SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark One)

PROTEIN DESIGN LABS, INC.

(Exact name of registrant as specified in its charter)

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 an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). Yes ý No o

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

As of October 31, 2005 there were 112,836,807 shares of the Registrant’s Common Stock outstanding.

PROTEIN DESIGN LABS, INC.

INDEX

Protein Design Labs, the PDL logo and Nuvion® are registered trademarks of Protein Design Labs, Inc. HuZAF^TM and Zamyl^TM are trademarks of Protein Design Labs, Inc. Zenapax® is a registered trademark of Hoffmann-La Roche, Inc. Cardene® is a registered trademark of Roche Holding Inc. Ismo® is a registered trademark of Roche Diagnostics GMBH. Sectral® is a registered trademark of Aventis Pharma S.A. Declomycin® is a registered trademark of Wyeth Holdings Corporation. Busulfex® and Tenex® are registered trademarks of ESP Pharma, Inc. Retavase® is a registered trademark, owned by ESP Pharma, Inc. All other company names and trademarks included in this Quarterly Report are trademarks, registered trademarks or trade names of their respective owners.

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PART I. FINANCIAL INFORMATION

ITEM 1.                                         FINANCIAL STATEMENTS

PROTEIN DESIGN LABS, INC.

CONSOLIDATED CONDENSED STATEMENTS OF OPERATIONS

(unaudited)

(In thousands, except per share data)

See accompanying notes.

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PROTEIN DESIGN LABS, INC.

CONSOLIDATED CONDENSED BALANCE SHEETS

(unaudited)

(In thousands, except per share data)

See accompanying notes.

4

PROTEIN DESIGN LABS, INC.

CONSOLIDATED CONDENSED STATEMENTS OF CASH FLOWS

(unaudited)

(In thousands)

See accompanying notes.

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PROTEIN DESIGN LABS, INC.

NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS

September 30, 2005

(unaudited)

1. Summary of Significant Accounting Policies

Organization and Business

Protein Design Labs, Inc. (we, us, our, PDL or the Company) is a biopharmaceutical company focused on the research, development and commercialization of novel therapies for treatment of inflammation and autoimmune diseases, acute cardiac conditions and cancer. PDL markets several biopharmaceutical products in the United States through its hospital sales force and wholly-owned subsidiary, ESP Pharma, Inc. As a leader in the development of humanized antibodies, PDL has licensed its patents to numerous pharmaceutical and biotechnology companies, some of which are now paying royalties on net sales of licensed products.

On June 8, 2005, our stockholders approved a change in the name of the Company to PDL BioPharma, Inc. We anticipate that this name change will become effective in January 2006.

Basis of Presentation and Responsibility for Quarterly Financial Statements

The accompanying consolidated condensed financial statements are unaudited, but include all adjustments (consisting only of normal recurring adjustments), which we consider necessary for a fair presentation of our financial position at such dates and the operating results and cash flows for those periods. Although we believe that the disclosures in our financial statements are adequate to make the information presented not misleading, certain information normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States has been condensed or omitted pursuant to the rules and regulations of the Securities and Exchange Commission for quarterly reporting.

The information included in this quarterly report on Form 10-Q should be read in conjunction with the consolidated financial statements and accompanying notes included in our Annual Report on Form 10-K filed with the Securities and Exchange Commission for the year ended December 31, 2004. The Consolidated Condensed Balance Sheet as of December 31, 2004 is derived from our audited consolidated financial statements as of that date.

Revenues, expenses, assets and liabilities can vary during each quarter of the year. Therefore, the results and trends in these interim consolidated condensed financial statements may not be indicative of results for any other interim period or for the entire year. For example, we receive a substantial portion of our royalty revenues on sales of the product Synagis® marketed by MedImmune, Inc. (MedImmune). This product has significantly higher sales in the fall and winter, which to date have resulted in much higher royalties recognized by us in our first and second quarters than in other quarters since we generally recognize royalty revenue in the quarter subsequent to sales by our licensees (see Royalties section below). In addition, as a result of the closing of our acquisition of ESP Pharma Holding Company, Inc. (ESP Pharma) on March 23, 2005, the results of operations of ESP Pharma from March 24, 2005 are included in our consolidated condensed financial statements (see Note 6).

Principles of Consolidation

The consolidated condensed financial statements include the accounts of the Company and its wholly owned subsidiaries after elimination of inter-company accounts and transactions.

Management Estimates

The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires the use of management’s estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Actual results could differ from those estimates.

Inventories

Inventories are stated at the lower of cost or market. Cost is determined using a weighted-average approach, which approximates the first-in, first-out method. If the inventory costs exceed the market value, reserves are recorded currently for the difference between the cost and the market value. These reserves are determined based on management’s estimates. Inventories consist of finished goods, work-in-process and raw materials (including active pharmaceutical ingredients). As a result of the ESP Pharma and Retavase®

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acquisitions (see Notes 6 and 7), we acquired and recorded inventories at then fair market value, which approximated the original cost of the inventory purchased from third-party manufacturers.

Revenue Recognition

We currently recognize revenues resulting from product sales, from licensing and use of our technology, from reimbursement of development costs and from services we sometimes perform in connection with the licensed technology under the guidance of Staff Accounting Bulletin (SAB) No. 104, “Revenue Recognition.” Royalty, licensing and other revenues are typically derived from our proprietary patent portfolio covering the humanization of antibodies for use as drugs, in drug development and production.

If we determine that separate elements exist in a revenue arrangement under Emerging Issues Task Force Issue No. 00-21, “Revenue Arrangements with Multiple Deliverables” (EITF 00-21), we recognize revenue for delivered elements only when the fair values of undelivered elements are known, when the associated earnings process is complete, when payment is reasonably assured and, to the extent the milestone amount relates to our performance obligation, when our customer confirms that we have met the requirements under the terms of the agreement.

Revenues, and their respective treatment for financial reporting purposes, are as follows:

Product Sales

We recognize revenue from product sales when there is persuasive evidence that an arrangement exists, title passes, the price is fixed and determinable, and collectibility is reasonably assured. Allowances and accruals are established for estimated discounts, sales returns, doubtful accounts, chargebacks and rebates.

Accounts Receivable, Sales Allowances and Rebate Accruals

Accounts receivable are recorded net of allowances for cash discounts for prompt payment, doubtful accounts, government chargebacks, rebates and sales returns. When we estimate cash discounts, government chargebacks and sales returns we consider contractual terms, historical trends experienced by ESP Pharma and the previous owner of the products, and expectations regarding the utilization rates for these programs. These amounts are recorded as an offset to product sales in the same period the related revenue is recognized. In determining allowances for product returns, chargebacks and rebates, we must make significant judgments and estimates. For example, in determining these amounts, we estimate hospital demand, buying patterns by hospitals and group purchasing organizations from wholesalers and the levels of inventory held by wholesalers. Making these determinations involves estimating whether trends in past buying patterns will predict future product sales. Our estimates are based on the historical chargeback data we receive from wholesalers and the applicable customer chargeback rates, returns and rebate thresholds we have from Wyeth and Centocor, Inc. (Centocor) with respect to Cardene IV and Retavase, respectively. Allowances for chargebacks, returns and rebate accruals require substantial judgment. Actual results may differ from our estimates and could impact our earnings in any period in which an adjustment is made, based on actual results.

Since our acquisition of ESP Pharma, we have adjusted our allowances for product returns, chargebacks and rebates based on more recent experience rates, and we will likely be required to make adjustments to these allowances in the future as we market and promote these products for ourselves. We continually monitor our allowances and make adjustments when we believe actual experience may differ from our estimates.

