This Quarterly Report on Form 10-Q contains forward-looking statements that have been made pursuant to the provisions of the Private Securities Litigation Reform Act of 1995 and concern matters that involve risks and uncertainties that could cause actual results to differ materially from those projected in the forward-looking statements. Discussions containing forward-looking statements may be found in the material set forth under "Management's Discussion and Analysis of Financial Condition and Results of Operations," and in other sections of this Quarterly Report on Form 10-Q. Words such as "may," "will," "should," "could," "expect," "plan," "anticipate," "believe," "estimate," "predict," "potential," "continue" or similar words are intended to identify forward-looking statements, although not all forward-looking statements contain these words. Although we believe that our opinions and expectations reflected in the forward-looking statements are reasonable as of the date of this Quarterly Report on Form 10-Q, we cannot guarantee future results, levels of activity, performance or achievements, and our actual results may differ substantially from the views and expectations set forth in this Quarterly Report on Form 10-Q. We expressly disclaim any intent or obligation to update any forward-looking statements after the date hereof to conform such statements to actual results or to changes in our opinions or expectations. Readers are urged to carefully review and consider the various disclosures made by us, which attempt to advise interested parties of the risks, uncertainties, and other factors that affect our business, including without limitation the disclosures made under the caption "Management's Discussion and Analysis of Financial Condition and Results of Operations" in this Quarterly Report on Form 10-Q and the audited financial statements and the notes thereto and disclosures made under the captions "Management Discussion and Analysis of Financial Condition and Results of Operations", "Risk Factors", " Consolidated Financial Statements" and "Notes to Consolidated Financial Statements" included in our Annual Report on Form 10-K for the year ended December 31, 2008. We obtained the market data and industry information contained in this Quarterly Report on Form 10-Q from internal surveys, estimates, reports and studies, as appropriate, as well as from market research, publicly available information and industry publications. Although we believe our internal surveys, estimates, reports, studies and market research, as well as industry publications, are reliable, we have not independently verified such information, and, as such, we do not make any representation as to its accuracy.

The following discussion and analysis of our financial condition and results of operations should be read in conjunction with our audited consolidated financial statements and related notes included in our Annual Report on Form 10-K for the year ended December 31, 2008 and the unaudited condensed consolidated financial statements and related notes included in this Quarterly Report on Form 10-Q. References in this Quarterly Report on Form 10-Q to "ISTA", "we", "our", "us", or the "Company" refer to ISTA Pharmaceuticals, Inc.

Overview

We are an ophthalmic pharmaceutical company. Our products and product candidates address the $5.1 billion U.S. prescription ophthalmic market and include therapies for inflammation, ocular pain, glaucoma, allergy and dry eye. In addition, we plan to compete in a $2.3 billion U.S. allergic rhinitis market with our nasal formulation of bepotastine. We currently have four products for sale in the U.S.: Bepreve (bepotastine besilate ophthalmic solution) for the treatment of ocular itching associated with allergic conjunctivitis, Xibrom (bromfenac sodium ophthalmic solution) for the treatment of inflammation and pain following cataract surgery, Istalol (timolol maleate ophthalmic solution) for the treatment of glaucoma, and Vitrase (hyaluronidase for injection) for use as a spreading agent. We also have several product candidates in various stages of development. We have incurred losses since inception and had an accumulated deficit of $396.7 million through September 30, 2009.

During the third quarter ended September 30, 2009, we had the following announcements:

• We announced that the FDA approved Bepreve as a twice-daily prescription eye drop treatment for ocular itching associated with allergic conjunctivitis in patients two years of age and older. We successfully launched Bepreve in September 2009.

• We announced that we had entered into a Memorandum to modify our existing License and Supply Agreements with Otsuka for the development, manufacturing, marketing, distribution and sale of Vitrase (hyaluronidase for injection) Lyophilized, Ovine, for the posterior segment of the eye in Japan. Among other changes, we both agreed that the Supply Agreement would terminate, resulting in us having no future obligation to supply Otsuka with hyaluronidase for injection. As a result, we recognized the remaining $2.9 million of previously deferred revenue resulting from the up-front payment we received from Otsuka in 2001.

