Summary of ANADYS PHARMACEUTICALS INC

Item 2. Management's Discussion and Analysis of Financial Condition and Results
of Operations
This discussion and analysis should be read in conjunction with our unaudited condensed consolidated financial statements and notes included in this Quarterly Report on Form 10-Q (this Quarterly Report) and the audited consolidated financial statements and notes as of and for the year ended December 31, 2007 included with the Company's Annual Report on Form 10-K filed with the U.S. Securities and Exchange Commission (SEC) on March 5, 2008. Operating results are not necessarily indicative of results that may occur in future periods.
This Quarterly Report contains forward-looking statements. These forward-looking statements involve a number of risks and uncertainties. Such forward-looking statements include statements about our strategies, objectives, discoveries, collaborations, clinical trials, internal programs, financial forecasts and other statements that are not historical facts, including statements which may be preceded by the words "intend," "will," "plan," "expect," "anticipate," "estimate," "aim," "seek," "believe," "hope" or similar words. For such statements, we claim the protection of the Private Securities Litigation Reform Act of 1995. Readers of this Quarterly Report are cautioned not to place undue reliance on these forward-looking statements, which speak only as of the date on which they are made. We undertake no obligation to update publicly or revise any forward-looking statements. Actual events or results may differ materially from our expectations. Important factors that could cause actual results to differ materially from those stated or implied by our forward-looking statements include, but are not limited to, the risk factors identified in our SEC reports, including this Quarterly Report. Overview
Anadys Pharmaceuticals, Inc. is a biopharmaceutical company dedicated to improving patient care by developing novel medicines in the areas of hepatitis C and oncology. We are developing ANA598, a small-molecule, non-nucleoside inhibitor of the NS5b polymerase for the treatment of hepatitis C and ANA773, an oral Toll-like receptor 7 (TLR7) agonist prodrug for cancer. During April 2008, we filed an Investigational New Drug (IND) application for ANA598, and subject to Food and Drug Administration (FDA) allowance, we plan to initiate a Phase 1 single, ascending dose clinical trial in healthy volunteers in the second quarter of 2008 to assess the safety and pharmacokinetics of ANA598. Following the healthy volunteer study, we plan to initiate in the third quarter of 2008 a short-term Phase Ib study of ANA598 in patients with chronic hepatitis C virus (HCV) infection. In February 2008, patient dosing commenced in a Phase I clinical trial of ANA773 in cancer patients in the United States. This first-in-human trial is a safety and tolerability study designed to identify pharmacologically active doses and preliminary anti-tumor activity as well as to select the dose and schedule for Phase II trials.
We have made the strategic decision to accelerate certain non-clinical development activities for ANA598. If ANA598 is successful in early stage clinical trials, it is anticipated that the acceleration of these non-clinical activities into 2008 will enable a more rapid and continuous development path into mid-stage clinical trials during 2009. The acceleration of the ANA598 program is expected to be partially offset by a somewhat slower pace of the ANA773 program compared to previous expectations. While Anadys expects the rate of enrollment in the ANA773 oncology trial to increase in the coming quarters, the Company now expects that the pace of the program will accelerate more slowly than had been anticipated, in part due to the increased focus on the ANA598 program, making it less likely that specific tumor types and a recommended Phase II dose will be identified during 2008. We continue to explore the safety and tolerability profile of ANA773 in the ongoing Phase I trial and expect to identify pharmacologically active doses and establish the profile of immune stimulation this year, which information will support the future design of clinical trials of ANA773 (alone or in combinations) in specific tumor types.
We have incurred significant operating losses since our inception and, as of March 31, 2008, our accumulated deficit was $231.1 million. We expect to incur substantial losses for at least the next several years as we:
• continue the development of ANA598 for the treatment of HCV;

• continue the development of ANA773 for the treatment of cancer;

• develop methods for and scale-up manufacturing of ANA598 and ANA773 for clinical trials and potential commercialization;

• commercialize any product candidates that receive regulatory approval; and

• potentially in-license technology and acquire or invest in businesses, products or technologies that are synergistic with our own.