Accrued rebates include amounts due under Medicaid and other commercial contractual rebates. Rebates are recorded in the same period that the related revenue is recognized resulting in a reduction of product sales revenue and the establishment of either a contra asset or a liability, which are included in sales allowances or other accrued liabilities, respectively. Accrued rebates are recorded based on a percentage of selling price determined from historical experience rates. Medicaid rebate accruals are evaluated based on historical rebate payments by product as a percentage of historical sales, product pricing and current contracts.

Estimates for our allowance for doubtful accounts are determined based on existing contractual obligations, historical payment patterns of our customers, credit quality of our customers and individual customer circumstances and are included in selling, general and administrative expenses.

Royalties

Under most of our patent license agreements, we receive royalty payments based upon our licensees’ net sales of products. Generally, under these agreements we receive royalty reports from our licensees approximately one quarter in arrears; that is, generally in the second month of the quarter after the licensee has sold the royalty-bearing product. We also receive royalties on a generic product that

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we have licensed for sale. We recognize royalty revenues when we can reliably estimate such amounts and collectibility is reasonably assured. Accordingly, we recognize royalty revenue in the quarter reported to us by our licensees (i.e., generally royalty revenue is recognized one quarter following the quarter in which sales by our licensees occurred).

License and Other

We include revenue recognized from upfront licensing and license maintenance fees, milestone payments and reimbursement of development expenses in License and Other revenues.

Upfront License and License Maintenance Fees

We generally recognize revenue from upfront fees when the agreement is signed, we have completed the earnings process and we have no ongoing performance obligation with respect to the arrangement. Revenues recognized from upfront fees typically relate to patent license and patent rights agreements. Generally there are three types of collaboration arrangements PDL enters into under which we provide access to our proprietary patent portfolio covering the humanization of antibodies.

•               Under Patent License Agreements, the licensee typically obtains a non-exclusive license to one or more of our patents. In this arrangement, the licensee is responsible for all of the development work on its product. The licensee has the technical ability to perform the humanization of the antibody it is developing using our patented technology, but needs to obtain a license from us to avoid infringing our patents. We have no future performance obligations under these agreements. Consideration that we receive for patent license agreements is recognized upon execution and delivery of the patent license agreement and when payment is reasonably assured. Nonrefundable upfront licensing fees, including certain guaranteed, time-based payments that require continuing involvement in the form of development, manufacturing or other commercialization efforts by us are recognized as revenue either (a) ratably over the development period if development risk is significant, or (b) ratably over the manufacturing period or estimated product useful life if development risk has been substantially eliminated.

•               Under Patent Rights Agreements, the licensee purchases a research patent license in exchange for an upfront fee. In addition, the licensee has the right to obtain, in exchange for consideration separate from the upfront fee, patent licenses for commercial purposes for a specified number of drug targets to be designated by the licensee subsequent to execution of the agreement. The licensee performs all of the research, and we have no further performance obligations with respect to the research patent license and the grant of the right to obtain commercial patent licenses; therefore, upon delivery of the patent rights agreement, the earnings process is complete. When a licensee exercises its right to obtain patent licenses to certain designated drug targets for commercial purposes, we recognize the related consideration as revenue upon the licensee’s exercise of such right, execution and delivery of the associated patent license agreement and when payment is reasonably assured.

•               Under Humanization Agreements, the licensee typically pays an upfront fee for us to humanize an antibody. These upfront fees are recognized as the humanization work is performed, which is typically over three to six months.

Under Patent License Agreements and Humanization Agreements, we may also receive annual license maintenance fees, payable at the election of the licensee to maintain the license in effect. We have no performance obligations with respect to such fees. Maintenance fees are recognized as they are due and when payment is reasonably assured.

Milestones

We enter into patent license and humanization agreements that may contain milestones related to reaching particular stages in product development. We recognize revenues from milestones when we have no further obligation with respect to the activities under the agreement and when we have confirmed that the milestone has been achieved. Where we have continuing involvement obligations in the form of development, manufacturing or other commercialization efforts, we recognize revenues from milestones either (a) ratably over the development period if development risk is significant, or (b) ratably over the manufacturing period or estimated product useful life if development risk has been substantially eliminated. Generally, there are three types of agreements under which a customer would owe us a milestone payment:

•               Humanization Agreements provide for the payment of certain milestones to us after the completion of services to perform the humanization process. These milestones generally include delivery of a humanized antibody meeting a certain binding affinity and, at the customer’s election, delivery of a cell line meeting certain criteria described in the original agreement.

•               Patent License Agreements and Humanization Agreements sometimes require our licensees to make milestone payments to us when they achieve certain progress, such as FDA approval, with respect to the licensee’s product.

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•               We may also receive certain milestone payments in connection with licensing technology to or from our licensees, such as product licenses. Under these agreements, our licensees may make milestone payments to us when they or we achieve certain levels of development with respect to the licensed technology.

Reimbursement of Development Costs

Reimbursement of development costs from our collaborators is recognized as revenue as the related costs are incurred. In certain instances, our collaboration agreements involve a combination of upfront fees, milestones and development costs where we are not able to establish fair value of all of the undelivered elements. We recognize these upfront fees, milestones and reimbursements of development costs as the services are performed and out-of-pocket costs are incurred.

Advertising and Promotion

The Company engages in promotional activities, which typically take the form of industry publications, journal ads, exhibits, speaker programs, and other forms of media. In accordance with procedures defined under Statement of Position 93-7, “Reporting on Advertising Costs,” advertising and promotion expenditures are expensed as incurred. Total advertising costs incurred during the three and nine months ended September 30, 2005 were $6.2 million and $9.9 million, respectively, and no such costs were incurred in 2004.

Stock-Based Compensation

As of September 30, 2005, we had six stock-based employee compensation plans. We account for our plans under the recognition and measurement principles of Accounting Principles Board (APB) Opinion No. 25, “Accounting for Stock Issued to Employees,” and related Interpretations. Accordingly, we recognize no compensation expense in our consolidated statements of operations with respect to options awarded to our employees with exercise prices greater than or equal to the fair value of the underlying common stock at the date of grant. However, we recognize compensation expense in our consolidated statements of operations with respect to the modification of certain employee stock option awards. During the quarter ended September 30, 2005, we recognized approximately $121,000 in stock-based compensation expense related to the issuance of restricted stock to certain employees, compared to $17,000 recognized in the corresponding quarter of 2004 related to the modification of certain employee stock option awards. The tables below illustrate the effect on net loss and net loss per share if we had applied the fair value recognition provisions of Financial Accounting Standards Board (FASB) Statement No. 123, “Accounting for Stock-Based Compensation” (SFAS 123), as amended by FASB Statement No. 148, “Accounting for Stock-Based Compensation — Transition and Disclosure,” to our stock-based employee compensation plans.

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For the periods presented in the table above, the fair value of each option grant is estimated on the date of grant using the Black-Scholes option-pricing model with the following weighted-average assumptions:

In December 2004, the FASB issued Statement No. 123R “Share Based Payment,” (SFAS 123R) which revises SFAS No. 123 and requires all equity-based awards to employees to be recognized in the statement of operations based on their fair values. Under SFAS 123R, we must determine the appropriate fair value model to be used for valuing share-based payments, the amortization method for compensation cost and the transition method to be used at date of adoption. The transition methods include prospective and retroactive adoption options. Under the retroactive option, prior periods may be restated either as of the beginning of the year of adoption or for all periods presented. The prospective method requires that compensation expense be recorded for all unvested stock options and restricted stock at the beginning of the first quarter of adoption of SFAS 123R, while the retroactive method would record compensation expense for all unvested stock options and restricted stock beginning with the first period restated. We are evaluating the requirements of SFAS 123R and we expect that the adoption of SFAS 123R will have a material impact on our consolidated results of operations. We have not yet determined the method of adoption or the effect of adopting SFAS 123R, and we have not determined whether the adoption will result in amounts that are similar to the current pro forma disclosures under SFAS 123. Under the current regulations, as amended in April 2005, we will be required to adopt SFAS 123R on January 1, 2006.