• We announced positive preliminary Phase 3 results from the Xibrom 0.09% QD confirmatory clinical study. Xibrom 0.09% QD achieved statistical significance in the study's primary endpoint, the absence of ocular inflammation 15 days following cataract surgery, and the secondary efficacy endpoint, the elimination of ocular pain one day post surgery. Once we complete our analysis of the full dataset, we expect to file a sNDA with the FDA prior to the end of 2009, seeking approval of the Xibrom 0.09% formulation for once-daily treatment for the inflammation and pain following cataract surgery.

• We announced preliminary results from two recently completed studies on our investigational ophthalmic product, T-Pred, as a treatment for inflammatory ocular conditions for which a corticosteroid is indicated and where bacterial ocular infection exists, or there is a risk of bacterial infection. We are discussing the study results with the FDA to determine the best path forward for T-Pred.

Results of Operations

Three Months Ended September 30, 2009 and 2008

Revenue. Net revenue was approximately $32.0 million for the three months ended September 30, 2009, as compared to $21.7 million for the three months ended September 30, 2008. The increase in revenue is the result of the following:

• Increased growth in prescription levels and market share for our core products, particularly for Xibrom, our highest gross margin product,

• Launch of our newest product, Bepreve, in September 2009 resulting in $1.2 million in net revenue, and

• Recognition of $2.9 million of previously deferred revenue related to the termination of a supply agreement.

The following table sets forth our net revenue for each of our products for each of the three month periods ended September 30, 2009 and 2008 and the corresponding percentage change:

                                  Net Revenue

                             (dollars in millions)



                                               Three Months
                                           Ended September 30,
                                         2009     2008    % Change
                    Xibrom              $ 21.4   $ 16.2         32 %
                    Istalol                5.1      3.9         31 %
                    Vitrase                1.4      1.5         -7 %
                    Bepreve                1.2       -          -

                    Product Revenue       29.1     21.6         35 %
                    Other                  2.9      0.1         -

                    Total Net Revenue   $ 32.0   $ 21.7         47 %

Gross margin and cost of products sold. Gross margin for the three months ended September 30, 2009 was 77% of net revenue, or $24.7 million, as compared to 73% of net revenue, or $15.9 million, for the three months ended September 30, 2008. Product gross margin was 75% for the three months ended September 30, 2009, excluding the $2.9 million in previously deferred revenue. The increase in product gross margin for the three months ended September 30, 2009, as compared to the three months ended September 30, 2008 is primarily the result of continued increased growth in prescription levels and market share, particularly for Xibrom, our highest gross margin product.

Cost of products sold was $7.3 million for the three months ended September 30, 2009, as compared to $5.8 million for the three months ended September 30, 2008. Cost of products sold for the three months ended September 30, 2009 and 2008 consisted primarily of standard costs for each of our commercial products, distribution costs, royalties, inventory reserves and other costs of products sold. The increase in cost of products sold is primarily the result of increased net product sales.

Research and development expenses. Research and development expenses vary due to timing of initiation and completion of clinical trials. Research and development expenses were $6.3 million for the three months ended September 30, 2009, as compared to $7.8 million for the three months ended September 30, 2008. The decrease in research and development expenses for the three months ended September 30, 2009 was primarily the result of a decrease in clinical development costs, which include clinical investigator fees, study monitoring costs, and data management costs, offset by a $2.0 million milestone payment upon the FDA approval of our Bepreve New Drug Application, or NDA. Stock-based compensation costs included in research and development expenses were $0.3 million for the three months ended September 30, 2009, as compared to $0.2 million for the three months ended September 30, 2008.

Generally, our research and development resources are not dedicated to a single project but are applied to multiple product candidates in our portfolio. As a result, we manage and evaluate our research and development expenditures generally by the type of costs incurred. We generally classify and separate research and development expenditures into amounts related to clinical development costs, regulatory costs, pharmaceutical development costs, manufacturing development costs, and medical affairs costs. In addition, we also record as research and development expenses any up front and milestone payments that have accrued to third parties prior to regulatory approval of a product candidate under our licensing agreements unless there is an alternative future use. For the three months ended September 30, 2009, approximately 26% of our research and development expenditures were for clinical development costs, 14% were for regulatory costs, 5% were for pharmaceutical development costs, 8% were for manufacturing development costs, 10% were for medical affairs costs, 32% was for a one time milestone payment, and 5% were for stock-based compensation costs.

