, service providers and certain agencies and regulatory organizations. Noven has been reviewing and continues to review with its critical suppliers and major customers the status of their Year 2000 readiness. Some third parties have either declined to provide the requested information or have limited the scope of their assurances. Noven has established a plan for the continued monitoring of critical business partners during 1999.

Costs
The estimated total cost of the Year 2000 project is $250,000. As of December 31, 1998, Noven had incurred costs of approximately $150,000 related to this project. The project is being funded by cash on hand and from internally generated funds, which Noven expects to be adequate to complete the project.

Risks
Noven believes that failure to correct a material Year 2000 problem could result in an interruption in, or failure of, certain normal business activities or operations. Noven is unable to determine at this time whether the results of any Year 2000 readiness issues will have an impact on Noven’s results of operations, liquidity or financial condition. The Year 2000 project is expected to significantly reduce Noven’s level of uncertainty about Year 2000 problems, including the Year 2000 compliance and readiness of its material third parties. Noven believes that its programs for Year 2000 readiness will significantly improve its ability to deal with its own Year 2000 readiness issues and those of material third parties. A contingency plan has not been developed for dealing with the most reasonably likely worst case scenario, and such scenario has not yet been clearly identified. Noven currently plans to complete such analysis and develop and implement any necessary contingency plans by December 31, 1999. Such plans will not, however, guarantee that no material adverse effects will occur.

The costs of Noven’s Year 2000 project and the dates on which Noven believes it will complete the various phases of this project are based upon management’s best estimates, which were derived using numerous assumptions regarding future events, including the continued availability of certain resources, third-party remediation plans and other factors. There can be no assurance that these estimates will prove to be accurate, and actual results could differ materially from those currently anticipated. Specific factors that could cause such material differences include, but are not limited to, the availability and cost of personnel trained in Year 2000 issues, the ability to identify, assess, remediate and test all relevant computer code and embedded technology, the performance of new systems and equipment, the reduction of productivity pending completion of employee training and similar uncertainties.

Liquidity and Capital Resources
Noven has historically financed its operations through public offerings of common stock, including the exercise of warrants issued in connection with the first such offering, private placements of its equity securities, license and contract revenues, and interest income. Cash generated from these sources was sufficient to fund the losses experienced by Noven through 1998. As of December 31, 1998 and 1997, Noven had $5.6 million and $11.3 million, respectively, in cash and cash equivalents.

Net cash used in operating activities for the year ended December 31, 1998 was $5.0 million compared to $4.2 million for the year ended December 31, 1997. Cash used in 1998 funded the net operating loss and increases in accounts receivable and inventories, partially offset by increases in accounts payable and compensation and other accrued liabilities. Cash used in 1997 funded the net operating loss offset by a decrease in accounts receivable and inventories and an increase in accounts payable.

During the year ended December 31, 1998, Noven’s cash flow used in investing activities was $3.4 million, compared to $6.7 million provided by investing activities in the prior year. Net cash used during 1998 in investing activities was primarily for the investment in the Joint Venture, property and equipment, and patent costs, partially offset by the sale of securities held to maturity. Net cash provided by investing activities during 1997 was primarily derived from the sale of securities held to maturity, offset by the investment in property and equipment and patent costs. As of December 31, 1998, Noven had no significant commitments for capital expenditures.

During the year ended December 31, 1998, Noven’s financing activities provided approximately $2.7 million, compared to $3.4 million provided in the prior year. In 1998, net cash provided by financing activities was primarily from Novartis’ purchase of approximately 966,000 shares of common stock for $2.5 million. In 1997, net cash was provided by RPR’s purchase of 500,000 shares of common stock for $4.0 million, offset by Noven’s purchase of 97,100 shares of treasury stock for $663,000. The balance of the cash provided by financing activities in 1998 and 1997 was due to the exercise of options pursuant to the employee stock option plan.

Noven’s principal sources of short term liquidity are existing cash and cash generated from product sales, royalties under license agreements and distributions from the Joint Venture, which Noven believes will be sufficient to meet its operating needs and anticipated capital requirements over the short term. For the long term, Noven intends to utilize funds derived from these sources, as well as funds generated through sales of products under development. Noven expects that such funds will be comprised of payments received pursuant to future licensing arrangements, as well as Noven’s direct sales of its own products. There can be no assurance that Noven will successfully complete the development of products under development, that Noven will obtain regulatory approval for any such products, or that any approved product may be produced in commercial quantities, at reasonable costs, and be successfully marketed. To the extent that capital requirements exceed available capital, Noven will need to seek alternative sources of financing to fund its operations. Noven has no existing credit facility and no assurance can be given that alternative financing will be available, if at all, in a timely manner, on favorable terms. If Noven is unable to obtain satisfactory alternative financing, Noven may be required to delay or reduce its proposed expenditures, including expenditures for research and development, or sell assets in order to meet its future obligations.