We account for stock options granted to non-employees at fair value using the Black-Scholes option-pricing model in accordance with EITF 96-18, “Accounting for Equity Instruments That Are Issued to Other Than Employees for Acquiring, or in Conjunction with, Selling, Goods or Services.” Stock options granted to non-employees are subject to periodic revaluation over their vesting terms. We recognize the resulting stock-based compensation expense over the service period in which the non-employee provides services to the Company. We recognized stock-based compensation expense related to stock options issued to non-employees of approximately $62,000 and $273,000 for the three months ended September 30, 2005 and 2004, respectively, and $245,000 and $442,000 for the nine months ended September 30, 2005 and 2004, respectively.

Segment and Concentrations Disclosure

In accordance with FASB Statement No. 131, “Disclosure About Segments of an Enterprise and Related Information” we are required to report operating segments and related disclosures about our products, services, geographic areas and major customers. We have only one segment with facilities located primarily within the United States. The majority of our revenues are earned in the United States.

Sales of Cardene IV, IV Busulfex and Retavase accounted for 88% of total product sales in the third quarter of 2005, and 91% of total product sales in the first nine months of 2005. Sales of Cardene IV, IV Busulfex and Retavase accounted for 50% of total revenues in the third quarter of 2005, and 37% of total revenues in the first nine months of 2005.

Royalty, license and other revenues from Genentech, Inc. (Genentech) in the third quarters of 2005 and 2004 accounted for 29% and 70% of total revenues, respectively, and revenues from Genentech in the first nine months of 2005 and 2004 accounted for 31% and 45% of total revenues, respectively. Royalty, license and other revenues from MedImmune in the third quarters of 2005 and 2004 accounted for 2% and 8% of total revenues, respectively, and revenues from MedImmune in the first nine months of 2005 and 2004 accounted for 15% and 37% of total revenues, respectively. No other revenue from any other source exceeded 10% of total revenues for any periods presented.

Goodwill, Other Intangible Assets and Other Long-Lived Assets

Intangible assets consist of purchased core technology, a reversion right to purchase certain technology from Hoffmann-La Roche Inc. and F. Hoffmann-La Roche Ltd (Roche), product rights obtained through the acquisition of ESP Pharma and licensed research technology. In accordance with FASB Statement No. 142, “Goodwill and Other Intangible Assets” (SFAS 142), we are amortizing our intangible assets with definite lives over their estimated useful lives and review them for impairment when events or changes in circumstances indicate that the carrying amount of such assets may not be recoverable. We are amortizing the core technology, product rights and licensed research technology assets on a straight-line basis over their estimated useful lives, 10, 4 to 12, and 5 years, respectively. We will reclassify the reversion right asset into core technology at that time when the rights to the technology revert back to us. Upon reclassifying the reversion right asset to core technology, we will amortize the asset over the remaining term of the patents underlying the acquired technology. Amortization of intangible assets is included primarily in research and development expenses and costs of product sales in the Consolidated Condensed Statement of Operations.

On March 23, 2005, we recorded goodwill in connection with our acquisition of ESP Pharma (see Note 6). In accordance with SFAS 142, we do not amortize goodwill. We will test goodwill for impairment using a two-step process on an annual basis, and between

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annual tests under certain circumstances. Factors that are considered important when evaluating whether impairment might exist include a significant adverse change in the business climate, unanticipated competition, loss of key personnel, significant continued under-performance compared to peers, or other factors specific to each asset or reporting unit being evaluated. Any changes in key assumptions about the business and its prospects, or changes in market conditions or other externalities, could result in an impairment charge and such a charge could have a material effect on our consolidated results of operations.

In accordance with FASB Statement No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets,” we identify and record impairment losses, as circumstances dictate, on long-lived assets used in operations when events and circumstances indicate that the assets might be impaired and the discounted cash flows estimated to be generated by those assets are less than the carrying amounts of those assets. During the three months ended September 30, 2005, we recorded an impairment charge of $15.2 million related to certain intangible assets we acquired from ESP Pharma (see Note 10).

2. Net Loss Per Share

In accordance with FASB Statement No. 128, “Earnings Per Share,” basic net loss per share amount is computed using the weighted-average number of shares of common stock outstanding during the periods presented, while diluted net loss per share is computed using the sum of the weighted-average number of common and common equivalent shares outstanding. Common equivalent shares used in the computation of diluted earnings per share result from the assumed release of shares in escrow from the ESP Pharma acquisition and the assumed exercise of stock options, restricted stock and convertible notes, using the treasury stock method. For all periods presented, we incurred a net loss, and as such, we did not include the effect of outstanding stock options, outstanding shares in escrow, outstanding restricted stock, or outstanding convertible notes in the diluted net loss per share calculations, as their effect would be anti-dilutive.

The following table summarizes the number of common equivalent shares excluded from the calculation of diluted net loss per share reported in the statement of operations and excluded from the table presented in the Stock-Based Compensation section in Note 1 above, as their effect would have been anti-dilutive:

3. Comprehensive Loss

Comprehensive loss is comprised of net loss and the change in unrealized gains and losses on our available-for-sale securities. The following table presents the calculation of our comprehensive loss:

4. Inventory

Inventories consisted of the following:

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5. Other Accrued Liabilities

Other accrued liabilities consisted of the following:

6. ESP Pharma Acquisition

In January 2005, we entered into a definitive agreement with ESP Pharma Holding Company, Inc. (ESP Pharma), a privately held, hospital focused pharmaceutical company, under which PDL would acquire ESP Pharma for $300 million in cash and approximately $175 million in PDL common stock, or an aggregate value of approximately $475 million. In February 2005, this agreement was amended to reflect ESP Pharma’s agreement to acquire from Centocor, a biopharmaceutical operating company of Johnson & Johnson, rights to manufacture, develop, market and distribute Retavase® (reteplase) in the United States and Canada. The amendment increased the purchase price for ESP Pharma by $25 million in cash payable to the ESP Pharma stockholders at the closing of the ESP Pharma acquisition. The acquisition price paid to Centocor for the rights to Retavase was $110.5 million. Milestone payments of up to $45 million may be made to Centocor if additional conditions relating to ongoing clinical trials and manufacturing arrangements for Retavase are satisfied. As of September 30, 2005, no milestone payments have been achieved.

On March 23, 2005, we completed the acquisition of all of the outstanding stock of ESP Pharma. The aggregate purchase price was approximately $471.3 million, including the cash paid to ESP Pharma stockholders of $325.0 million, the fair value of 9,853,770 shares of PDL’s common stock issued to ESP Pharma stockholders totaling approximately $140.9 million, and direct transaction costs of approximately $5.4 million. The value assigned to our common stock issued to ESP Pharma stockholders was based on the average closing market price of our common stock a few days before and after the “measurement date.” In accordance with EITF Issue No. 99-12, “Determination of the Measurement Date for the Market Price of Acquirer Securities Issued in a Purchase Business Combination,” the measurement date was the date on which the number of shares issuable to ESP Pharma became fixed at 9,835,770 (March 4, 2005). The ESP Pharma acquisition has been accounted for as a business combination in accordance with FASB Statement No. 141, “Business Combinations.” The results of operations of ESP Pharma from March 24, 2005 have been included in our three and nine months ended September 30, 2005 condensed consolidated financial statements.