Changes in our research and development expenses are primarily due to the following:

• Clinical Development Costs - Overall clinical costs, which include clinical investigator fees, study monitoring costs and data management, for the three months ended September 30, 2009 were $1.6 million as compared to $3.8 million for the three months ended September 30, 2008. Due to the variation in the initiation, timing and completion of clinical studies, we realized a decrease in our clinical costs of $2.2 million. The three months ended September 30, 2008 included costs associated with our Xibrom QD once-daily studies, costs associated with our T-Pred studies and costs incurred in support of our Bepreve NDA. The three months ended September 30, 2009 showed a significant reduction in our clinical costs as the Xibrom QD once-daily studies and the T-Pred studies were complete. Additionally, we received approval from the FDA for our Bepreve NDA during the three months ended September 30, 2009.

• Regulatory Costs - Regulatory costs, which include compliance expense for existing products and other activity for pipeline projects, for the three months ended September 30, 2009 were $0.9 million as compared to $1.3 million for the three months ended September 30, 2008, or a decrease of $0.4 million. The decrease is attributable to a reduction in overall outside consulting costs.

• Manufacturing Development Costs - Manufacturing development costs, which include costs related to production scale-up and validation, raw material qualification, and stability studies, for the three months ended September 30, 2009 were $0.5 million as compared to $1.6 million for the three months ended September 30, 2008, or a decrease of $1.1 million. The decrease is primarily attributable to a reduction in outside consulting costs and research related costs such as clinical supplies and stability studies.

• Medical Affairs Costs - Medical affairs costs, which include activities that relate to medical information in support of our products, for the three months ended September 30, 2009 were $0.7 million as compared to $0.6 million for the three months ended September 30, 2008, or an increase of $0.1 million.

Our research and development activities reflect our efforts to advance our product candidates through the various stages of product development. The expenditures that will be necessary to execute our development plans are subject to numerous uncertainties, which may affect our research and development expenditures and capital resources. For instance, the duration and the cost of clinical trials may vary significantly depending on a variety of factors including a trial's protocol, the number of patients in the trial, the duration of patient follow-up, the number of clinical sites in the trial, and the length of time required to enroll suitable patient subjects. Even if earlier results are positive, we may obtain different results in later stages of development, including failure to show the desired safety or efficacy, which could impact our development expenditures for a particular product candidate. Although we spend a considerable amount of time planning our development activities, we may be required to deviate from our plan based on new circumstances or events or our assessment from time to time of a product candidate's market potential, other product opportunities and our corporate priorities. Any deviation from our plan may require us to incur additional expenditures or accelerate or delay the timing of our development spending. Furthermore, as we obtain results from trials and review the path toward regulatory approval, we may elect to discontinue development of certain product candidates in certain indications, in order to focus our resources on more promising candidates or indications. As a result, the amount or ranges of estimable cost and timing to complete our product development programs and each future product development program is not estimable.

Selling, general and administrative expenses. Selling, general and administrative expenses were $13.2 million for both the three months ended September 30, 2009 and 2008, respectively. Stock-based compensation costs included in selling, general and administrative expenses were $0.6 million for the three months ended September 30, 2009, as compared to $0.8 million for the three months period ended September 30, 2008. Selling, general and administrative expenses are expected to increase as we incur costs associated with launching Bepreve and expanding our sales force.

Stock-based compensation. For the three months ended September 30, 2009 and 2008, we granted stock options to employees to purchase 63,000 shares of common stock (at a weighted average exercise price of $5.13 per share) and 48,400 shares of common stock (at a weighted average exercise price of $1.76 per share), respectively, equal to the fair market value of our common stock at the time of grant. We also issued 3,066 restricted stock awards for the three months ended September 30, 2009. There were no restricted stock awards issued for the three months ended September 30, 2008. Included in stock-based compensation costs were $0.2 million for both the three months ended September 30, 2009 and 2008, related to restricted stock awards.