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Critical Accounting Policies
Our discussion and analysis of our financial condition and results of operations are based on our consolidated financial statements, which have been prepared in accordance with U.S. generally accepted accounting principles (U.S. GAAP). The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities and expenses and related disclosure of contingent assets and liabilities. We review our estimates on an on-going basis and make adjustments to the financials statements as considered necessary. We base our estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities. Actual results may differ from these estimates under different assumptions or conditions.
Revenue Recognition. We may receive payments from collaborators for compound licenses, technology access fees, option fees, research services, milestones and royalty obligations. These payments are recognized as revenue or reported as deferred revenue until they meet the criteria for revenue recognition as outlined in Staff Accounting Bulletin, No. 104, Revenue Recognition, which provides guidance on revenue recognition in financial statements, and is based on the interpretations and practices developed by the SEC, and Emerging Issues Task Force (EITF) Issue 00-21, Revenue Arrangements with Multiple Deliverables. We recognize revenue when (1) persuasive evidence of the arrangement exists;
(2) delivery has occurred or services were rendered; (3) the price is fixed or determinable and (4) the collectibility is reasonably assured. Specifically, we have applied the following policies in recognizing revenue:
• Revenue from milestones is recognized when earned, as evidenced by written acknowledgment from the collaborator or other persuasive evidence that the milestone has been achieved, provided that (i) the milestone event is substantive and its achievability was not reasonably assured at the inception of the agreement, (ii) our performance obligations after the milestone achievement will continue to be funded by the collaborator at the comparable level and (iii) the milestone is not refundable or creditable. If all of these criteria are not met, the milestone payment is recognized over the remaining minimum period of our performance obligations under the agreement. Upfront fees under our collaborations, such as technology access fees, are recognized over the period the related services are provided. Non-refundable upfront fees not associated with our future performance are recognized when received.

• Fees that we receive for research services are generally recognized as the services are provided, as long as the amounts received are not refundable regardless of the results of the research project.

Drug Development Costs. We review and accrue drug development costs based on work performed, relying on estimates of total costs incurred based on subject enrollment, estimated timeline for completion of studies and other events. These costs and estimates vary based on the type of clinical trial, the site of the clinical trial and the length of dose period for each subject as well as other factors. Drug development cost accruals are subject to revisions as trials and studies progress to completion. Expense is adjusted for revisions in the period in which the facts that give rise to the revision become known.
Share-Based Compensation. We account for share-based compensation in accordance with Statement of Financial Accounting Standards No. 123(R) (SFAS
123(R)), Share-Based Payment. Under the provisions of SFAS 123(R), share-based compensation cost is estimated at the grant date based on the award's fair-value as calculated by a Black-Scholes option-pricing model and is recognized as expense evenly over the requisite service period. The determination of the fair value of stock-based payment awards on the date of grant using an option-pricing model is affected by our stock price as well as assumptions regarding a number of complex and subjective variables. These variables include, but are not limited to, our expected stock price volatility over the term of the awards, the risk-free interest rate and the expected term of the awards. If any of the assumptions used in the model change significantly, share-based compensation expense may differ materially in the future from that recorded in the current period.
Pending Adoption of Accounting Pronouncements In December 2007, the Financial Accounting Standards Board (FASB) ratified the consensus reached by the Emerging Issues Task Force (EITF) on EITF Issue 07-1, Accounting for Collaborative Arrangements (EITF 07-1). EITF 07-1 requires collaborators to present the results of activities for which they act as the principal on a gross basis and report any payments received from (made to) other collaborators based on other applicable U.S. GAAP or, in the absence of other applicable U.S. GAAP, based on analogy to authoritative accounting literature or a reasonable, rational, and consistently applied accounting policy election. Further, EITF 07-1 clarified that the determination of whether transactions within a collaborative arrangement are part of a vendor-customer (or analogous) relationship subject to EITF 01-9, Accounting for Consideration Given by a Vendor to a Customer (Including a Reseller of the Vendor's Products). EITF 07-1 will be effective for us beginning on January 1, 2009. The adoption of EITF 07-1 is not expected to have a material effect on our consolidated financial statements.

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Results of Operations
Three Months Ended March 31, 2008 and 2007 Revenue. During the first quarter of 2008 we did not recognize any revenue. The Company had revenue of $1.1 million for the first quarter of 2007. This revenue was primarily derived from the amortization of an upfront payment and milestone payment under our former collaboration with Novartis for the development of ANA975 that was discontinued in 2007.
Research and Development Expenses. Research and development expenses were $6.0 million for the three months ended March 31, 2008 compared to $6.7 million for the three months ended March 31, 2007. The $0.7 million decrease is primarily due to cost savings associated with our completed strategic restructuring, which included the halting of early stage discovery efforts and the termination of our collaborations with both Novartis and LG Life Sciences. These decreases were partially offset by increases in development costs for ANA598 and ANA773, which can be attributed to our continued focus towards bringing ANA598 into clinical development and our on-going Phase 1 clinical trial of ANA773. Our non-cash share-based compensation expense was $0.3 million and $0.6 million for the three months ended March 31, 2008 and 2007, respectively.
The following summarizes our research and development expenses for the three months ended March 31, 2008 and 2007. Facility costs, depreciation and amortization, research and development support personnel and other indirect personnel related costs are included as a component of infrastructure and support personnel.