Of the 9,853,770 shares of PDL common stock issued to ESP Pharma stockholders, 2,523,588 shares were to remain in an escrow account for a period of between six months and one year from the date of the close of the acquisition, pursuant to the terms of the Amended and Restated Agreement and Plan of Merger. At acquisition, we expected to issue substantially all of the shares to the former ESP Pharma stockholders at the end of this contingency period, and as such, we included the value for all shares issued in the purchase price of ESP Pharma in March 2005. However, in September 2005, we delivered a claim against 952 shares held in escrow based on ESP Pharma’s breaches of certain representations and warranties under the Amended and Restated Agreement and Plan of Merger; if the agent representing the ESP Pharma stockholders does not respond to this claim within 60 days from the date of the claim, then the 952 shares will be released to us and cancelled. Pursuant to the terms of the Amended and Restated Agreement and Plan of Merger, 1,260,842 shares were released from escrow to the ESP Pharma stockholders on September 23, 2005, leaving 1,261,794 shares remaining in escrow until March 23, 2006 (in addition to the 952 shares held pending the outcome of our claim). Moreover, we estimated based on information to date that we will be able to deliver a claim against some of the remaining shares held in escrow primarily as a result of higher sales returns than originally anticipated at acquisition. As such, the escrow value was reduced by $5.8 million during the third quarter of 2005.

As part of the purchase and included in the $325.0 million paid to ESP Pharma stockholders, ESP Pharma had established a workforce reduction plan and as of the acquisition date, approximately $7.4 million of employee termination costs had been recorded as a severance liability to be paid out over a period of approximately one year. ESP Pharma stockholders were obligated to pay such termination costs from the cash acquisition proceeds of $325.0 million. At September 30, 2005, approximately $0.4 million of these ESP Pharma termination costs remained as a liability.

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The net book value of acquired assets and liabilities, which approximated fair value as of March 23, 2005, was as follows (in thousands):

Based in part upon an independent third-party valuation of the intangible assets acquired, we have allocated the total purchase price on March 23, 2005 as follows (in thousands):

The $339.2 million value assigned to the intangible assets relates to product rights for the six products sold by ESP Pharma, and this value is amortized over periods between 4 and 12 years, or a weighted-average period of approximately 10 years, the estimated useful lives of these assets. As discussed in Note 10, during the third quarter of 2005, we concluded that the carrying amount of the product rights for the off-patent branded products, representing four of the six products purchased, was impaired as the fair value of these product rights was less than the net carrying value. Accordingly, we recorded an impairment charge of $15.2 million in the third quarter to reduce the carrying value of these product rights to $11.0 million.

The amount of the purchase price originally allocated to goodwill was reduced in the third quarter of 2005 by a $10.1 million federal deferred tax asset related to the carry back of a tax loss for the tax period from January 1, 2005 through March 23, 2005, $0.4 million of prepaid state taxes related to the tax year ended December 31, 2004 and $0.5 million related to carry forward of a tax loss for the tax period from January 1, 2005 through March 23, 2005. It was partially offset by a $1.2 million increase for tax exposure items related to tax years ended December 31, 2002, 2003 and 2004.

As part of the allocation of the purchase price, $79.4 million was allocated to acquired in-process research and development related to ESP Pharma’s incomplete research and development programs that had not yet reached technological feasibility and had no alternative future use as of the acquisition date. A summary of these programs follows:

The nature of the remaining efforts for completion of ESP Pharma’s research and development projects primarily consist of clinical trials, the cost, length and success of which are extremely difficult to determine. Numerous risks and uncertainties exist which could prevent completion of development, including the uncertainty and timing of patient enrollment and uncertainties related to the results

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of the clinical trials, and obtaining FDA and other regulatory body approvals. Feedback from regulatory authorities or results from clinical trials might require modifications or delays in later stage clinical trials or additional trials to be performed. We cannot be certain that these potential products will be approved in the United States or the European Union or whether marketing approvals will have significant limitations on their use. The acquired products under development may never be successfully commercialized due to the uncertainties associated with the pricing of new pharmaceuticals and the fact that the cost of sales to produce these products in a commercial setting has not been determined. As a result, we may make a strategic decision to discontinue development of a given product if we do not believe successful commercialization is possible. If these programs cannot be completed on a timely basis or at all, then our prospects for future revenue growth would be adversely impacted.

The value of the acquired in-process research and development was determined by estimating the related future net cash flows using a present value discount rate of 14%. This discount rate is a significant assumption and is based on our estimated weighted-average cost of capital taking into account the risks associated with the projects acquired. The projected cash flows from the acquired projects were based on estimates of revenues and operating profits related to the projects considering the stage of development of each potential product acquired, the time and resources needed to complete the development and approval of each product, the life of each potential commercialized product and associated risks including the inherent difficulties and uncertainties in developing a drug compound including obtaining FDA and other regulatory approvals, and risks related to the viability of and potential alternative treatments in any future target markets. In determining the value of the in-process research and development, the assumed commercialization dates for these potential products begins in 2007.

Pro Forma Results

The unaudited pro forma results of operations for the three and nine months ended September 30, 2005 and 2004 are set forth below. This presentation assumes that the ESP Pharma acquisition had been consummated as of the beginning of each period presented. The net loss includes, on a pre-tax basis, $79.4 million for the write-off of acquired in-process research and development costs, $15.2 million for the impairment of off-patent branded product rights and $11.9 million and $33.0 million for the amortization of intangible assets for the three and nine months ended September 30, 2005, respectively, and $8.9 million and $26.9 million for the three and nine months ended September 30, 2004, respectively.

The unaudited pro forma information is not necessarily indicative of the results that actually would have occurred had the above-noted acquisition been consummated on January 1, 2004 or 2005, or of results that may occur in the future.

7. Retavase® Acquisition

On March 23, 2005, ESP Pharma completed its acquisition of rights to manufacture, develop, market and distribute Retavase in the United States and Canada. The aggregate purchase price was approximately $110.5 million, the cash paid to Centocor. As we did not acquire any employees, and therefore the acquisition lacked the necessary inputs, processes and outputs to constitute a business, we have accounted for the Retavase acquisition as an acquisition of assets rather than as a business combination in accordance with EITF Issue No. 98-3, “Determining Whether a Nonmonetary Transaction Involves Receipt of Productive Assets or of a Business.” There were no Retavase product sales included in our results of operations during the first quarter of 2005, as the re-launch of the product occurred during April 2005.

The following table summarizes the purchase price allocation of the Retavase assets on March 23, 2005 (in thousands):

The $93.5 million value assigned to the intangible assets is amortized over periods between 3 and 8 years, or a weighted-average period of 7.9 years, the estimated useful lives of these assets.

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8. Convertible Debt

In February 2005, we issued 2.00% Convertible Senior Notes due February 14, 2012 with a principal amount of $250.0 million (the 2005 Notes). The 2005 Notes are convertible into our common stock at a conversion price of $23.69 per share, subject to adjustment in certain events. Interest on the 2005 Notes is payable semiannually in arrears on February 15 and August 15 of each year. The 2005 Notes are unsecured and senior in right to all our existing and future indebtedness which is subordinated by its terms and may be redeemed at our option, in whole or in part, beginning on February 19, 2010 at par value.

9. Collaborative and Licensing Agreements

On August 2, 2005 we entered into a collaboration with Biogen Idec, Inc. (Biogen Idec) for the joint development, manufacture and commercialization of three Phase II antibody products. The agreement provides for shared development and commercialization of daclizumab in multiple sclerosis and indications other than transplant and respiratory diseases, and for shared development and commercialization of M200 (volociximab) and HuZAF™ (fontolizumab) in all indications.