Interest expense. Interest expense was $2.4 million for the three months ended September 30, 2009, as compared to $4.1 million for the three months ended September 30, 2008. Interest expense included interest on our Facility Agreement ($1.1 million), interest on our borrowings under our Revolving Credit Facility ($0.1 million), and amortization of the discount on the Facility Agreement ($1.2 million). Included in the three months ended September 30, 2008 is the impact of the adoption of ASC 470-20, which required retrospective application as if ASC 470-20 had been in effect in prior periods. This retrospective application required us to record additional non-cash interest expense of $2.3 million, or $0.07 per share, in our financial results for the three months ended September 30, 2008. This additional non-cash interest expense represents the amortization of a debt discount recorded against our principal debt obligation on our balance sheet. Because our convertible debt was repaid in September 2008, there was no impact to our third quarter ended September 30, 2009.

Loss on warrant valuation. Included in the three months ended September 30, 2009 is the impact of the application of ASC 815-40, which required us to analyze the accounting for warrants under our Facility Agreement issued in 2008. During 2008, the warrants were classified as equity. With the adoption of ASC 815-40 on January 1, 2009, we were required, due to certain provisions in the Facility Agreement, to reclassify the warrants as a liability and mark to market the value of the warrants on a quarterly basis. As a result, we recorded a non-cash valuation adjustment of $3.4 million, or $0.10 per share, in our financial results for the three months ended September 30, 2009. The change in the valuation of the warrants was primarily driven by an increase in our stock price plus an increase in related volatility.

Updating 2009 Financial Outlook

Based upon the continued growth of our business, we provide this updated 2009 financial outlook:

• Net product revenue for our four marketed products for the full-year 2009 now is expected to be $103 to $106 million.

• Total net revenue for full-year 2009, including net product revenue and $2.9 million from the one-time recognition of deferred revenue resulting from the previously disclosed modification of our partnership with Otsuka, now is expected to be $106 to $109 million.

• We expect to be approximately operating income breakeven in 2009.

• Full-year 2009 gross margin guidance has been increased to 73% to 75%.

• Full-year 2009 research and development expenses are now expected to be approximately $23 to $26 million.

• We expect our net loss for 2009 (excluding any mark-to-market valuation adjustments relating to warrants issued in 2008) will be approximately $7 to $10 million, as our increased net revenue will offset the costs associated with launching Bepreve and expanding our sales force.

• We now expect to end 2009 with a cash balance of $45 to $55 million, including cash drawn on our Silicon Valley Bank Revolving Credit Facility.

Nine Months Ended September 30, 2009 and 2008

Revenue. Net revenue was approximately $76.4 million for the nine months ended September 30, 2009, as compared to $55.0 million for the nine months ended September 30, 2008. The increase in revenue is the result of the following:

• Increased growth in prescription levels and market share for our core products, particularly for Xibrom, our highest gross margin product,

• Launch of our newest product, Bepreve, in September 2009 resulting in $1.2 million in net revenue, and

• Recognition of $2.9 million of previously deferred revenue related to the termination of a supply agreement.

The following table sets forth our net revenue for each of our products for each of the nine month periods ended September 30, 2009 and 2008 and the corresponding percentage change:

                                  Net Revenue

                             (dollars in millions)



                                               Nine Months
                                           Ended September 30,
                                         2009     2008    % Change
                    Xibrom              $ 55.1   $ 41.6         32 %
                    Istalol               13.0      9.5         37 %
                    Vitrase                4.0      3.7          8 %
                    Bepreve                1.2       -          -

                    Product Revenue       73.3     54.8         34 %
                    Other                  3.1      0.2         -

                    Total Net Revenue   $ 76.4   $ 55.0         39 %

Gross margin and cost of products sold. Gross margin for the nine months ended September 30, 2009 was 76% of net revenue, or $57.7 million, as compared to 73% of net revenue, or $40.2 million, for the nine months ended September 30, 2008. Product gross margin was 75% for the nine months ended September 30, 2009, excluding the $2.9 million in previously deferred revenue. The increase in product gross margin for the nine months ended September 30, 2009, as compared to the nine months ended September 30, 2008 is primarily the result of continued increased growth in prescription levels and market share, particularly for Xibrom, our highest gross margin product.