                                                                     Three months ended March 31,
                                                                      2008                  2007
                                                                            (In thousands)
ANA773                                                                    2,260                   675
ANA598                                                                    2,105                 1,824
ANA380                                                                        -                   489
ANA975, net of reimbursement                                                 15                   145
Discovery stage programs                                                      -                   779
Infrastructure and support personnel                                      1,319                 2,142
Non-cash employee and non-employee share-based compensation                 310                   644

Total research and development expense $ 6,009 $ 6,698

General and Administrative Expenses. General and administrative expenses were $2.0 million for the three months ended March 31, 2008 compared to $2.1 million for the three months ended March 31, 2007. The $0.1 million decrease is primarily due to a decrease in share-based compensation expense. Non-cash share-based compensation expense for the three months ended March 31, 2008 and 2007 was $0.4 million and $0.5 million, respectively.
Interest Income and Other, net. Interest income and other, net was $0.6 million for the three months ended March 31, 2008 compared to $1.0 million for the three months ended March 31, 2007. The $0.4 million decrease in our interest income and other, net from the three months ended March 31, 2007 to the three months ended March 31, 2008 was primarily the result of a lower average cash, cash equivalents and securities available-for-sale balances, which were invested in interest bearing securities, during the three months ended March 31, 2008 compared to the three months ended March 31, 2007. The decrease in our interest income from the three months ended March 31, 2007 to the three months ended March 31, 2008 was also driven by a reduction in the yield on our investment portfolio which was driven by a decrease in short-term interest rates over this same period.
Liquidity and Capital Resources
Our cash, cash equivalents and available-for sale securities decreased by $7.7 million from December 31, 2007 to March 31, 2008 which represents the use of our cash, cash equivalents and securities available-for-sale to fund our operations during the three months ended March 31, 2008. As of March 31, 2008, we have $48.8 million of marketable securities consisting of money market funds, U.S. government sponsored enterprise securities and corporate debt securities with maturities that range from 1 day to 29 months with an overall average months to maturity of 6.5 months. We have the ability to liquidate these investments without restriction. As of March 31, 2008 we do not own any securities which are classified as asset-backed securities or auction rate securities.
We believe that our existing cash, cash equivalents and securities available-for-sale will be sufficient to meet our projected operating requirements for at least the next twelve months. We expect to incur substantial expenses for at least the next several years as we continue our research and development activities, including manufacturing and development expenses for compounds in preclinical and clinical studies. We continue to review our programs and resource requirements. Changes to our current operating plan may require us to consume available capital resources significantly sooner than we expect.
Until we can generate significant cash from our operations, we expect to continue to fund our operations with existing cash resources that were primarily generated from the proceeds of offerings of our equity securities and cash receipts from former

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collaboration agreements. In addition, we likely will need to finance future cash needs through the sale of other equity securities, new strategic collaboration agreements, project financing or debt financing. However, we may not be successful in obtaining collaboration agreements, or in receiving milestone or royalty payments under those agreements. In addition, we cannot be sure that our existing cash and securities available-for-sale resources will be adequate or that additional financing will be available when needed or that, if available, financing will be obtained on terms favorable to us or our stockholders. Having insufficient funds may require us to delay, reduce the scope of or eliminate some or all of our research or development programs or to relinquish greater or all rights to product candidates at an earlier stage of development or on less favorable terms than we would otherwise choose. Failure to obtain adequate financing also may adversely affect our ability to operate as a going concern. If we raise additional funds by issuing equity securities, substantial dilution to existing stockholders would likely result. If we raise additional funds by incurring debt financing, the terms of the debt may involve significant cash payment obligations as well as covenants and specific financial ratios that may restrict our ability to operate our business.
Cash Flows from Operating Activities and Investing Activities:
Our condensed consolidated statements of cash flows are summarized as follows:

                                                                           For the three months ended March 31,
                                                                             2008                        2007
                                                                                      (In thousands)
Net cash used in operating activities                                 $           (7,775 )        $           (6,354 )

Investing Activities:
Purchases of securities available-for-sale                            $                -          $           (4,165 )
Proceeds from sale and maturity of securities available-for-sale                   5,991                           -
Purchases of property and equipment                                                  (74 )                       (85 )

Net cash provided by (used in) investing activities                   $            5,917          $           (4,250 )