The collaboration and purchase agreements became effective on September 12, 2005. PDL received an upfront cash license fee payment of $40.0 million, and Biogen Idec purchased approximately 4.1 million shares of our common stock at $24.637 per share, which represents the then fair market value of the stock, for approximately $100.0 million in cash. These shares are subject to a lock-up period, half for six months and the remainder one year from the closing date. Biogen Idec also agreed to a standstill period of one year during which it is restricted from acquiring or soliciting other parties to acquire PDL’s voting securities.

We and Biogen Idec will share equally the costs of all development activities and all operating profits from each collaboration product within the United States and Europe. The companies will jointly oversee development, manufacturing and commercialization plans for collaboration products and intend to divide implementation responsibilities to leverage each company’s capabilities and expertise. PDL will be eligible to receive development and commercialization milestones based on the further successful development of these molecules. Each party will have co-promotion rights in the United States and Europe. Outside the United States and Europe, Biogen Idec will fund all incremental development and commercialization costs and pay a royalty to PDL on sales of collaboration products.

We determined that all elements under the collaboration agreement should be accounted for as a single unit of accounting under EITF 00-21, Multiple Element Arrangements. As such, we have continuing obligations under the collaboration agreement, and as significant development risk remains, we recorded the $40.0 million upfront cash license fee as deferred revenue and recognize this amount over development periods of the various molecules ranging from 5 to 9 years. During the three months ended September 30, 2005, we recognized $0.9 million related to the amortization of the upfront license fee and $3.9 million for reimbursement of certain research and development expenses.

10. Asset Impairment Charge

In March 2005, we acquired both branded and off-patent branded products through the acquisition of ESP Pharma. In June 2005, we engaged a financial advisor to market our off-patent branded products for sale. During the third quarter of 2005, we received inquiries from multiple potential buyers to acquire the off-patent branded products and the related inventory. Based on the indications of interests that we have received, we concluded that the net carrying value of these product rights and related inventory was impaired at September 30, 2005 and recorded an impairment charge of $15.2 million to reduce the net carrying value of these product rights to $11.0 million. As of September 30, 2005, we also classified these product rights and the related inventory as held for sale and ceased the amortization of these product rights. In addition, we reserved $1.0 million of this off-patent inventory on hand as of September 30, 2005 based on its expected realizable amount. We anticipate that a sale of these products will be completed in the fourth quarter of 2005.

11. Restructuring Charges

As part of a strategic initiative to centralize our U.S. clinical operations efforts and to improve our efficiency and productivity in the conduct of clinical trials in June 2004, management approved a formal plan pursuant to which we closed our New Jersey office, which was principally responsible for the oversight of certain clinical trials. The plan was a combination of a reduction in workforce of nine employees, which represents less than 2% of the Company’s total workforce, and the abandonment of our New Jersey leased facility. As a result of the restructuring plan, we incurred a charge of approximately $305,000, including an adjustment in the fourth quarter of 2004 related to the extension of a sublease of the facilities, included in research and development expenses in the Consolidated Condensed Statement of Operations, $288,000 of which was expenses in the nine months ended September 30, 2004. The restructuring charge included approximately $164,000 of severance-related amounts, $97,000 of which was included in the nine months ended September 30, 2004; $119,000 of committed costs for our New Jersey leased facility (net with expected

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proceeds from a short-term sublease entered into in October 2004), $169,000 of which was included in the nine months ended September 30, 2004, primarily related to lease expenses for the remaining term of the lease; and $22,000 related to the net book value of assets that we abandoned at the facility. The estimated cost of abandoning our leased facilities was based on the contractual lease payments from the date of our abandonment of the facility through the term of the lease, which expired in October 2005, partially offset by expected proceeds from a short-term sublease entered into in October 2004. The actual future cash requirements were adjusted downward from the accrual at June 30, 2004 due to subleasing the facility. The balance of the severance costs was paid during the third quarter of 2004, and the balance of the facility-related costs was paid during the third quarter of 2005.

12. Income Taxes

We recorded a tax provision of approximately $1.7 million and $12,000 for the three months ended September 30, 2005 and 2004, respectively. We recorded a tax provision of approximately $1.8 million and $68,000 for the nine months ended September 30, 2005 and 2004, respectively. Taxes during the three and nine months ended September 30, 2005 are primarily related to state income taxes on income earned by ESP Pharma, federal alternative minimum taxes on the consolidated income, and foreign taxes on income earned by our foreign operations. Taxes during the three and nine months ended September 30, 2004 are primarily related to foreign taxes on income earned by our foreign operations and foreign withholding tax in connection with a license maintenance fee. We recorded a $10.1 million federal deferred tax asset related to the carry back of ESP Pharma’s tax loss for the period from January 1, 2005 through March 23, 2005, the date of the ESP Pharma acquisition. This $10.1 million deferred tax asset was recorded as a reduction of the goodwill from the ESP Pharma acquisition (see Note 6).

13. Related-Party Transaction

On September 15, 2005, we entered into a transition agreement (the Transition Agreement) with Glen Sato, our Senior Vice President and Chief Financial Officer (CFO), pursuant to which Mr. Sato resigns as our CFO and all other positions as an officer of PDL, including principal financial officer, effective as of the date we file our Form 10-Q for the quarter ended September 30, 2005 (the Termination Date). Under the terms of the Transition Agreement, Mr. Sato will remain a non-officer employee after the Termination Date, reporting to our Chief Accounting Officer, until and including January 1, 2006. Effective as of the Termination Date, George Jue, PDL’s Vice President, Finance and Chief Accounting Officer, will oversee our financial organization until a new CFO is hired. Mr. Sato and we also agree to enter into a consulting agreement for the period January 2, 2006 through and including March 1, 2006.

14. Subsequent Event

On October 28, 2005, we executed an Amended and Restated Co-Development and Commercialization Agreement and a Second Amended and Restated Worldwide Agreement (collectively, the Agreements) with Roche. The Agreements amended the Amended and Restated Worldwide Agreement dated October 1, 2003 and the Co-Development and Commercialization Agreement dated September 14, 2004 between Roche and PDL (the Prior Agreements).

The Agreements expand the existing relationship between us and Roche to include the co-development and commercialization of daclizumab for organ transplant patients on longer term maintenance therapy (transplant maintenance). The Agreements provide that we will receive a $10 million upfront payment and may receive up to $145 million in development and commercialization milestone payments if the development of daclizumab in transplant maintenance is successful. We will share global development costs equally with Roche. We will have the option to co-promote daclizumab for transplant maintenance in the United States and will share in the profits in the United States, and we will receive royalties on net sales of the product in transplant maintenance outside the United States.

The Agreements also provide that we will not exercise the option, under the Prior Agreements, to promote Zenapax for prevention of acute kidney transplant rejection, and PDL is no longer required to make a payment for such right that would otherwise be due in 2006. The Agreements also amended the royalty obligations of Roche with respect to future sales of Zenapax in the existing transplant indication by including a revenue threshold below which royalties are not due.