Cost of products sold was $18.6 million for the nine months ended September 30, 2009, as compared to $14.8 million for the nine months ended September 30, 2008. Cost of products sold for the nine months ended September 30, 2009 and 2008 consisted primarily of standard costs for each of our commercial products, distribution costs, royalties, inventory reserves and other costs of products sold. The increase in cost of products sold is primarily the result of increased net product sales.

Research and development expenses. Research and development expenses were $19.6 million for the nine months ended September 30, 2009, as compared to $25.1 million for the nine months ended September 30, 2008. The decrease in research and development expenses for the nine months ended September 30, 2009 was primarily the result of a decrease in clinical development costs, which include clinical investigator fees, study monitoring costs, and data management costs, offset by $3.0 million in milestone payments. Stock-based compensation costs included in research and development expenses were $0.9 million for the nine months ended September 30, 2009, as compared to $0.5 million for the nine months ended September 30, 2008.

For the nine months ended September 30, 2009, approximately 35% of our research and development expenditures were for clinical development costs, 16% were for regulatory costs, 5% were for pharmaceutical development costs, 13% were for manufacturing development costs, 12% were for medical affairs costs, 15% was for both a one time milestone payment ($2.0 million) upon the FDA approval of our Bepreve NDA and a one time milestone payment ($1.0 million) upon the FDA acceptance of our Bepreve NDA and 4% were for stock-based compensation costs.

Changes in our research and development expenses are primarily due to the following:

• Clinical Development Costs - Overall clinical costs, which include clinical investigator fees, study monitoring costs and data management, for the nine months ended September 30, 2009 were $6.9 million as compared to $14.6 million for the nine months ended September 30, 2008. Due to the variation in the initiation, timing and completion of clinical studies, we realized a decrease in our clinical costs of $7.7 million. The nine months ended September 30, 2008 included costs associated with our Xibrom QD once-daily studies, costs associated with our T-Pred studies and costs incurred in support of our Bepreve NDA. The nine months ended September 30, 2009 showed a significant reduction in our clinical costs as the Xibrom QD once-daily studies and the T-Pred studies completed. Additionally, we filed our Bepreve NDA and received approval from the FDA during the nine months ended September 30, 2009.

• Regulatory Costs - Regulatory costs, which include compliance expense for existing products and other activity for pipeline projects, were $3.0 million for the nine months ended September 30, 2009 as compared to $2.6 million for the nine months ended September 30, 2008. The increase of $0.4 million was due primarily to an overall increase in costs associated with the preparation of our NDA filings for both Xibrom QD once-daily and T-Pred, offset by reduced costs in the first quarter of 2008 of $1.0 million due to a partial refund of our NDA filing fee paid in December 2007 for Xibrom (bromfenac sodium 0.18%).

• Pharmaceutical Development Costs - Pharmaceutical development costs, which include costs related to the testing and development of our pipeline products were $1.0 million for both the nine months ended September 30, 2009 and 2008 respectively.

• Manufacturing Development Costs - Manufacturing development costs, which include costs related to production scale-up and validation, raw material qualification, and stability studies, for the nine months ended September 30, 2009 were $2.4 million as compared to $4.4 million for the nine months ended September 30, 2008 or a decrease of $2.0 million. The decrease is primarily attributable to a decrease in outside consulting costs and research related costs such as clinical supplies and stability studies.

• Medical Affairs Costs - Medical affairs costs, which include activities that relate to medical information in support of our products, for the nine months ended September 30, 2009 were $2.4 million as compared to $2.0 million for the nine months ended September 30, 2008, or an increase of $0.4 million. The increase is primarily attributable to an overall increase in outside consulting, continuing medical education and investigator costs.

Selling, general and administrative expenses. Selling, general and administrative expenses were $38.9 million for the nine months ended September 30, 2009, as compared to $40.2 million for the nine months ended September 30, 2008. The $1.3 million decrease primarily results from an overall improvement in expense management. Stock-based compensation costs included in selling, general and administrative expenses were $1.9 million for the nine months ended September 30, 2009, as compared to $2.8 million for the nine months period ended September 30, 2008. Selling, general and administrative expenses are expected to increase as we incur costs associated with launching Bepreve and expanding our sales force.

Stock-based compensation. For the nine months ended September 30, 2009 and 2008, . . .