Cash flows used in operating activities increased by $1.4 million from the three months ended March 31, 2007 to the three months ended March 31, 2008. The increase was primarily due to the receipt of $1.0 million from Novartis during the three months ended March 31, 2007 compared to no cash receipts from Novartis during the three months ended March 31, 2008. We expect to continue to utilize cash to fund our operating activities as we continue to advance our wholly owned product candidates: ANA598 and ANA773. We are not currently party to any development collaborations and therefore cash to fund future operations will most likely have to be obtained from one of the following sources: our current investment portfolio, the sale of other equity securities, new strategic collaboration agreements, project financing or debt financing.
Cash flows provided by investing activities increased by $10.2 million from the three months ended March 31, 2007 to the three months ended March 31, 2008. The overall increase in the cash flows provided by investing activities from the three months ended March 31, 2007 to the three months ended March 31, 2008 is primarily related to the timing of the purchases and maturities of marketable securities. We expect to continue to fund operations over the next several quarters utilizing the securities currently included in our investment portfolio. The use of these securities may be partially offset by the receipt of funds from other financing sources.
Cash Flows from Financing Activities:
Our condensed consolidated statements of cash flows are summarized as follows:

                                                                       For the three months ended March 31,
                                                                      2008                           2007
                                                                                  (In thousands)
Financing Activities:
Proceeds from exercise of stock options                           $           -               $               87


Net cash provided by financing activities                         $           -               $               87

Cash flows provided by financing activities decreased by $0.1 million from the three months ended March 31, 2007 to the three months ended March 31, 2008. There were no stock option exercises during the three months ended March 31, 2008 therefore resulting in the decrease from the three months ended March 31, 2007.

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Future Cash Requirements
We expect our development expenses to be substantial as we continue the advancement of our current development programs. The lengthy process of completing clinical trials and seeking regulatory approval for our product candidates requires the expenditure of substantial resources. Any failure by us or delay in completing clinical trials, or in obtaining regulatory approvals, could cause our research and development expenses to increase and, in turn, have a material adverse effect on our results of operations.
Our future capital uses and requirements depend on numerous forward-looking factors. These factors include but are not limited to the following:
• the progress of our clinical trials;

• the progress of our preclinical development activities;

• our ability to establish strategic collaborations;

• the costs involved in enforcing or defending patent claims and other intellectual property rights;

• the costs and timing of regulatory approvals;

• the costs of establishing or expanding manufacturing, sales and distribution capabilities;

• the costs related to development and manufacture of pre-clinical, clinical and validation lots for regulatory and commercialization of drug supply;

• the success of the commercialization of ANA598, ANA773, or any other product candidates we may develop; and

• the extent to which we acquire or invest in other products, technologies and businesses.

We expect our development expenses to be substantial as we continue the advancement of our current development programs. The lengthy process of completing clinical trials and seeking regulatory approval for our product candidates requires the expenditure of substantial resources. Any failure by us or delay in completing clinical trials, or in obtaining regulatory approvals, could cause our research and development expenses to increase and, in turn, have a material adverse effect on our results of operations.
As of March 31, 2008 and 2007, we did not have any relationships with unconsolidated entities or financial partnerships, such as entities often referred to as structured finance or special purpose entities, which would have been established for the purpose of facilitating off-balance sheet arrangements or other contractually narrow or limited purposes. In addition, we do not engage in trading activities involving non-exchange traded contracts. As such, we are not materially exposed to any financing, liquidity, market or credit risk that could arise if we had engaged in these relationships.
Fair Value Inputs
We adopted SFAS 157, as of January 1, 2008. See Note 4 and Note 6 to the Condensed Consolidated Financial Statements. Fair value is a market-based measurement that is determined based on assumptions that market participants would use in pricing an asset.
We value our marketable securities by using quoted market prices, broker or dealer quotations or alternative pricing sources with reasonable levels of price transparency. The types of securities valued based on quoted market prices in active markets include money market securities. We do not adjust the quoted price for such securities. The types of instruments valued based on quoted prices in markets that are not active, broker or dealer quotations, or alternative pricing sources with reasonable levels of price transparency include Commercial paper, U.S. government sponsored enterprise securities and corporate debt securities. The price for each security at the measurement date is sourced from an independent pricing vendor. Periodically, management assesses the reasonableness of these sourced prices by comparing them to the prices provided by our portfolio managers to derive the fair value of these financial instruments. Historically, we did not experience significant deviation between the prices from the independent pricing vendor and our portfolio managers. Management assesses the inputs of the pricing in order to categorize the financial instruments into the appropriate hierarchy levels.

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