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ITEM 2.          MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

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

OVERVIEW

We are a biopharmaceutical company focused on the research, development and commercialization of novel therapies for treatment of inflammation and autoimmune diseases, acute cardiac conditions and cancer. PDL markets several biopharmaceutical products in the United States through its hospital sales force and wholly-owned subsidiary, ESP Pharma, Inc. As a leader in the development of humanized antibodies, PDL has licensed its patents to numerous pharmaceutical and biotechnology companies, some of which are now paying royalties on net sales of licensed products. On March 23, 2005, we completed the acquisition of all of the outstanding stock of ESP Pharma Holding Company, Inc. (ESP Pharma), a privately held, hospital-focused pharmaceutical company. The aggregate purchase price was approximately $471.3 million, including the cash paid to ESP Pharma stockholders of $325.0 million, the fair value of 9,853,770 shares of PDL’s common stock issued to ESP Pharma stockholders totaling approximately $140.9 million, and direct transaction costs of approximately $5.4 million. The ESP Pharma acquisition has been accounted for as a business combination in accordance with FASB Statement No. 141, “Business Combinations.” The results of operations of ESP Pharma from March 24, 2005 have been included in our first quarter consolidated condensed financial statements.

Also on March 23, 2005, ESP Pharma completed its acquisition of rights to manufacture, develop, market and distribute Retavase® in the United States and Canada. The aggregate purchase price was approximately $110.5 million, including the cash paid to Centocor of $110.0 million and direct transaction costs of approximately $0.5 million.

In order to partially fund the acquisition of ESP Pharma, in February 2005, we issued 2.00% Convertible Senior Notes due February 14, 2012 with a principal amount of $250.0 million (the 2005 Notes). The 2005 Notes are convertible into our common stock at a conversion price of $23.69 per share, subject to adjustment in certain events. Interest on the 2005 Notes is payable semiannually in arrears on February 15 and August 15 of each year. The 2005 Notes are unsecured and subordinated to all our existing and future indebtedness and may be redeemed at our option, in whole or in part, beginning on February 19, 2010 at par value.

Significant Risks

In general, we have a history of operating losses and may not achieve sustained profitability. As of September 30, 2005, we had an accumulated deficit of approximately $400.2 million. Our expenses will continue to increase over the next several years because of the extensive resource commitments required to identify and develop antibody candidates to achieve regulatory approval, to market and sell products and to develop potential products. Also, over the next several years we expect to incur substantial additional expenses as we continue to invest in research and improve and expand our development and manufacturing capabilities.

Our operating expenses may also increase as some of our earlier stage potential products move into later stage clinical development, as additional potential products are selected as clinical candidates for further development, as we invest in additional manufacturing capacity, as we defend or prosecute our patents and patent applications, and as we invest in research or acquire additional technologies, product candidates or businesses.

The integration of the product rights, technologies, operations and personnel of PDL and ESP Pharma is a complex, time consuming and expensive process and has and will require significant attention from management and other personnel, which may distract their attention from the day-to-day business of the combined company. The diversion of management’s attention and any difficulties associated with integrating ESP Pharma into PDL could have a material adverse effect on the operating results of the combined company after the merger and the value of PDL shares, and could result in the combined company not achieving the anticipated benefits of the merger. While we have achieved a significant level of integration, it is not certain that we will achieve all aspects of integration successfully or that all of the anticipated benefits will be realized. Failure to do so could have a material adverse effect on the business and operating results of the combined company.

In order to reach our goal to be cash flow positive on a quarterly basis beginning in the fourth quarter of 2005, we will have to continue to increase sales from historical levels for Cardene IV, Retavase and IV Busulfex. Accordingly, we will need to continue to effectively transition existing relationships with distributors, third-party vendors, manufacturers and customers of ESP Pharma. Although we have retained most of the hospital focused sales force and related sales infrastructure, we have never sold, marketed or distributed products, and we may not be able to successfully integrate and further grow such capabilities from ESP Pharma necessary to continue to successfully promote the ESP Pharma products. In addition, the markets for Cardene IV and Retavase are highly competitive, and we will be marketing against pharmaceutical, biopharmaceutical and specialty pharmaceutical companies with substantially greater revenues and experience in marketing products than we have.

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Since we or our collaborative partners or licensees may not be able to successfully develop additional products, obtain required regulatory approvals, manufacture products at an acceptable cost and with appropriate quality, or successfully market our proprietary products or maintain desired margins for products sold, we may never achieve sustained profitable operations. The amount of net losses and the time required to reach a sustainable cash flow positive position and profitability are highly uncertain.

In the absence of substantial revenues from increased product sales, new corporate collaborations or patent rights or patent licensing or humanization agreements, significant royalties on sales of products licensed under our intellectual property rights or other sources of revenue, we will continue to incur substantial operating losses.

In addition, as of September 30, 2005 we have approximately $500.0 million in convertible notes outstanding, approximately $250.0 million of which are callable in each of 2008 and 2010. In order to be able to service our debt in the future, we will need to generate positive cash flows from our operations or obtain other financing.

Significant Events and Recent Events

On August 2, 2005 we entered into a collaboration with Biogen Idec for the joint development, manufacture and commercialization of three Phase II antibody products. The agreement provides for shared development and commercialization of daclizumab in multiple sclerosis and indications other than transplant and respiratory diseases, and for shared development and commercialization of M200 (volociximab) and HuZAF™ (fontolizumab) in all indications.

The collaboration agreement and purchase agreement became effective on September 12, 2005. PDL received an upfront cash license fee payment of $40.0 million, and Biogen Idec purchased approximately 4.1 million shares of our common stock at $24.637 per share, which represents the then fair market value of the stock, for approximately $100.0 million in cash. These shares are subject to a lock-up period, half for six months and the remainder one year from the closing date. Biogen Idec also agreed to a standstill period of one year during which it is restricted from acquiring or soliciting other parties to acquire PDL’s voting securities.

We and Biogen Idec will share equally the costs of all development activities and all operating profits from each collaboration product within the United States and Europe. The companies will jointly oversee development, manufacturing and commercialization plans for collaboration products and intend to divide implementation responsibilities to leverage each company’s capabilities and expertise. PDL will be eligible for development and commercialization milestones based on the further successful development of these molecules, if achieved. Each party will have co-promotion rights in the United States and Europe. Outside the United States and Europe, Biogen Idec will fund all incremental development and commercialization costs and pay a royalty to PDL on sales of collaboration products.

In March 2005, we acquired both branded and off-patent branded products through the acquisition of ESP Pharma. In June 2005, we engaged a financial advisor to market our off-patent branded products for sale. During the third quarter of 2005, we received inquiries from multiple potential buyers to acquire the off-patent branded products and the related inventory. Based on the indications of interests that we have received, we concluded that the net carrying value of these product rights and related inventory was impaired at September 30, 2005 and recorded an impairment charge of $15.2 million to reduce the net carrying value of the these product rights to $11.0 million. As of September 30, 2005, we also classified these product rights and the related inventory as held for sale and ceased the amortization of these product rights. In addition, we reserved $1.0 million of this off-patent branded inventory on hand as of September 30, 2005 based on its expected realizable amount. We anticipate that a sale of these products will be completed in the fourth quarter of 2005.

On October 28, 2005, subsequent to the third quarter of 2005, we executed an Amended and Restated Co-Development and Commercialization Agreement and a Second Amended and Restated Worldwide Agreement (collectively, the Agreements) with Roche. The Agreements amended the Amended and Restated Worldwide Agreement dated October 1, 2003 and the Co-Development and Commercialization Agreement dated September 14, 2004 between Roche and PDL (the Prior Agreements).

The Agreements expand the existing relationship between us and Roche to include the co-development and commercialization of daclizumab for organ transplant patients on longer term maintenance therapy (transplant maintenance). The Agreements provide that we will receive a $10 million upfront payment and may receive up to $145 million in development and commercialization milestone payments if the development of daclizumab in transplant maintenance is successful. We will share global development costs equally with Roche. We will have the option to co-promote daclizumab for transplant maintenance in the United States and will share in the profits in the United States, and we will receive royalties on net sales of the product in transplant maintenance outside the United States.

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The Agreements also provide that we will not exercise the option, under the Prior Agreements, to promote Zenapax for prevention of acute kidney transplant rejection, and PDL is no longer required to make a payment for such right that would otherwise be due in 2007. The Agreements also amended the royalty obligations of Roche with respect to future sales of Zenapax in the existing transplant indication by including a revenue threshold below which royalties are not due.

CRITICAL ACCOUNTING POLICIES AND THE USE OF ESTIMATES

The preparation of our financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the amounts reported in our financial statements and accompanying notes. Actual results could differ materially from those estimates. The items in our financial statements requiring significant estimates and judgments are as follows:

Revenue Recognition

We currently recognize revenues resulting from the licensing and use of our technology and from services we sometimes perform in connection with the licensed technology. These revenues are typically derived from our proprietary patent portfolio covering the development, use, sale and importation of humanized antibodies. In addition, as a result of the acquisition of ESP Pharma, we recognize revenues from product sales, net of estimated allowances for cash discounts, product returns and rebates. We recognize revenue from product sales when there is persuasive evidence that an arrangement exists, title passes, the price is fixed and determinable, and collectibility is reasonably assured. Allowances are established for estimated discounts, product returns, bad debts, and rebates.

We enter into patent license, collaboration and humanization agreements that may contain multiple elements, such as upfront license fees, reimbursement of research and development expenses, milestones related to the achievement of particular stages in product development and royalties. As a result, significant contract interpretation is sometimes required to determine the appropriate accounting, including whether the deliverables specified in a multiple-element arrangement should be treated as separate units of accounting for revenue recognition purposes, and if so, how the aggregate contract value should be allocated among the deliverable elements and when to recognize revenue for each element. We recognize revenue for delivered elements only when the fair values of undelivered elements are known, when the associated earnings process is complete and, to the extent the milestone amount relates to our performance obligation, when our licensee confirms that we have met the requirements under the terms of the agreement, and when payment is reasonably assured. Changes in the allocation of the contract value between deliverable elements might impact the timing of revenue recognition, but in any event, would not change the total revenue recognized on the contract. For example, as we did not establish fair value for all undelivered elements of the Co-Development and Commercialization Agreement with Roche (the Roche Collaboration Agreement), including milestones and the reimbursement of research and development expenses, we are recognizing the $17.5 million upfront license fee that we received from Roche over the term of the Roche Collaboration Agreement as services are provided. Similarly, we did not establish fair value for all undelivered elements of the multiple products of the Collaboration Agreement with Biogen Idec (the Biogen Idec Collaboration Agreement). We are recognizing the $40.0 million upfront license fee, milestones and the reimbursement of research and development expenses that we received from Biogen Idec over the term of the Biogen Idec Collaboration Agreement as services are provided with respect to the specific products under development to which the upfront license fees, if any, and reimbursement relate.

In addition, we enter into non-monetary transactions in connection with our patent licensing arrangements, and management must use estimates and judgments when considering the fair value of the technology rights acquired and the patent licenses granted under these arrangements. When available, the fair value of the non-monetary transaction is based on vendor-specific objective evidence of fair value of each significant element of the patent license agreement. Otherwise, management uses other methods of estimating fair value, such as current pricing information within the Company. Therefore, the fair value of the technology right(s) acquired from the licensee is typically based on the fair value of the patent license and other consideration we exchange with the licensee.

Under our humanization agreements, the licensee typically pays an upfront fee for us to “humanize” an antibody. These upfront fees are recognized as the humanization work is performed, which is typically over three to six months. We follow this method because we can reliably estimate the progress of each project based on information from our scientists. Due to our extensive experience in humanizing antibodies, coupled with the short-term nature of the humanization contracts, the likelihood that the actual progress is materially different than that reflected in our revenues at the end of any particular reporting period is low. Historically, revenues recognized have approximated actual progress under each humanization agreement.

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Sales Allowances and Rebate Accruals

We record estimated reductions to product sales for expected returns of products under our current policies, chargebacks, government rebate programs, such as Medicaid reimbursements, and customer incentives, such as cash discounts for prompt payment. Estimates for government rebate programs and cash discounts are based on contractual terms, historical utilization rates experienced by ESP Pharma and expectations regarding future utilization rates for these programs. Estimates for product returns, including new products, are based on an on-going analysis of industry and historical return patterns experienced by ESP Pharma and the companies from which ESP Pharma acquired their products. Our current estimates include monitoring the feedback that we receive from our sales force regarding customer use and satisfaction, reviewing inventory data available to us in monitoring channel inventory levels, the purchase of third-party data to monitor prescriptions as well as, for new products, a review of our products we have sold through the same or similar channels. In addition, our estimates are based on the historical chargeback data we receive from wholesalers and the applicable customer chargeback rates, returns and rebate thresholds we have from Wyeth and Centocor with respect to Cardene IV and Retavase, respectively. Further, we monitor the activities and clinical trials of our key competitors and assess the potential impact on our future sales and return expectations where necessary. If conditions become more competitive for any of the markets served by our drugs or if other circumstances change, we may take actions to increase our product return estimates or we may offer additional customer incentives. This would result in an incremental reduction of future revenue at the time the return estimate is changed or new incentives are offered. Product sales receivable allowances for chargebacks, returns and rebate accruals require substantial judgment. Actual results may differ from our estimates and could impact our earnings in any period in which an adjustment is made, based on actual results.

We also maintain an allowance for doubtful accounts for estimated losses resulting from the inability of our customers to make required payments. This allowance is based on our analysis of several factors including, but not limited to, contractual payment terms, historical payment patterns of our customers experienced by ESP Pharma and individual customer circumstances, an analysis of days sales outstanding by customer and geographic region, and a review of the local economic environment and its potential impact on government funding and reimbursement practices. If the financial condition of our customers or the economic environment in which they operate were to deteriorate, resulting in an inability to make payments, additional allowances may be required. We believe that the allowance for doubtful accounts is adequate to cover anticipated losses under current conditions; however, significant deterioration in any of the above factors could materially change these expectations and result in an increase to our allowance for doubtful accounts.

Clinical Trial Expenses

Our cost accruals for clinical trials are based on estimates of the services received and efforts expended pursuant to contracts with numerous clinical trial centers and clinical research organizations. In the normal course of business we contract with third parties to perform various clinical trial activities in the on-going development of potential drugs. The financial terms of these agreements are subject to negotiation and variation from contract to contract and may result in uneven payment flows. Payments under the contracts depend on factors such as the achievement of certain events or the successful accrual of patients or the completion of portions of the clinical trial or similar conditions. The objective of our accrual policy is to match the recording of expenses in our financial statements to the actual services received and efforts expended. As such, direct expenses related to each patient enrolled in a clinical trial are recognized on an estimated cost-per-patient basis as services are performed. In addition to considering information from our clinical operations group regarding the status of our clinical trials, we rely on information from contract research organizations (CROs), such as estimated costs per patient, to calculate our accrual for direct clinical expenses at the end of each reporting period. For indirect expenses, which relate to site and other administrative costs to manage our clinical trials, we rely on information provided by the CRO, including costs incurred by the CRO as of a particular reporting date, to calculate our indirect clinical expenses. In the event of early termination of a clinical trial, we accrue an amount based on our estimate of the remaining non-cancelable obligations associated with the winding down of the clinical trial, which we confirm directly with the CRO. Our estimates and assumptions could differ significantly from the amounts that may actually be incurred; however, our experience has been that our estimates at the end of any particular reporting period have been materially accurate.

Goodwill and Other Intangible Assets

The valuation in connection with the initial purchase and the ongoing evaluation for impairment of goodwill and other intangible assets requires significant management estimates and judgment. The value ascribed to each asset requires management estimates and judgment as to expectations for various products and business strategies. For example, we estimate future probability-adjusted cash flows and certain discount rates as well as assumed commercialization dates for future potential products. These estimations affect the allocation between charges to acquired in-process research and development and capitalization of intangible assets. If any of the significant assumptions differ from the estimates and judgments used in the purchase price allocation, this could result in different valuations for intangible assets.

Once the values for intangible assets are established, we must test intangible assets with definite useful lives for impairment in accordance with Financial Accounting Standards Board (FASB) Statement No. 144 “Accounting for the Impairment or Disposal of Long-Lived Assets.” When we conduct our impairment tests for intangibles, factors that are considered important in determining whether impairment might exist include significant changes in our underlying business and product candidates or other factors specific

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to each asset being evaluated. Any changes in key assumptions about the business and its prospects, or changes in market conditions or other externalities, could result in an impairment charge and such a charge could have a material adverse effect on our consolidated results of operations. During the third quarter of 2005, we recorded an impairment charge of $15.2 million in the third quarter of 2005 to reduce the net carry value of the intangible assets for our off-patent branded product rights to its fair value (see Note 10 to the Financial Statements in Part I, Item 1 of this Quarterly Report).

RESULTS OF OPERATIONS

Three and Nine Months Ended September 30, 2005 and 2004

Revenues

Product sales, net

We acquired marketed products from the acquisition of ESP Pharma, which closed on March 23, 2005. Total product sales in the third quarter of 2005, our second full quarter of ownership of the acquired ESP Pharma products, were $43.1 million. Net product sales of Cardene IV, IV Busulfex and Retavase totaled $38.0 million for the period. Off-patent brand sales for the period totaled $5.1 million. During the quarter, we increased our reserves for estimated product returns by approximately $2.8 million due primarily to inventory levels of the off-patent brand products, in particular Declomycin, that are currently in the hands of the wholesaler channel. Declomycin sales to the end users have been adversely affected by a significant price difference in the context of the introduction of two generic competitors for this product in the second half of 2004. Total net product sales in the first nine months of 2005 (i.e., from March 23, the date of acquisition, through September 30) were $79.4 million, of which $72.3 million was from the sales of Cardene IV, IV Busulfex and Retavase and the remaining $7.1 million was from the off-patent brand sales.

On March 23, 2005, ESP Pharma completed its acquisition of rights to manufacture, develop, market and distribute Retavase in the United States and Canada. We re-launched Retavase in April 2005. As a result of this re-launch, we had a stock-out situation on Retavase. During May and June 2005, we implemented an allotment program, which provided product to wholesalers that stocked-out and for emergency requests. We are in the process of transferring the product labeling from Centocor to ESP Pharma and we may experience a delay between the time we were allowed to supply product bearing the Centocor label and the time when we are able to release product under the ESP Pharma label.

Royalties

Royalty revenues increased during the three and nine months ended September 30, 2005 compared to the same periods in 2004 due primarily to royalties recognized on sales of Genentech’s Avastin product, which was launched in the first quarter of 2004. Royalty payments from sales of Genentech’s products accounted for 86% and 62% of total royalty revenues during the three and nine months ended September 30, 2005, respectively, up from 81% and 49% in the comparable period of 2004, respectively. Sales of MedImmune’s product accounted for 6% and 31% of total royalty revenues for the three and nine months ended September 30, 2005, respectively, down from 9% and 42% in the comparable periods in 2004.

In addition, the increase in royalty revenues is attributable to higher reported product sales for most products in our royalty portfolio during the first nine months of 2005 as compared to the comparable period of 2004. The largest portion of this increase relates to Genentech’s Herceptin and Avastin, and MedImmune’s Synagis humanized antibody products. Royalty payments from sales of Herceptin, Avastin and Synagis accounted for 41%, 33% and 6% of our royalty revenues for the three months ended September 30, 2005 as compared to 48%, 0% and 9% in the comparable period in 2004, respectively. Royalty payments from sales of Herceptin, Avastin and Synagis accounted for 32%, 21% and 31% of our royalty revenues for the nine months ended September 30, 2005 as compared to 36%, 0% and 42% in the comparable period in 2004, respectively.

We expect that royalty revenues will continue to increase as sales of these products continue to increase. Further, we expect to continue to experience quarterly fluctuations in royalty revenues due to the seasonality of sales of Synagis, which results in higher royalty revenues reported to us in the first and second quarters of the year as compared to the third and fourth quarters.

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License and Other

License and other revenues recognized during the first nine months of 2005 and 2004 primarily consisted of upfront licensing and patent rights fees, milestone payments related to licensed technology and license maintenance fees. Also included in license and other revenues for the first nine months of 2005 were revenues recognized under our collaborations with Roche and Biogen Idec entered into in September 2004 and August 2005, respectively.

License and other revenues increased 184% to $7.5 million in the third quarter of 2005 from $2.7 million in the corresponding quarter of 2004 primarily due to revenue recognized from our collaboration with Biogen Idec and revenue recognized under our asthma collaboration with Roche.

License and other revenues increased 84% to $17.1 million in the first nine months of 2005 from $9.3 million in the corresponding period of 2004 primarily due to the revenue recognized under our collaborations with Biogen Idec and Roche, with no corresponding revenue during the comparable period in 2004.

Costs and Expenses

Cost of Product Sales

Cost of product sales (COS) of $22.2 million and $43.5 million as a percentage of product sales was 51% and 55% for the three and nine months ended September 30, 2005, respectively, with no such costs incurred in 2004. COS largely reflects cost of goods sold, amortization of product rights on Retavase and the products acquired from ESP Pharma, royalty expenses, and certain start-up production costs related to the transition of sales, labeling and shipping responsibilities to us from Centocor for Retavase. Amortization of product rights was 54% and 57% of COS for the three and nine months ended September 30, 2005, respectively, with no such costs incurred in 2004. For the full year 2005, due principally to the amortization of product rights for our marketed products, we continue to expect COS to be in the range of approximately 55% to 58% of product sales, with continued quarter-to-quarter variability based on product mix changes and production results, acknowledging that there is always potential for an increase in COS if we have unforeseen manufacturing, contract manufacturing, or inventory related issues.

Research and Development

Research and development costs of $49.5 million in the third quarter of 2005 include costs of personnel to support our research and development activities, milestone payments and technology licensing fees, costs of preclinical studies, costs of conducting our clinical trials, such as clinical investigator fees, monitoring costs, data management and drug supply costs, research and development funding provided to third parties and an allocation of facility and overhead costs. The increase in the third quarter of 2005 compared to the corresponding quarter of 2004 was primarily due to an increase in clinical development expenses for our major research and development projects of $9.3 million, personnel related costs of $4.9 million, facility-related costs of $2.6 million, production material costs of $2.5 million and outside services costs of $0.5 million, offset partially by a decrease in contract manufacturing costs of $1.5 million and other miscellaneous items of $3.9 million.

The increase in research and development costs during the first nine months of 2005 compared to the same period in 2004 was primarily due to increases in research and development personnel-related costs of $14.8 million, clinical development expenses for our major research and development projects of $9.9 million, facility-related costs of $6.9 million, production material costs of $5.3 million and outside services costs of $1.4 million. These increases were partially offset by decreases in contract manufacturing services of $6.3 million and research and development licensing costs of $3.3 million. We expect our research and development expenses will increase further as we advance our product candidates into later stages of development and add new product candidates.

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Below is a summary of products and the latest related stages of development for each product in clinical development, including the research and development expenses recognized in connection with each product.